IRS Approves Foundation's Dual Scholarship and Prize Program

Foundation Secures Approval for Dual Grant Program

In a recent victory for private foundations, the IRS has given its stamp of approval to a foundation seeking to run both a scholarship program and a separate program awarding grants for specific achievements. The IRS determined that grants made under these programs will not be treated as "taxable expenditures" under Section 4945 of the Internal Revenue Code, thus avoiding potentially significant excise taxes. This decision, outlined in Private Letter Ruling (PLR) 202606008 (UIL code 4945.04-04), provides clarity for foundations navigating the complex rules governing individual grant-making.

The Proposal: Scholarships and Achievement Awards

The foundation's request detailed two distinct programs. The first was a scholarship program under Section 4945(g)(1) of the Internal Revenue Code (IRC), which addresses scholarships or fellowship grants. This program aims to provide financial assistance to students at the primary, secondary, undergraduate, and graduate levels, enabling them to pursue education at the institution of their choice. Scholarships are awarded for one-year periods, with recipients required to reapply and provide updated materials for renewal, demonstrating continued eligibility and compliance with grant terms.

The second program involved awarding grants and prizes to individuals achieving specific objectives, aligning with Section 4945(g)(3), which covers individual grants for specific objectives. These grants support individuals in producing reports, creating similar products, or enhancing literary, artistic, musical, scientific, teaching, or other skills related to the foundation's mission. Eligible recipients could include graduate students, scholars, professionals, and leaders with specialized skills.

The foundation represented that its selection processes would maintain strict governance controls. An independent selection committee, comprising board members and at least one non-board member with relevant experience, would oversee grant applications and approvals. Conflict-of-interest checks would be implemented to ensure no committee member has family ties or other potential conflicts with candidates. Furthermore, the foundation stated that it would arrange to receive and review grantee reports annually, investigate any diversions of funds, take steps to recover diverted funds, and withhold further payments until assurances are received that diversions will not reoccur. Whenever possible, grants would be paid directly to the recipient's educational institution and would only be used for tuition and fees, books, supplies, and equipment required for courses. The foundation also committed to maintaining records related to individual grants, identifying disqualified persons, establishing the amount and purpose of each grant, and undertaking the supervision and investigation of grants.

IRS Analysis: Meeting the 4945(g) Standard

The IRS scrutinized the foundation's grant-making procedures to ensure they aligned with the requirements of Section 4945(g) of the Internal Revenue Code (IRC). Section 4945 addresses "taxable expenditures" by private foundations, and subsection (g) provides an exception for grants to individuals when certain conditions are met. Specifically, to avoid the imposition of excise taxes, the grants must be awarded on an objective and nondiscriminatory basis, and the procedures must receive advance approval from the IRS.

The IRS determined that the foundation's scholarship program met the requirements of IRC Section 4945(g)(1). This section applies to scholarships or fellowships, and the IRS requires that the foundation award grants objectively and without discrimination. The foundation's selection criteria included prior academic performance, standardized test scores, recommendations, relevant experience, financial need, and the selection committee's assessment of the applicant's motivation, character, ability, and potential. To further promote impartiality, the selection committee comprised board members and at least one non-board member, all of whom possessed relevant experience in grant applications. The organization performed conflict-of-interest checks to ensure that no committee member had family ties or other potential conflicts with the candidates. The IRS found these procedures sufficient to satisfy the objectivity and non-discrimination requirements.

The IRS further clarified how awards made under these procedures qualify as scholarships or fellowship grants and are not taxable to the recipients if they use them for qualified tuition and related expenses, as defined in Section 117(b). Section 117(a) excludes "qualified scholarships" from gross income, but only to the extent the funds are used for tuition, fees, books, supplies, and equipment required for courses.

The IRS also analyzed the foundation's program for awarding educational grants and prizes designed to achieve a specific objective, finding that it satisfied the requirements of IRC Section 4945(g)(3). This section applies to grants that enable individuals to achieve a specific objective, produce a report or similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar skill or talent. While scholarships under Section 117(a) focus on tuition and academic expenses, these achievement awards are assessed under Section 74(b), which governs prizes and awards. For these prizes to be excluded from the recipient's income, the recipient must be selected without any action on their part, must not be required to render substantial future services, and the award must be transferred directly by the payor to a governmental unit or 501(c)(3) charity as designated by the recipient.

Implications for Private Foundations

This ruling offers key insights for private foundations considering similar dual grant programs. To avoid "taxable expenditure" penalties under Section 4945, which imposes excise taxes on foundations for improper distributions, foundations must secure advance IRS approval for their grant-making procedures, especially when grants are made to individuals. Section 4945(d)(3) defines taxable expenditures to include grants for travel or study unless advance approval is obtained per 4945(g). This Private Letter Ruling (PLR) demonstrates that the IRS will scrutinize the objectivity and non-discriminatory nature of the selection process. While this PLR cannot be cited as precedent, as PLRs are only applicable to the taxpayer who requested the ruling, it serves as a useful roadmap. Foundations should pay close attention to establishing independent selection committees, defining clear and objective selection criteria, and maintaining thorough documentation of the grant-making process to ensure compliance and avoid potential tax penalties.