501(c)(3) Scholarship Rules: Selection, Approval, and Reporting

A 501(c)(3) organization can run a scholarship program, but the 501(c)(3) scholarship rules require that recipients be chosen through objective procedures, that grants pay only for qualified educational expenses at eligible schools, and — if the sponsor is a private foundation — that the IRS approve the grant-making procedures before the first award goes out. Public charities have more room to operate without pre-clearance. Private foundations do not: every individual scholarship is a potential “taxable expenditure” under Internal Revenue Code Section 4945 unless the foundation follows advance-approved procedures and confirms the money reaches qualified educational costs.¹ Across both categories, the money has to serve a genuine charitable purpose and cannot function as disguised compensation or a channel for private benefit.

What the Money Can Pay For

IRC Section 117 defines the expenses a recipient can exclude from gross income. Pay for anything outside that definition and the recipient owes tax on that portion, and the grant may no longer serve an exempt purpose.² The qualified category is narrower than most program designers expect.

Tuition and fees required for enrollment or attendance at an eligible educational institution.
Books, supplies, and equipment required for courses of instruction — not general living supplies or optional purchases.

Everything else falls outside the definition. Room and board, travel, and personal living costs are not qualified expenses, even when the student incurs them because of enrollment. The statute simply does not list them, so scholarship money spent on those items becomes taxable income to the recipient.²

Section 117(c) adds a separate limit: any portion of a scholarship paid as compensation for teaching, research, or other services the student must perform as a condition of the grant is not a qualified scholarship.³ A scholarship funding a student’s tuition while they independently pursue a research topic remains qualified. A scholarship conditioned on the student working as a lab research assistant does not; that payment looks more like wages.

The “eligible educational institution” language in Section 117 references Section 170(b)(1)(A)(ii), which generally covers accredited schools that maintain a regular faculty, curriculum, and enrolled student body. Community colleges, four-year universities, and accredited trade schools all qualify. Before disbursing funds to a student attending an unaccredited program, verify the institution’s status.

Objective Selection and an Independent Committee

Every 501(c)(3) scholarship program needs written selection criteria applied consistently to every applicant. The IRS wants tax-exempt funds to flow to people who qualify on the merits, not to insiders. Criteria should rest on factors like academic achievement, financial need, or pursuit of a particular field of study. Geographic restrictions are permissible when they serve a broad charitable class rather than a handful of connected individuals.

An independent selection committee reviews applications and chooses recipients. Independence is the linchpin. The people choosing recipients cannot be the same people — or related to the people — who control or funded the organization.⁴ The IRS looks at whether committee members are in a position to exercise “substantial influence” over the organization’s affairs. Family members of anyone who holds substantial influence are also disqualified, as are entities those individuals control.⁵

In practice, no committee member should vote on an application from their own child, a relative, or the child of an organization officer. Document the committee’s composition and confirm its independence each grant cycle. A committee that looks independent on paper but operates under the influence of a major donor will not survive an IRS review of the foundation’s system of standards and procedures.⁶

Advance Approval for Private Foundations

Public charities can generally launch scholarship programs without pre-clearance. Private foundations cannot. Before awarding the first grant, a private foundation must obtain IRS advance approval of its grant-making procedures. Without it, every individual grant is automatically treated as a taxable expenditure under Section 4945(d)(3), no matter how well the program runs.⁷

The foundation requests approval by showing three things:

The program awards grants on an objective and nondiscriminatory basis.
The procedures are designed to ensure grantees actually use the funds for the intended purpose.
The foundation will supervise grants to verify recipients fulfill the terms.⁶

Approval is a one-time event. Once the IRS blesses your system of standards and procedures, it carries forward to future programs as long as those procedures do not change in any material way.⁶ The foundation files Form 8940 with a user fee that the IRS updates annually in its Revenue Procedure; the current amount is available at IRS.gov or by calling 877-829-5500.⁸

Skipping this step is one of the most expensive mistakes a private foundation can make. The 20% excise tax under Section 4945(a) applies to every dollar of every grant awarded without approved procedures, and foundation managers who knowingly approved those grants face their own personal tax.⁹

Extra Rules for Employer-Related Programs

Scholarships that benefit employees of a particular company or their children draw the closest IRS scrutiny. If an employer funds a foundation that hands scholarships to its workers’ kids, it can look less like charity than like a tax-free fringe benefit. To avoid classification as taxable expenditures, these programs must satisfy the special requirements in Revenue Procedure 76-47.¹⁰

The Percentage Test

The program must cap how many employee-connected recipients it awards each year. The IRS applies two alternative limits, and the foundation picks whichever is more favorable:

Grants cannot go to more than 25% of the employees’ children who were eligible, applied, and were actually considered by the selection committee that year.
Grants cannot go to more than 10% of the employees’ children who can be shown to be eligible, whether or not they applied.¹¹

When a program combines scholarships and educational loans for the same eligible pool, the percentage tests apply to the total number of individuals receiving any type of grant.¹¹ Failing the test reclassifies the grants as taxable expenditures.

