How Do You Create a Scholarship? Steps, Selection Rules, and Taxes

To create a scholarship, you choose a legal structure to hold the money, get the IRS to recognize the entity and approve your grant-making procedures, write objective selection criteria, put an independent committee in charge of picking recipients, and pay awards directly to the school. The step most first-time founders miss is advance IRS approval of the selection process: without it, every grant a private foundation makes is automatically a taxable expenditure, triggering a 20 percent excise tax that can rise to 100 percent if left uncorrected.¹

Pick Where the Fund Will Live

Three structures are common, and the right one depends on how much control you want against how much administrative work you’ll accept.

A private foundation gives you the most control. You decide who reviews applications, how assets are invested, and who gets funded. In exchange, you take on annual tax filings, a minimum payout requirement, and an excise tax on investment income. This route makes sense if you plan to fund scholarships over many years and want to run the operation yourself.

A donor-advised fund at a community foundation lets you contribute assets and recommend how awards are distributed. The community foundation handles reporting, investments, and compliance. You give up direct control for simplicity. Many community foundations charge around 1 percent of the fund balance annually, sometimes with a separate investment fee.²

Working directly with a university development office is the simplest path if you want to support students at one specific school. The university manages the investment, runs selection through its financial aid framework, and keeps the fund compliant. Most schools require a minimum contribution to establish a named endowed fund, and those minimums can be substantial at larger institutions.

Get 501(c)(3) Recognition

If you go the private foundation route, the entity needs IRS recognition as tax-exempt under Section 501(c)(3). That means Form 1023, with a $600 user fee.³ The application asks you to describe planned activities, governance, finances, and grant-making procedures in detail.

Smaller organizations may qualify for the streamlined Form 1023-EZ at $275, but only if projected annual gross receipts stay at or below $50,000 for each of the next three years and total assets stay under $250,000.⁴ Most scholarship foundations with a meaningful endowment cross those thresholds and need the full Form 1023.

Plan on roughly six months of processing time. As of early 2026, the IRS issues 80 percent of Form 1023 determinations within 191 days.⁵ Once approved, the foundation files Form 990-PF each year by the 15th day of the fifth month after its fiscal year ends.⁶

Get Advance IRS Approval of Your Grant Procedures

This is the compliance step that causes the most trouble because people don’t know it exists. Before a private foundation makes a single scholarship award, it has to submit its grant-making procedures to the IRS for advance approval.⁷ Without it, every grant is a taxable expenditure by default.

The submission has to show three things: the procedure awards grants on an objective and nondiscriminatory basis, it’s reasonably designed to ensure recipients use the money for its intended purpose, and the foundation will supervise grants to confirm students meet the terms.⁷ If you’re already filing Form 1023, you can include grant procedures there on Schedule H. Otherwise, the IRS uses Form 8940 for standalone requests.

If awards go out before approval, the foundation can cure the problem retroactively by getting the procedures approved and showing no grant funds were diverted. The IRS may still impose additional requirements, like quarterly reporting or restrictions on future grants to the same recipients.⁸

Write Criteria That Define a Real Charitable Class

Recipients have to come from a group broad enough to constitute a “charitable class.” The applicant pool must be selected on criteria reasonably related to the scholarship’s purpose, and the group has to be large enough that awarding a grant genuinely serves a charitable goal rather than benefiting a pre-selected individual.⁹ Define eligibility so narrowly that only a handful of people could ever qualify, and the IRS may treat the awards as private gifts rather than scholarships.

Start with a mission statement that describes the scholarship’s purpose and the qualities you’re looking for. Build eligibility around that mission: minimum GPA, a particular field of study, financial need, community involvement, or some combination. Need-based awards typically require applicants to complete the FAFSA. The application should let students demonstrate they meet the criteria through an essay, activity list, recommendation letters, or transcripts.

The criteria go into a formal Scholarship Agreement or Memorandum of Understanding with the foundation or university. That document specifies the award amount, whether the scholarship is renewable, and whether the fund is endowed (only investment returns are spent each year) or expendable (full principal is distributed). Read the terms carefully. The IRS will hold the foundation to whatever is documented.

