Can a 501(c)(3) Give Scholarships? IRS Rules and Approval

Yes, a 501(c)(3) can give scholarships, and awarding them fits squarely within the educational purpose that qualifies an organization for tax-exempt status. The rules you have to follow depend on whether your organization is classified as a public charity or a private foundation. Public charities can run a scholarship program as long as they use objective criteria and keep good records. Private foundations have to get their grant procedures approved by the IRS before writing the first check.

Public Charity or Private Foundation Changes Everything

Every 501(c)(3) is classified as one or the other, and the IRS applies different standards to each. This is the first thing to confirm before you design a program.

Public charities have more flexibility. They need written procedures, objective selection criteria, and detailed case histories for every grant, including the recipient’s name and address, the purpose of the grant, how the recipient was selected, and any relationship between the recipient and the organization’s officers, trustees, or substantial donors.¹ They do not have to clear their scholarship procedures with the IRS in advance.

Private foundations do. Under federal tax law, a scholarship a private foundation awards to an individual is treated as a “taxable expenditure” unless the foundation follows grant procedures that the IRS has approved in advance.² Taxable expenditures trigger excise taxes on both the foundation and the managers who approved them.

How a Private Foundation Gets Advance Approval

Section 4945(g) of the Internal Revenue Code exempts a scholarship from taxable-expenditure treatment only when it is “awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance” by the IRS.² A foundation requests that approval by filing Form 8940 (Request for Miscellaneous Determination) and completing Schedule C. Organizations that got their 501(c)(3) status through the streamlined Form 1023-EZ have to file Form 8940 separately for scholarship approval.³

The application has to show three things:

The selection procedure uses objective, nondiscriminatory criteria.
The procedure is reasonably designed to make sure recipients actually use the funds for the intended educational purpose.
The foundation will collect reports verifying that grantees are using the money as intended.⁴

Don’t award any scholarships until the determination letter arrives. The whole point of the rule is that approval has to come first.

What Any Compliant Program Needs

Whether you’re a public charity or a private foundation, three features show up in every defensible scholarship program.

Written Criteria That Mean Something

Eligibility rules have to be specific enough to apply consistently. “Academic merit” is vague. “Minimum 3.0 GPA and enrollment in an accredited four-year institution” is something a selection committee can actually apply the same way to every applicant. Spell out what applicants have to submit, whether that’s transcripts, personal statements, or recommendation letters, and apply the standard uniformly.

An Independent Selection Committee

The people picking recipients should not have a personal stake in who wins. For private foundations, IRS regulations explicitly require that the selection committee be independent from the foundation, its organizers, and any related employer.⁵ Public charities aren’t held to the same formal standard, but using an independent committee is the safest practice. When donors or board members pick recipients, questions about private benefit follow.

Case Histories for Every Grant

Public charities must keep case histories documenting the recipient’s name and address, the purpose of each grant, how the recipient was selected, and any relationship between the recipient and the organization’s insiders.¹ Private foundations keep the same records plus documentation that each award followed their IRS-approved procedures. Hold applications, committee notes, and financial records for at least three years after the related return is filed.

Employer-Related Programs

Private foundations set up by a company to award scholarships to employees’ children face additional scrutiny. The obvious concern is a company dressing up compensation as charity. Under Revenue Procedure 76-47, an employer-related program is acceptable if it meets one of two tests:

The number of scholarships awarded in a year does not exceed 25% of the eligible employees’ children who applied and were considered by the selection committee, or
The number does not exceed 10% of all eligible employees’ children, whether or not they applied.⁶

Blow past those caps and the IRS can treat the awards as compensation rather than charitable grants.

