The IRS guidelines for starting a scholarship fund center on a sequence of decisions and filings: choosing whether the fund will operate as a public charity or a private foundation, drafting governing documents with the specific language Section 501(c)(3) requires, applying for tax-exempt status on Form 1023 or Form 1023-EZ within 27 months of formation, awarding scholarships through an objective and nondiscriminatory process, and filing an annual information return every year to keep the exemption alive. Each piece has its own rules, and the choices you make early shape your compliance load for the life of the fund.
Public Charity or Private Foundation
Every 501(c)(3) is one or the other, and the classification drives donor deduction limits, operating rules, and how much the IRS will watch you.
A public charity draws a substantial share of its support from the general public, government sources, or other publicly supported organizations rather than from a small group of donors.1Internal Revenue Service. Publicly Supported Charities The IRS measures this through a public support test over a five-year period, with the organization generally needing more than one-third of its total support from public sources.2Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Schedules A and B: Public Charity Support Test Donors to a public charity can generally deduct cash gifts up to 50 percent of their adjusted gross income, with lower limits for appreciated property, and carry forward any excess for up to five years.3Internal Revenue Service. Charitable Contribution Deductions
If your fund will be supported primarily by one family, individual, or company, the IRS will almost certainly classify it as a private foundation. Cash deduction limits for donors drop to 30 percent of adjusted gross income, and gifts of long-term appreciated property top out at 20 percent.3Internal Revenue Service. Charitable Contribution Deductions4Office of the Law Revision Counsel. 26 U.S. Code 4942 – Taxes on Failure to Distribute Income5Internal Revenue Service. Taxes on Failure to Distribute Income – Private Foundations Private foundations also face tight self-dealing rules and must obtain advance IRS approval of their scholarship procedures before awarding a single grant.
Nonprofit Corporation or Charitable Trust
Within either classification, the fund usually takes one of two legal forms. A nonprofit corporation is run by a board of directors and gives those directors limited liability protection. A charitable trust is governed by trustees under a trust agreement; it can be simpler to establish but tends to be harder to amend as the fund grows. Most scholarship funds incorporate because of the liability shield and the easier path to changing bylaws later.
What Your Governing Documents Must Say
The IRS reads your articles of incorporation (or trust agreement) and bylaws as a threshold test. Vague or missing language is the most common reason applications stall.
The purpose clause has to state clearly that the organization exists exclusively for charitable and educational purposes as described in Section 501(c)(3).6Internal Revenue Service. Exemption Requirements – 501(c)(3) Organizations A general statement about “helping students” is not enough. The language should specifically describe providing scholarships for educational purposes at qualifying institutions.
The dissolution clause has to state that if the fund ever winds up, remaining assets go to another 501(c)(3) organization or to a federal, state, or local government for a public purpose.7Internal Revenue Service. Does the Organizing Document Contain the Dissolution Provision Required Under Section 501(c)(3) or Does State Law Satisfy the Requirement? Assets cannot revert to founders, board members, or any private individual. Some state laws accomplish this by default, but writing it in avoids ambiguity.
Two prohibitions also have to appear. No part of the organization’s net earnings can benefit any private individual or insider, a concept the IRS calls private inurement.8Office of the Law Revision Counsel. 26 U.S. Code 501 – Exemption From Tax on Corporations, Certain Trusts, Etc. And the fund cannot participate in political campaigns for or against candidates, with lobbying activity kept substantially limited.6Internal Revenue Service. Exemption Requirements – 501(c)(3) Organizations
All of these documents need to be signed, dated, and formally adopted by the initial board or trustees before you file the exemption application.
Applying for Tax-Exempt Status
You need an Employer Identification Number first. Apply online through the IRS or file Form SS-4; the online application returns the EIN immediately.9Internal Revenue Service. About Form SS-4, Application for Employer Identification Number (EIN)
Form 1023 or Form 1023-EZ
The standard application is Form 1023. It is comprehensive and asks for detailed descriptions of your planned activities, financial projections, officer information, compensation arrangements, and copies of your governing documents.10Internal Revenue Service. About Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code
A streamlined Form 1023-EZ is available for smaller organizations. To qualify, your projected annual gross receipts cannot exceed $50,000 in any of the next three years, and your total assets cannot exceed $250,000. You must complete the eligibility worksheet in the instructions before filing; if you don’t meet the thresholds, you have to file the full Form 1023.11Internal Revenue Service. Instructions for Form 1023-EZ
Both forms must be submitted electronically through Pay.gov.12Internal Revenue Service. Applying for Tax Exempt Status The user fee is $600 for Form 1023 and $275 for Form 1023-EZ, non-refundable, paid at filing.13Internal Revenue Service. Form 1023 and 1023-EZ: Amount of User Fee Review of a full Form 1023 typically takes several months, and a specialist may issue a development letter asking for more detail on your governance or grant-making plans.
The 27-Month Deadline
File Form 1023 or Form 1023-EZ within 27 months from the end of the month your organization was legally formed, and your tax-exempt status is retroactive to the formation date. File late, and the IRS recognizes the exemption only from the date it actually receives your application.14Internal Revenue Service. Application/Notice Requirement: Charitable Organization Contributions received during the uncovered gap are not deductible for donors, which can snarl early fundraising.
