Scholarship Programs Conducted by Association-Related 501(c)(3) Foundations

by Robert Sumner
Sumner & Associates, P.C.

§501(c)(3) of the Internal Revenue Code provides tax-exempt status for organizations operating exclusively for charitable purposes. Allowing organizations operating for charity to enjoy a tax-exempt status as a concept in taxation is nothing new: In 1601, the English Statute of Charitable Purposes set forth a concept of charity to include, amongst others, support for the elderly, poor, sick, injured soldiers, orphans, young tradesmen in training, and education to citizens.

Today, this concept is embodied in section §501(c)(3) of the Internal Revenue Code by the specific mention of “religious, charitable, scientific, testing for public safety, literary, or educational purposes…”

A §501(c)(3) organization must, in operating for the specifically-mentioned purposes above, provide a public benefit to a charitable class. Unfortunately, clarification of the definitions of public benefit and charitable class are not easily found. These terms, although being used for quite some time, are still vague. A negative definition of these concepts is more readily located. The IRS has often stated what a public benefit and charitable class are not. By understanding what is not included in these concepts, we can begin to ascertain that which is. These concepts are of central importance when a 501(c)(3) organization is creating a scholarship program.

Most association-related 501(c)(3) foundations have received recognition of tax-exempt status as public charities. In a nutshell, this means that the organization receives its funding from a broader group than do private foundations. Private foundations are subject to a number of restrictions that make this form generally unsuitable to association-related foundations.

Whereas a 501(c)(3) private foundation has significant guidance in creating a scholarship program, the public charity is left largely in the dark. The central reason for the difference in guidance is the fact that private foundations are more closely examined by the Service, exposed to the possibility that a scholarship or grant may be a taxable expenditure (and thus not under the tax-exempt umbrella), and under more strict requirements in obtaining tax-exempt approval of a scholarship program. It seems safe to assume that a scholarship program that would be approved for a private foundation would also be approved for the public charity. The requirements for a private foundation scholarship program are described in IRS Publication 578, Tax Information for Private Foundations and Foundation Managers. This can be reviewed for guidance as to how a scholarship program should be designed, even though not specifically applicable to the public charity. Furthermore, guidance as to IRS concerns about scholarship programs can be found in Revenue Procedure 76-47, 1976-2 CB 670, and Revenue Procedure 80-39, 1980-2 CB 772. Inferences about scholarship program approval can also be drawn from the types of information requested in Form 1023, the application for recognition of tax-exempt status. The instructions for completing Schedule H of Form 1023 outline basic scholarship program requirements.


Further guidance can be obtained by studying the manual the IRS uses to train its examiners. In the Internal Revenue Manual, §, the IRS examiner is given some direct guidance on public charity scholarship programs. First, the scholarship program must serve charitable purposes rather than private interests. This brings us to the definition of a public benefit: that which goes to a charitable class to a significant degree, and does not substantially benefit individuals who are not a part of the charitable class. In fact, if an organization provides an improper private benefit to an individual, they are at risk of losing tax-exempt status, and the individuals that receive the benefit and those that manage the organization are subject to penalties. The question is whether the program is benefiting the charitable class in furtherance of the organization’s one or more charitable purposes. The amount received by any one individual does not create an improper private benefit alone. The recipient only needs to be a member of the charitable class and the amount received should not be disproportionate to the cost of the educational benefit that is the subject of the scholarship grant.

§ of the Internal Revenue Manual gives the IRS examiner several items to consider in determining whether the scholarship program is serving an improper private benefit. The manual instructs the agent to:

  1. Look for the existence of “thank you” letters than indicate that a particular award was given on a personal, rather than objective basis. The examiner should look for awards to children of friends, officers, employees, and trustees of an organization. For this reason, an organization giving awards to children of the organization’s “insiders” is suspect of serving a private interest.
  2. Check payroll records for names to look for any relationships that have influenced the awarding of scholarships.
  3. Ask employees if they are aware of how recipients are selected, looking for evidence that the awarding is on a personal, rather than objective basis.
  4. Look for the eligibility requirements for receiving a scholarship. If the restrictions are too narrow, the pool of individuals eligible to receive an award is too narrow to constitute a charitable class (discussed later).
  5. Look for any link between contributions and awards received (such as to a contributor’s child). This may be an attempt to allow individuals to effectively claim deductions on tuition payments for their children, which are otherwise non-deductible.