For multi-year awards, build in renewal requirements. Federal financial aid rules require satisfactory academic progress, generally a minimum 2.0 cumulative GPA and completion of at least two-thirds of attempted credits. Your scholarship can set a higher bar, but including some academic check protects the foundation from funding students who are no longer actively pursuing a degree.

Put an Independent Committee in Charge of Selection

The people who choose recipients cannot be in a position to benefit personally from selecting one applicant over another.⁹ In practice, committee members should be independent from the foundation’s donors and managers.

Employer-related scholarship programs, where a company funds scholarships for employees’ children, face tighter rules. The selection committee must consist entirely of individuals independent from the foundation, its creator, and the employer. Former employees of either the foundation or the employer don’t qualify as independent.¹⁰ These programs also have to pass a percentage test each year: recipients cannot exceed 25 percent of eligible applicants considered by the committee, or 10 percent of all eligible individuals whether they applied or not.¹¹

Give the committee a scoring rubric tied to your published criteria. Consistent scoring creates the paper trail showing each decision was based on merit.

Keep Family and Insiders Out of the Awards

Federal law limits transactions between a private foundation and its “disqualified persons,” which include substantial contributors, officers, directors, trustees, their family (spouses, children, grandchildren, great-grandchildren, and those descendants’ spouses), and entities where those individuals hold significant ownership.¹²

Awarding a scholarship directly to a disqualified person is self-dealing under Section 4941, which triggers a 10 percent tax on the disqualified person for each year the violation continues.¹³ If you fund a foundation, your own children, grandchildren, and their spouses cannot receive its scholarships.

Employer-related programs get a narrow carve-out. A scholarship to the child of a company employee (where the child is not a disqualified person) isn’t self-dealing merely because a disqualified person, such as the company owner who funded the foundation, gets an incidental benefit. The grant still has to qualify under Section 501(c)(3), support deductible contributions, and satisfy the Section 4945(g) procedures.¹⁴

Award and Pay the Scholarship

Once the entity is formed, tax-exempt status is granted, and the IRS has approved the grant procedures, the operating steps move quickly. The donor signs the agreement with the foundation or university and transfers initial funding by wire, securities, or check. The managing institution assigns an account number to track future contributions and earnings.

The opportunity gets publicized to relevant schools or departments to draw a wide applicant pool. After the deadline, the committee reviews submissions against the rubric and picks a recipient. The committee issues a grant award letter spelling out the terms and any renewal requirements.

Send the money directly to the university bursar rather than to the student. Direct payment keeps the funds tied to tuition, fees, and other qualified educational expenses, which keeps the award tax-free for the recipient.¹⁵ From opening applications to disbursement, the full cycle often runs eight to ten months; a December application window can mean funds don’t reach the bursar until August.

Stay Compliant Year to Year

A private foundation is not a set-and-forget project. Every year, it has to distribute roughly 5 percent of its average net investment assets as qualifying distributions, which includes scholarship grants and reasonable administrative expenses (but not investment management fees). Fall short and the foundation owes a 30 percent tax on the undistributed amount, escalating to 100 percent if the shortfall isn’t corrected in time.¹⁶ Excess distributions in one year can be carried forward for up to five years.

Foundations also pay a 1.39 percent excise tax on net investment income each year, which counts toward the minimum distribution.¹⁷

Form 990-PF is due by the 15th day of the fifth month after year-end. Late filing without reasonable cause runs $25 per day up to $13,000, or up to $65,000 for foundations with gross receipts above roughly $1.3 million.⁶ Keep records for each recipient, including name, address, award amount, and how funds were used; the Form 1023 instructions require adequate case histories for every individual grant.¹⁸ Retain those records for at least three years after the final financial report for the relevant period, longer if any audit or litigation is pending.

What Donors Can Deduct

How much of a contribution is deductible depends on the type of organization and the type of asset. The limits are expressed as a percentage of adjusted gross income.