Advance Approval for Private Foundation Grants
If your fund is a private foundation, you have an extra step before any scholarships go out the door: you must get advance IRS approval of your grant-making procedures. Without it, every scholarship grant to an individual is treated as a “taxable expenditure” under IRC Section 4945, even if the grant itself is reasonable and goes to a deserving student.15Internal Revenue Service. IRC Section 4945(g) Individual Grants Penalties start at a 10 percent excise tax on the expenditure and climb from there, with separate taxes on the managers who approve unapproved grants.16Internal Revenue Service. IRC 4945 – Scholarship Grants to Individuals and the Validity of Racially Restricted Scholarship Trusts
To secure approval, the foundation has to show three things: that its procedures award grants on an objective and nondiscriminatory basis, that the procedures are designed so grantees actually use the funds as intended, and that the foundation will supervise grants to confirm compliance with the terms.17Internal Revenue Service. Advance Approval of Grant-Making Procedures The IRS looks at the overall system, not individual grants, and once approved the procedures carry forward to future programs as long as they don’t materially change.
Public charities do not need this advance approval, but they still have to run an objective, nondiscriminatory process.
How You Can Select and Award Scholarships
Every scholarship fund, public charity or private foundation, needs a written selection policy that applies objective, nondiscriminatory criteria serving a genuine charitable purpose. Acceptable criteria include academic merit, financial need, residence in a particular geographic area, enrollment at a specific type of institution, or pursuit of a particular field of study.
Selection cannot be driven by the personal interests of founders, directors, or major donors. The IRS strongly favors an independent selection committee applying the criteria consistently, and any appearance that scholarships are being steered to insiders can put the exemption at risk.
Scholarships Involving Insiders or Employees
For a private foundation, awarding a scholarship to a “disqualified person,” a category that includes substantial contributors, foundation managers, and their family members, is generally treated as self-dealing and triggers excise taxes. A private foundation that runs a scholarship program for children of a company’s employees can avoid self-dealing treatment if it has obtained an IRS ruling confirming that the program qualifies under Section 117(a) and meets the conditions of the applicable revenue procedure.18eCFR. 26 CFR 143.2 – Taxes on Self-Dealing; Scholarship and Fellowship Grants by Private Foundations
For employer-related programs, the IRS applies a percentage test. The number of grants awarded to employees’ children in a given year generally cannot exceed 25 percent of the eligible applicants considered by the selection committee, or 10 percent of all eligible employees’ children. Exceeding these thresholds doesn’t automatically disqualify a program, but it moves it from presumptive approval to a facts-and-circumstances review.
Public charities have more flexibility with employee-children programs, but awards still have to rest on objective standards, and the benefit to the employee must be incidental to the charitable purpose.
What the Scholarship Money Can Pay For
Under IRC Section 117, a scholarship is excluded from the recipient’s gross income only to the extent it covers “qualified tuition and related expenses”: tuition, fees required for enrollment, and books, supplies, and equipment required for courses at an eligible educational institution.19Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships
Money spent on room and board, travel, or general living expenses is taxable income to the recipient. So is any portion that represents payment for teaching or research services the student is required to perform as a condition of the grant.19Office of the Law Revision Counsel. 26 USC 117 – Qualified Scholarships Restricting awards to tuition and required fees, or paying the educational institution directly, simplifies compliance and protects recipients from surprise tax bills. Keep records showing each recipient was enrolled as a degree candidate at an eligible institution and that the funds went to qualified expenses.
Scholarships to nonresident alien students bring extra duties. Taxable amounts paid to nonresident aliens are subject to a standard 30 percent federal income tax withholding rate, which can drop to 14 percent for students on F, J, M, or Q visas when the taxable amount is tied to a qualified scholarship, and treaty students may qualify for further reductions.20Internal Revenue Service. Withholding Federal Income Tax on Scholarships, Fellowships and Grants Paid to Nonresident Aliens Build these obligations into your procedures before the first international award goes out.
Keeping the Exemption: Annual Filings
Tax-exempt status is not a one-time achievement. The IRS requires an annual information return, with the specific form depending on classification and size.21Internal Revenue Service. Form 990 Series Which Forms Do Exempt Organizations File Filing Phase In
- Form 990 is required for public charities with gross receipts of $200,000 or more, or total assets of $500,000 or more.
- Form 990-EZ is available for public charities with gross receipts under $200,000 and total assets under $500,000.
- Form 990-N, the e-Postcard, is available for organizations with gross receipts normally $50,000 or less.
- Form 990-PF is required for every private foundation, regardless of size.
Miss three consecutive years and the IRS automatically revokes your tax-exempt status. No warning letter, no grace period.22Internal Revenue Service. Automatic Revocation of Exemption Reinstatement requires a fresh Form 1023 application and the associated fees.23Internal Revenue Service. Automatic Reinstatement of Tax-Exempt Status This happens most often to small funds that assume the simplest e-Postcard is optional.
All Form 990 returns, and your original exemption application, must be available for public inspection for three years from the filing due date or the actual filing date, whichever is later.24Internal Revenue Service. Public Disclosure and Availability of Exempt Organization Returns and Applications
Records and Donor Receipts
Keep documentation of every contribution received (date, amount, donor) and every scholarship awarded (recipient, amount, institution, verification that the money went to qualified expenses). These records substantiate your charitable activity and matter if the IRS ever questions your operations.
For any contribution of $250 or more, the fund has to provide the donor with a written acknowledgment that includes the organization’s name, the cash amount, a description of any non-cash contribution (without a value estimate), and a statement about whether the fund provided any goods or services in return.25Internal Revenue Service. Charitable Contributions: Written Acknowledgments Scholarship funds normally provide nothing in return, so the acknowledgment typically says exactly that. Donors need the letter to claim their deduction.
State Registration
Federal exemption does not satisfy state obligations. Most states require charitable organizations to register before soliciting donations from their residents, and many impose periodic financial reports.26Internal Revenue Service. Charitable Solicitation – State Requirements Some cities add their own rules. A fund that solicits online may trigger registration requirements in every state where donors sit, not just where the fund is based. Handle this early; enforcement problems here distract from the mission the fund was built to serve.