The benefit provided must, as mentioned before, serve a public, not private, interest. However, the IRS has recognized that the entire public is not typically benefited by a particular program, including a scholarship program. So, for this analysis, the general public can be replaced with a charitable class, a sufficient subset of the general population for tax analysis. A charitable class is simply a group broad enough “to warrant a conclusion that [the benefit] is serving a broad public interest rather than a private one.” Rev. Rul. 75-196, 1975-1 CB 155. “Broad enough” is a deceptive term; the actual number of members of a charitable class is not the test for a broad public interest. For example, 115 members of a Church were found to constitute a charitable class. Bethel Conservative Mennonite Church v. Commissioner, 746 F.2d 388 (7th Cir. 1984). On the other hand, 110,000 members of a private residential community did not qualify as a charitable class. Columbia Park & Recreation Association v. Commissioner, 88 TC 1 (1987). The distinction, then, goes back to the initial definition of “charitable” and whether the purpose of the scholarship program is one for which tax-exemption would be granted. In Bethel, the church was deemed to be providing certain benefits to church members in a manner consistent with its religious purpose. The Court opined that a church, by definition, provides benefits to its members and that providing services to church members is a tax-exempt purpose. In Columbia, on the other hand, the Association was providing benefits to private residents, albeit a large group. The Court found that the beneficiaries were not selected based on criteria related to a tax-exempt purpose and therefore did not create a charitable class.

Learning from these decisions, one should insure that the criteria and the purpose of the scholarship program further the organization’s exempt purposes. Furthermore, the selection criteria must be objective and non-discriminatory. The organization should publish the program and selection criteria, and have a firm plan in place to make sure that improper private benefit is not given. A common practice is to have a non-interested awards committee to review applicants and grant awards. This demonstrates to the IRS that the program is objective, non-discriminatory, and not improperly serving private interests.

Some association-related foundations may seek to limit scholarship awards to members and their relatives. This is not a per se violation of the public benefit requirement– but it is suspect, especially when the organization is a smaller one. First, would an examiner have reason to believe that the program is a “scholarship club?”  A “scholarship club” is one in which scholarship funds are directed towards members only — not to serve a segment of the population with a public benefit, but to “keep money in the family.”


If membership in the organization is readily available, the group stands a better chance of surviving an examination of its scholarship program. If membership costs are low and a reasonably large group of persons can join, then the program appears more like one available to the public, rather than a “scholarship club.” The IRS apparently considers an association where membership is available to all of those engaged in a particular trade or profession to be sufficiently equivalent to the “public.”

A foundation seeking to limit a scholarship program to members and their relatives should be very careful. The following concerns should individually be addressed:

  1. There should not be substantial barriers to membership. Membership, if limited in any way, the limitations should not be arbitrary. Limitations that are reasonable and seem proper with respect to the organization’s purpose are acceptable (e.g., engaged in a particular trade or profession).
  2. Eligibility must be non-discriminatory and objective even though limited to members and their relatives.
  3. Published selection criteria are a must. Brochures, public announcements, standardized applications, and clear selection criteria are essential.
  4. The purpose of the scholarship program must be to serve a public interest, even when limited to the members and their relatives.
  5. Any criteria based on merit or financial need should conform to reason and legitimate standards. Other criteria used must not directly or indirectly limit awards to private groups. Lottery system selection has generally not been approved by the IRS. The selection procedure should be logical and firm and select recipients in furtherance of the purpose behind the program.
  6. An outside or non-interested committee assembled to select recipients is favored by the IRS. This lowers the chance of a finding of improper private benefit and thus increases the chance for approval. Likewise, regardless of how selection takes place, any individual who could receive a private benefit (e.g., a grant to relatives and close friends) should not be involved in the selection process. A committee member in this situation should recuse herself.
  7. A follow up procedure for ensuring that the terms and conditions of scholarship awards is necessary to assure the IRS that the scholarships are being used for the exempt purpose that gave rise to the program approval in the first place.


Granting scholarships to further the tax-exempt purpose of a 501(c)(3) organization can be limited to members and relatives of members of a related trade association. However, if membership in the organization is restrictive, or the tax-exempt purpose of the organization is not furthered, the grant will be deemed an improper benefit. Scholarship awards must be based on objective criteria and recipients must be selected by persons who would not receive a private benefit from an award.

Rob Sumner of Sumner & Associates, P.C. law firm in Atlanta specializes in the representation of trade associations and other nonprofit organizations.

