To set up a scholarship fund for a nonprofit, start by confirming whether the organization is a public charity or a private foundation, then build written eligibility rules, an impartial selection committee, a restricted fund, and grant-making procedures that meet the IRS standards under Section 4945. A public charity can launch its program without asking the IRS for permission first. A private foundation cannot award a single dollar until the IRS approves its procedures on Form 8940.
Confirm Whether You Are a Public Charity or a Private Foundation
This classification shapes almost every decision that follows. A public charity that qualifies under IRC Section 509(a) can design and run a scholarship program on its own authority, provided the procedures are sound and documented.
A private foundation has to file Form 8940, Schedule C, and receive advance approval before making grants to individuals. Any scholarship grant made before that approval is treated as a taxable expenditure under Section 4945, even if the procedures themselves would have qualified.1Internal Revenue Service. Instructions for Form 8940 (Rev. December 2025) The penalty is steep: a 20% initial excise tax on every dollar of the expenditure, a 5% tax on any foundation manager who knowingly approved it, and a 100% additional tax if the problem is not corrected in time.2Office of the Law Revision Counsel. 26 USC 4945 – Taxes on Taxable Expenditures
Your IRS determination letter states which category applies. Pull it before you do anything else.
Write Down Eligibility and Selection Criteria
Specific, measurable rules keep the program defensible. Decide up front whether awards go on academic merit, financial need, field of study, or some mix. Programs aimed at workforce shortages often limit awards to fields like nursing or engineering. Others set a minimum GPA such as 3.0.
If financial need is part of the formula, note that the FAFSA no longer produces an Expected Family Contribution. Starting with the 2024–2025 cycle, the federal government replaced it with the Student Aid Index, which can range from −1,500 to 999,999, with lower numbers indicating greater need.3Federal Student Aid. The Student Aid Index (SAI) Explained You can use the SAI as a benchmark or build your own need formula.
Vague language like “strong community involvement” invites inconsistent scoring and, for a private foundation, threatens the objective-and-nondiscriminatory standard the IRS demands. Every scholarship run by a tax-exempt organization must also be administered on a racially nondiscriminatory basis, and your application, brochures, and advertising should include a statement to that effect. Publicize the award broadly enough to reach the community you serve, not just people you already know.
Assemble an Impartial Selection Committee
Three to seven members with relevant expertise is a workable size. The Treasury regulations set a clear benchmark: committee members should not be in a position to benefit personally if one applicant is chosen over another.4eCFR. 26 CFR 53.4945-4 – Grants to Individuals IRS examples of acceptable committees describe members with no connection to the funding organization beyond serving on the committee itself.
In practice, that means no family members in the applicant pool, no employees of a company that funded the scholarship, no one who stands to gain professionally from the outcome. The nonprofit’s board should formally approve the committee’s composition and the scoring rubric it will use.
Self-Dealing Rules for Private Foundations
Private foundations face extra restrictions around “disqualified persons,” which include foundation managers, substantial contributors, and their family members. Family is defined broadly, covering spouses, ancestors, and lineal descendants.5Internal Revenue Service. IRC Section 4946 – Definition of Disqualified Person Awarding a scholarship to any of them can trigger self-dealing taxes under Section 4941. Many foundations adopt blanket policies against awards to anyone related to officers, directors, or major donors.
Build the Application and Supporting Documentation
Collect what the committee actually needs to score, and nothing more. A typical application asks for transcripts, one or two letters of recommendation, and a personal statement. If you use financial need, you can ask applicants to self-report their SAI or send in a copy of their Student Aid Report.
Schools that receive federal funding must comply with FERPA, which generally bars them from releasing grades, financial aid records, and similar information to third parties without written consent.6U.S. Department of Education. Frequently Asked Questions The simplest path is to have applicants send in their own transcripts. If you need to verify anything with the school, include a release authorization in the application packet.
Write a scholarship policy manual that spells out maximum award amounts, deadlines, eligibility rules, renewal conditions (such as maintaining full-time enrollment), and how personal data is handled. This is your reference during the cycle and your evidence of consistent administration if the IRS ever asks.
