Scholarship Fund

A scholarship fund is money committed to charity and reserved for education awards, administered by a charitable organization that owns the money and chooses the recipients. Donors commonly want the fund to carry a name, to serve a particular school or community, and to reflect criteria they care about, and all three of those are ordinary. What a donor cannot do, on any route, is select the individual who receives an award while also taking a charitable deduction for the money. Internal Revenue Code section 170(c) allows a deduction for "a contribution or gift to or for the use of" a qualifying organization, and a payment routed through a charity to a person the donor chose is a gift to the person.

Route one: a fund at a sponsoring public charity. A donor contributes to a charity that already exists, commonly a community foundation or a school's own foundation, and the charity establishes a named fund and administers awards from it. The donor takes the deduction on contribution, and the sponsoring organization owns and controls the money from that moment.

The statutory question this route has to answer is whether the fund is a donor-advised fund, because a donor-advised fund cannot make a grant to an individual at all. Section 4966(d)(2)(B)(ii) supplies an exception, and it is narrow and precise. It removes from donor-advised fund status a fund "with respect to which a person described in subparagraph (A)(iii) advises as to which individuals receive grants for travel, study, or other similar purposes, if" three conditions are met: the person's advisory privileges "are performed exclusively by such person in the person's capacity as a member of a committee all of the members of which are appointed by the sponsoring organization"; "no combination of persons described in subparagraph (A)(iii) (or persons related to such persons) control, directly or indirectly, such committee"; and "all grants from such fund or account are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization, and such procedure is designed to ensure that all such grants meet the requirements of paragraph (1), (2), or (3) of section 4945(g)."

Note what the exception is scoped to: grants "for travel, study, or other similar purposes." It is an education and research carve-out, not a general permission to give to individuals. The donor-advised fund page runs the three conditions and the excise regime around them in full.

Section 4966(d)(2)(C) supplies a second, less discussed route. The Secretary may exempt a fund from donor-advised fund treatment "if such fund or account is advised by a committee not directly or indirectly controlled by the donor or any person appointed or designated by the donor," or "if such fund benefits a single identified charitable purpose."

Route two: a private foundation. A donor creates and funds a separate charitable entity with its own board, which then makes the awards. A private foundation may make grants to individuals, which is the main thing it can do that a donor-advised fund cannot, and section 4945(g) sets the price: an individual grant escapes being a taxable expenditure only where it is "awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the Secretary," and only where the grant is a qualifying scholarship or fellowship for study at an educational institution, a prize or award to someone selected from the general public, or a grant to achieve a specific objective or improve a skill or talent. The private foundation page covers the excise regime, the payout requirement and the deduction consequences that come with the entity.

The comparison that decides between them, and it is not the one people expect. Put the two provisions side by side and the substantive test is the same words. Section 4966(d)(2)(B)(ii)(III) requires that grants be "awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization, and such procedure is designed to ensure that all such grants meet the requirements of paragraph (1), (2), or (3) of section 4945(g)." Section 4945(g) requires that the grant be "awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the Secretary."

The standard is identical and the approver is not. On the sponsored route the procedure is approved by the sponsoring organization's board, which is a question of that organization's own process and timetable. On the foundation route it is approved by the Internal Revenue Service, which is a filing, a wait and an outcome the donor does not control. That difference, rather than the criteria themselves, is the substantive distinction between the two routes, and it is why the sponsored route is faster to start and the foundation route gives the donor more control over everything afterwards.

Route three: give to a school's existing scholarship program. The simplest version. The school is already a qualifying organization, it already runs a selection process, and the donor's gift is deductible on ordinary principles. A named fund and stated criteria are usually available. What the donor gives up is any role in selection, which on this route is not a restriction so much as the entire arrangement.

The rule that catches donors on all three routes. Naming the recipient destroys the deduction. It does so for a different reason on each: on the sponsored route because the committee must be appointed by the sponsoring organization and not controlled by donors; on the foundation route because the selection procedure is the thing the Internal Revenue Service approved and a donor override is a departure from it; and on the school route because a gift the school must pass to a person the donor named is not a gift to the school at all. A donor who wants a particular student to have money can simply give the student money. That is a private gift, it is not deductible, and, within the limits of the gift tax rules, it is nobody's business but theirs.

1. The donor decides how much control over selection they want, because that single choice determines the route. No control means giving to a school. Influence within a committee the charity appoints means a sponsored fund. Own board, own process, own filings means a private foundation.

2. The vehicle is chosen and set up. A sponsored fund is opened by agreement with an existing charity. A private foundation is a new legal entity with its own application for exemption.

3. The criteria are written, and they must be capable of being applied objectively: a school or district, a field of study, a financial need standard, an academic threshold.

4. A selection procedure is approved in advance. By the sponsoring organization's board on the sponsored route; by the Internal Revenue Service on the private foundation route.

5. The fund is contributed, and the deduction is taken in that year subject to the ceilings and floor that govern charitable deductions generally.

6. Awards are made by the committee or the foundation, records are kept, and payments are made to or for the student.

A hypothetical showing what the size of the fund has to do. Yusuf leaves $200,000 to establish a named scholarship fund at a community foundation, and the fund is invested with a spending policy that pays out 4 percent of its value each year. That produces $8,000 of awards annually, which the committee can divide as two awards of $4,000 or four of $2,000. If instead Yusuf had wanted four awards of $4,000 a year, the fund would need to generate $16,000, so at the same 4 percent spending policy it would have to hold $400,000. Both the 4 percent and the award sizes are invented for this example; a sponsoring organization sets its own spending policy and charges for administration, and those are terms to read rather than assume. The arithmetic is the point: an endowed fund's annual awards are a small fraction of its balance, which is why a donor who wants meaningful awards soon often funds a spend-down fund instead and accepts that it ends.

What a scholarship fund does well

• It gives to a purpose rather than to a person, which is what makes the money deductible and what lets it keep working after the donor is gone.
• An endowed fund can pay awards indefinitely, and a named fund carries a name into a community that will keep saying it.
• The sponsored route needs no new entity, no separate exemption application and no board, and the sponsoring organization already knows how to run a selection process.
• The criteria can be specific, so a fund can serve a school, a field, a town or a set of circumstances the donor cares about.
• A private foundation route gives the donor's own board lasting control over criteria and awards.

What it costs and what a donor gives up

• The donor cannot choose the recipient. On the sponsored route the committee must be appointed by the charity and not controlled by donors.
• A private foundation must obtain advance approval of its selection procedure from the Internal Revenue Service before making individual grants, and it carries the whole excise tax and annual filing regime that comes with the entity.
• An endowed fund pays out only a fraction of its balance each year, so a fund large enough to make meaningful awards is a large gift.
• A sponsoring organization charges for administration and applies its own investment and spending policies, and the donor does not set them.
• The money is irrevocably charity's. It cannot come back if the donor's circumstances change.
• An outside award can reduce a student's other aid, which is a real effect on the recipient and is covered on the scholarship displacement page.