12 Comments for this entry

  • Derrick
    March 27th, 2017

    I’m interested in setting up a scholarship for high school graduates. Do I need to be in an organization in order to provide tax deduction to companies and individuals who would donate to the scholarship? Can I establish the scholarship without being in or part of a organization. (Non-profit, LLC, Inc…etc…)

    • Rob Sumner
      March 27th, 2017

      Thank you for your post. We cannot give specific advice on the website. The following general information is provided with the disclaimer that it is not legal advice and you should retain the services of an attorney for advice on your specific matter. You can give money to whoever you want, but to get a charitable tax deduction, it must be given to an organization recognized by the IRS as tax-exempt under Section 501(c)(3). Typically, a nonprofit corporation is formed, then the new entity files Form 1023 with the IRS to obtain 501(c)(3) status.

  • Keyani McNeil
    March 26th, 2017

    I am a business owner and I’d like to start a scholarship for female high school seniors. My goal is to have the funds for the scholarship come from a portion of profit sales for the business. Are their any certain forms I need to file or any specific things I need to file with the IRS for the business.

    • Rob Sumner
      March 27th, 2017

      Thank you for your post. We cannot give specific advice on the website. The following general information on the subject is provided with the disclaimer that it is not legal advice and you should retain the services of an attorney for advice on your specific matter. In order for contributions to be deductible for tax purposes, the funds are donated to an organization recognized as tax-exempt under Section 501(c)(3). You apply to the IRS for such recognition by filing Form 1023 which can be obtained on the IRS site at http://www.irs.gov.

  • Robin Hanley
    August 11th, 2015

    I am part of a 501(3)C nonprofit group (public charity). We are interested in starting a small scholarship fund. Does there need to be an endowment fund set up to begin? The scholarships are a yearly (not recapturing) scholarship at $2,000 per two winners.

    • Rob Sumner
      August 11th, 2015

      Use of the term “endowment” usually means that an amount of money (principal) is set apart to produce a stream of income to fund scholarship payments; the principal is invested. An endowment is not required, however.

  • Karen
    January 27th, 2015

    I am part of a 501(c)(3) Private Foundation that has been set up to give scholarships to local Public School graduates. One of the students has asked for a scholarship to attend a seminary to study to become a priest. Is this allowable under the guidelines?

    • Rob Sumner
      May 8th, 2015

      First, I am not sure the use of the phrase “private foundation” is really what was meant. A “private foundation” has a very specific meaning in tax law and is not applicable to the subject of this article. A foundation that gives scholarships to public school students should be a “public foundation” as that term is defined in tax-exemption law. The tax exemption determination letter from the IRS can be examined to determine a foundation’s actual status.

      Assuming a 501(c)(3) is a public foundation, giving a scholarship for religious study is not prohibited. As in all expenditures, the activity must further the purposes for which the foundation was organized and was recognized as a tax-exempt organization.

  • Mitch
    March 10th, 2014

    I am the new chair of a scholarship. I just learned that some schools will reduce their financial aid to students by the scholarship amount if we pay the funds directly to the school. While it strikes me as problematic (how do we know the money goes to tuition and not a new car) would it be better to award the funds directly to the student? Would that risk our non profit status or look like taxable income to the student?

    • Rob Sumner
      March 11th, 2014

      Scholarship funds are generally not taxable income for degree candidates. The important point is that a scholarship-granting organization must exercise due diligence to see that funds given are used for the purpose for which they were given. This can be done in various ways. The “shortcut” is to disburse funds to the school for the benefit of the student. However, this is not required. If an organization makes no effort to see that funds disbursed to individuals are used in a way that is consistent with the tax-exempt purpose, it will have problems with the IRS. One method would be to require the recipient to submit transcripts of courses taken.

      We cannot provide legal advice on the site. This is general information about scholarship programs conducted by tax exempt organizations.

  • Karla
    March 20th, 2012

    We are a small non profit Conservatory of Dance Theater providing $200 a month worth of scholarships for students to learn Russian Classical Ballet in our County. Does scholarship disbursement checks go to each student or can they go to the Academy that is providing the instruction? The recipient selection is non biased and based on financial need. How does the nonprofit report to the IRS the disbursements? Do we list the reciepients and their social security numbers or do we list the Academy and their UBI number?

    • Robert Sumner
      April 10th, 2012

      Thank you for your post. We cannot give specific advice on the website. The following general information on the subject is provided with the disclaimer that it is not legal advice and you should retain the services of an attorney for advice on your specific matter. Scholarships are often disbursed to the educational institution for the account of the recipient. The donor must exercise care to ensure that the funds are used only for the purpose for which they are given. The organization reports expenditures to the IRS on Form 990, Return of Organization Exempt From Income Tax. An accountant can determine what 1099 forms may be needed.

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