Who Can’t Receive a Scholarship

A 501(c)(3) scholarship cannot funnel benefits to the organization’s insiders. For private foundations, federal law defines a category of “disqualified persons” who face restrictions. This includes substantial contributors, foundation managers, owners of more than 20% of any entity that is a substantial contributor, and family members of all of the above. “Family” covers spouses, ancestors, children, grandchildren, great-grandchildren, and their spouses.⁷

Awarding a scholarship to a disqualified person isn’t automatically prohibited, but it draws scrutiny. The award has to come through the same objective process as every other grant, and the recipient has to qualify as a member of the broader class the program serves.

Public charities face a parallel “private benefit” doctrine. The principle is the same: the program must serve a public purpose, not channel money to people connected to the organization. A program where the founder’s child happens to qualify under genuinely objective criteria is defensible. A program whose criteria appear designed so that only the founder’s child qualifies is not.

Tax Treatment for the Recipient

Applicants often ask whether a scholarship is taxable, so it helps to know the answer. Under Section 117 of the Internal Revenue Code, a “qualified scholarship” is excluded from gross income when the recipient is a degree candidate at an eligible educational institution and uses the funds for qualified tuition and related expenses.⁸ Qualified expenses are tuition and fees required for enrollment and the books, supplies, and equipment required for courses.

Scholarship funds used for room and board, travel, or other living expenses are taxable to the recipient. So is any portion that represents payment for teaching, research, or other required services.⁸ Recipients report any taxable portion on their own return. An awarding organization that is not itself an eligible educational institution generally has no obligation to issue a tax form to the recipient for qualified educational expenses.

Reporting Scholarships on Form 990

The organization’s main reporting obligation runs through its annual Form 990. Scholarship awards to individuals are reported on Schedule I, Grants and Other Assistance to Domestic Individuals. You complete Part III of Schedule I if the organization reported more than $5,000 in total grants to individuals on Form 990, Part IX, line 2.⁹

You do not list recipients by name on Schedule I. Instead, you group assistance by type, such as “need-based scholarships” or “merit scholarships,” and report the number of recipients and the aggregate dollar amount for each category.⁹ If any grants went to someone with a relationship to the organization’s officers, trustees, or donors, that relationship has to be documented in your records and may need to be disclosed on Schedule L.¹⁰

What Happens If You Get It Wrong

A private foundation that awards scholarships without following IRS-approved procedures owes an initial excise tax of 20% of the non-compliant grant. Any foundation manager who knowingly approved the expenditure personally owes 5%. If the problem isn’t corrected within the allowed time, the foundation owes an additional 100% of the expenditure, and a manager who refuses to help correct it owes 50%.² On a $50,000 scholarship, that is a $10,000 initial tax that can balloon to $50,000. A manager’s personal exposure starts at $2,500 and can hit $25,000.

Monitoring Funds After the Award

Writing the check is not the end of the organization’s obligations. Both public charities and private foundations should have systems to verify that funds are used for their intended purpose. Private foundations operating under IRS-approved procedures typically must collect annual progress reports from recipients plus a final report at the end of the scholarship period.

If you discover a recipient diverted funds to non-educational purposes, you have to investigate, take reasonable steps to recover the diverted money, and withhold any future payments until the recipient gives assurance that the remaining funds will be used properly. Ignoring a known diversion can cost a foundation its advance approval and expose it to the taxable-expenditure penalties above.

1
Internal Revenue Service. Publication 4221-PC – Compliance Guide for 501(c)(3) Public Charities
2
Office of the Law Revision Counsel. 26 USC 4945 – Taxes on Taxable Expenditures
3
Internal Revenue Service. Instructions for Form 8940 – Request for Miscellaneous Determination
4
eCFR. 26 CFR 53.4945-4 – Grants to Individuals
5
Internal Revenue Service. Company Scholarship Programs
6
IRS.gov. Rev. Proc. 76-47
7
Office of the Law Revision Counsel. 26 U.S. Code 4946 – Definitions and Special Rules
8
Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
9
Internal Revenue Service. Instructions for Schedule I (Form 990)
10
Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Part VI and Schedule L: Scholarships