Cash to a public charity or university: up to 60 percent of AGI.
Cash to a private foundation: up to 30 percent of AGI.
Appreciated stock or other capital gain property to a public charity: up to 30 percent of AGI.
Appreciated stock to a private foundation: up to 20 percent of AGI.

Contributions above the applicable limit in a given year can be carried forward for up to five additional tax years.¹⁹ These limits are one reason donor-advised funds and university endowments often work out more tax-efficient for donors than private foundations. A $100,000 cash gift to a university is deductible up to 60 percent of AGI; the same gift to your own private foundation caps at 30 percent.

What Recipients Owe Tax On

A scholarship is excluded from a student’s gross income only to the extent it’s used for qualified tuition and related expenses: tuition, fees, and required books, supplies, and equipment. The student has to be a degree candidate at an eligible educational institution.¹⁵

Scholarship money used for room, board, travel, or optional equipment is taxable. So are amounts received as payment for teaching or research required as a condition of the award, with narrow exceptions for certain military and National Health Service Corps programs.²⁰ This is why well-structured funds pay the bursar directly for tuition and fees rather than cutting checks to students. It keeps the money clearly on the tax-free side. Foundation administrators should flag these rules for recipients in the award letter.

What Happens if You Skip a Step

The penalty structure is steep enough to warrant a clear summary. If a scholarship grant doesn’t satisfy Section 4945, the foundation pays an initial 20 percent tax on the grant amount. A foundation manager who knowingly approved the expenditure owes 5 percent personally. If the problem isn’t corrected before the IRS issues a notice of deficiency or assesses the tax, the foundation-level penalty escalates to 100 percent, and any manager who refused to participate in correction owes 50 percent.¹

Correction generally means recovering the misspent funds if possible. When full recovery isn’t practical, the IRS may require additional steps like withholding unpaid grant installments, barring future grants to the same recipient, or imposing quarterly reporting on all foundation expenditures.⁸ Self-dealing violations under Section 4941 carry their own layer: 10 percent per year on the disqualified person, rising to 200 percent if uncorrected.¹³

Most of these problems are avoidable. Get the advance approval. Staff the committee with independent members. Document every decision. Keep disqualified persons away from the awards. Foundations that run into trouble almost always skipped one of those four steps.

1
Office of the Law Revision Counsel. 26 USC 4945 Taxes on Taxable Expenditures
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Council on Foundations. Administrative Fees
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Internal Revenue Service. Form 1023 and 1023-EZ Amount of User Fee
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Internal Revenue Service. Instructions for Form 1023-EZ
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Internal Revenue Service. Where’s My Application for Tax-Exempt Status
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Internal Revenue Service. 2025 Instructions for Form 990-PF
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Internal Revenue Service. Advance Approval of Grant-Making Procedures
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eCFR. 26 CFR 53.4945-1 Taxes on Taxable Expenditures
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eCFR. 26 CFR 53.4945-4 Grants to Individuals
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Internal Revenue Service. IRC 4945 Scholarship Grants to Individuals
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Internal Revenue Service. Taxable Expenditures by Private Foundations Percentage Test
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Office of the Law Revision Counsel. 26 U.S. Code 4946 Definitions and Special Rules
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Office of the Law Revision Counsel. 26 USC 4941 Taxes on Self-Dealing
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eCFR. 26 CFR 53.4941(d)-2 Specific Acts of Self-Dealing
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Office of the Law Revision Counsel. 26 USC 117 Qualified Scholarships
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Office of the Law Revision Counsel. 26 USC 4942 Taxes on Failure to Distribute Income
17
Office of the Law Revision Counsel. 26 U.S. Code 4940 Excise Tax Based on Investment Income
18
Internal Revenue Service. Instructions for Form 1023
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Internal Revenue Service. Publication 526 Charitable Contributions
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Internal Revenue Service. Topic No. 421 Scholarships, Fellowship Grants, and Other Grants