Set Up the Fund and Decide Who Administers It
Scholarship money belongs in a restricted fund inside your accounting system, separate from general operating dollars. Create a dedicated ledger account for donations earmarked for scholarships and for outgoing payments to recipients or their institutions. This is both good accounting and a trust obligation to donors who gave for that purpose.
A smaller nonprofit without the staff to run the program in-house can partner with a community foundation, which handles application processing, selection, and fund management for an annual administrative fee that typically runs around 1% of the fund balance. You give up some control over selection in exchange for professional infrastructure.
Handle Donor Deductibility Carefully
Contributions to a 501(c)(3) scholarship fund are generally tax-deductible, but a donor cannot earmark a gift for a specific individual and still claim the deduction. The IRS is explicit that contributions made to a qualified organization for the benefit of a specific person are not deductible.7Internal Revenue Service. Publication 526, Charitable Contributions The same principle applies when a contribution functions as a substitute for tuition.
Put a written policy in place stating that all donations flow into the general scholarship pool and that the selection committee — not the donor — decides who receives awards. Communicate this before donors give.
Select Winners and Send the Money to the School
After the application window closes, have each committee member score candidates independently using the rubric before the group meets to discuss. Keep the scoring records. They demonstrate that the process was competitive and objective, which is exactly what an IRS examiner or an unhappy applicant will want to see.
Send payment directly to the educational institution’s bursar office rather than to the student. Direct disbursement keeps the funds tied to qualified educational expenses and simplifies the recipient’s tax picture. Confirm enrollment before issuing payment. A formal award letter should state the amount, permitted uses, any renewal requirements, and reporting obligations. Notify unsuccessful applicants too.
What Recipients Owe Tax On
Scholarship dollars used for tuition, required fees, books, supplies, and equipment required for coursework are excluded from the recipient’s gross income, provided the recipient is a degree candidate at an eligible educational institution.8Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships The exclusion does not cover room and board, travel, or equipment that is not required for enrollment.9Internal Revenue Service. Publication 970 (2025), Tax Benefits for Education Any portion spent on those expenses is taxable to the student.
This shapes how you might structure the award. Many nonprofits limit scholarships to tuition and required fees, or send funds straight to the tuition account, to keep the recipient out of taxable territory.
Does the nonprofit issue a 1099? No. The IRS instructions for Forms 1099-MISC and 1099-NEC state that scholarship and fellowship grants should not be reported on those forms.10Internal Revenue Service. Instructions for Forms 1099-MISC and 1099-NEC Any taxable portion is the student’s responsibility to report. Scholarship payments conditioned on the recipient performing services (such as teaching) are treated as wages and reported on a W-2, but that rarely applies to a standard nonprofit scholarship.
IRS Reporting and Recordkeeping
Report scholarship grants on Form 990, Schedule I. The obligation to complete Part III is triggered when total grants to domestic individuals exceed $5,000 in aggregate for the tax year, not per recipient.11Internal Revenue Service. Instructions for Schedule I (Form 990) (Rev. December 2024) You report each type of grant, the number of recipients, and the total dollar amount. Individual recipients are not listed by name on Schedule I.12Internal Revenue Service. About Form 990, Return of Organization Exempt from Income Tax
Keep internal records of every application, every score sheet, every award letter, and every disbursement. General IRS guidance calls for retaining documents at least three years from the date the return is filed, though many nonprofit advisors keep grant records longer. Private foundations subject to Chapter 42 excise taxes should be especially conservative, since the statute of limitations on those taxes can extend well beyond three years if the IRS argues a return was materially incomplete.
Extra Rules for Private Foundations
Every scholarship grant by a private foundation is presumed to be a taxable expenditure unless the foundation has obtained advance IRS approval of its procedures through Form 8940.1Internal Revenue Service. Instructions for Form 8940 (Rev. December 2025) Approval remains effective as long as the foundation makes no material changes to its process. If the IRS notifies you that your procedures are unacceptable, any grants made after that notification are taxable expenditures regardless of intent. Given the penalty structure under Section 4945, most private foundations work with legal counsel before launching a scholarship program.