Independence from the Employer

The selection committee for an employer-related program must be independent of both the foundation and the employer. No committee member can have the power to determine employees’ compensation. Criteria must focus on the applicant’s individual merit or need, not the parent’s job title, seniority, or years of service. The employer should receive no benefit from the program, and the scholarship cannot function as an inducement to keep the employee at the company.⁴ The grant decision has to sit apart from the employment relationship.

Records and Reporting

Thorough records protect the organization during an IRS examination. A 501(c)(3) scholarship program should keep, at minimum:

The written selection criteria and any updates over time.
Committee meeting minutes, including the rationale for each recipient chosen.
Documentation of each committee member’s independence from the organization and its donors.
Proof of enrollment at an eligible educational institution for every recipient.
Verification that funds were spent on qualified expenses, through direct payment to the school, receipts, or grantee expense reports.

Private foundations must go further. Individual grant files should include names, addresses, the purpose of each grant, how the recipient was selected, and any relationship the recipient has to the organization’s officers, trustees, or donors.¹⁰

On the annual return, most 501(c)(3) organizations report scholarship activity on Form 990 with Schedule I, which covers grants and assistance to individuals in the United States. Schedule I asks for a specific description of each type of assistance — “scholarships for students attending a particular school,” for example, rather than a vague label like “educational” — and it asks whether the organization keeps records substantiating grant amounts, recipient eligibility, and selection criteria. A narrative on how the organization monitors proper use of funds is required.¹²

Private foundations file Form 990-PF instead. It requires a full accounting of grants awarded during the year at the individual level, not just aggregate totals. Both filings are public.

What Goes Wrong: Excise Taxes and Loss of Status

The penalty structure for private foundations that make improper scholarship grants is steep enough to threaten a small foundation’s existence. Section 4945(a) imposes a first-tier excise tax of 20% on the amount of each taxable expenditure.¹ A foundation manager who knowingly approved the expenditure faces a separate personal tax.

In the scholarship context, a “taxable expenditure” usually comes from one of two failures: the foundation awarded grants without advance-approved procedures, or it did not properly supervise how recipients used the money. The foundation is responsible for making reasonable efforts to confirm grants are spent as intended, obtaining complete reports from grantees, and filing detailed reports with the IRS.¹³

If the foundation does not correct the problem after the first-tier tax is assessed, a much larger second-tier tax applies. Beyond excise taxes, repeated or egregious violations can lead the IRS to revoke the organization’s 501(c)(3) status entirely, an outcome that is extraordinarily difficult to reverse and ends the ability to receive tax-deductible contributions.

A Note on International Students

Awarding a scholarship to a nonresident alien student pulls in a separate set of federal withholding rules. The default withholding rate on taxable U.S.-sourced scholarship income paid to a nonresident alien is 30%, dropping to 14% (or lower under a tax treaty) for students in the U.S. on F, J, M, or Q visas when the taxable amounts are tied to a qualified scholarship under Section 117(a).¹⁴ Payments are reported on Form 1042-S.¹⁵ If your program plans to fund international students, treat withholding and 1042-S filing as a distinct compliance track and build time for it before the first payment.

1
Office of the Law Revision Counsel. 26 U.S. Code 4945 – Taxes on Taxable Expenditures
2
Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
3
Office of the Law Revision Counsel. 26 U.S. Code 117 – Qualified Scholarships
4
Internal Revenue Service. Company Scholarship Programs
5
Internal Revenue Service. Disqualified Person – Intermediate Sanctions
6
Internal Revenue Service. Advance Approval of Grant-Making Procedures
7
eCFR. 26 CFR 53.4945-4 – Grants to Individuals
8
Internal Revenue Service. Instructions for Form 8940
9
Office of the Law Revision Counsel. 26 USC 4945 – Taxes on Taxable Expenditures
10
Internal Revenue Service. Publication 4221-PF – Compliance Guide for 501(c)(3) Private Foundations
11
Internal Revenue Service. Taxable Expenditures by Private Foundations – Percentage Test – Employer-Related Educational Loans to Children of Employees
12
Internal Revenue Service. Instructions for Schedule I (Form 990)
13
Internal Revenue Service. IRC Section 4945(h) – Expenditure Responsibility
14
Internal Revenue Service. Withholding Federal Income Tax on Scholarships, Fellowships and Grants Paid to Nonresident Aliens
15
Internal Revenue Service. Instructions for Form 1042-S