The IRS has revoked (20223914) the tax-exempt status of an organization previously recognized as tax-exempt under IRC Sections 501(c)(3) and 509(a)(2). The IRS concluded that the organization primarily provided scholarships to employees of a related entity based on job performance, not need or merit, and therefore substantially benefitted the private interests of a narrow group of individuals in a non-charitable manner.

Facts

The organization's application for tax exemption described its activities as providing "educational opportunities to eligible individuals as determined by the Board of Directors." The organization acknowledged on its application that it maintained a close relationship with an IRC Section 501(c)(7) social club that hosted sports tournaments through which the organization raised funds for its scholarship activities.

Each scholarship was paid directly to a university on the student's behalf to help pay for tuition and books. Most of the scholarships were granted to employees of the related social club. To compete for a scholarship, eligible employees of the social club were required to submit applications to their managers who reviewed the applications, decided who met the requisite criteria, and submitted a pool of prospective recipients to the scholarship organization's board of directors. The amount granted to a scholar was dependent upon the amount of time the person had worked for the related organization. Although candidates were required to meet certain academic standards, the managers who culled the applicant pool made exceptions for some candidates whom they viewed as valuable employees.

When the IRS revenue agent held a closing conference with the treasurer for the scholarship organization, the IRS pointed out that:

• Managers of social club employees preselect some of their employees to be scholarship recipients
• The pool of applicants was too narrow and small
• The related organization "is significantly reducing the pool of applicants by enforcing [its] own set of requirements," such as the duration of employment, a minimum number of hours worked and "a commendable work performance"
• The scholarship grants are not based on need or merit
• The scholarship program is aimed at helping the related organization retain employees
• The scholarship program provides a substantial private benefit to the related social club

Law and analysis

To qualify for tax-exempt status as an organization described in IRC Section 501(c)(3), an entity must be organized and operated exclusively for exempt purposes, which may be charitable, scientific or educational. Further, an entity must establish that it is not organized or operated to serve private interests. (Treas. Reg. Section 1.501(c)(3)-1(d)(1)(ii).)

Various IRS rulings have helped flesh out what sort of activity constitutes a public versus a private purpose. For example, public purposes are served by:

• Awards, scholarships and grants given to needy individuals to help them continue work in the creative arts and continue their education, where no monetary benefit was conveyed to the donor organization (Revenue Ruling 66-103)
• Donations to worthy and needy students of free housing and funds to purchase books and instructional supplies or equipment (Revenue Ruling 64-274)
• Scholarships granted solely to undergraduate members of a designated fraternity (Revenue Ruling 56-403)

The IRS and courts have found that the following scholarship arrangements primarily, impermissibly serve private interests rather than furthering charitable purposes:

• A scholarship plan for making payments to preselected, specifically named individuals (Revenue Ruling 67-367)
• A fund established under a collective bargaining agreement between a chapter of the national electrical contractors association and a local union of electrical workers to award scholarships to the children of union employees (Local Union 712, I.B.W.E.W. Scholarship Trust Fund v. Comm'r, T.C. Memo. 1983-76)
• A fund set up to provide scholarships for pageant contestants who were required to enter into a contract obligating them to participate in the pageant if selected (Miss Georgia Scholarship Fund Inc. v. Comm'r, 72 T.C. 267 (1979))

The IRS analogized the facts at issue with the situation in Revenue Ruling 67-367, noting that the scholarship organization's "primary activity is the operation of a 'scholarship' plan for making payments to pre-selected, specifically named individuals."

The IRS distinguished the instant facts from the organization described in Revenue Ruling 56-403, which awarded scholarships to students at a national level, thus "sufficiently minimize[ing]" the benefit to a local group or individual in control of the program. Finally, the IRS pointed out that the scholarships at issue were not granted based on need or merit, as those described in Revenue Ruling 66-103 had been, but rather were compensatory in nature and provided primarily to benefit the related social club and its members.

The IRS concluded that providing scholarships not based on academic merit or financial need, but instead based on work performance and essentially to provide an employee benefit, does not amount to a charitable activity. Because the provision of such scholarships was the organization's primary activity, the IRS revoked its IRC Section 501(c)(3) tax-exempt status.

Implications

For any tax-exempt organization operating a scholarship program, it is important that the scholarships: (1) are awarded to members of a broad, indefinite class, based on objective non-discriminatory criteria (e.g., academic merit, financial need); (2) primarily serve charitable and educational purposes; and (3) do not substantially serve private interests. This is especially important for an organization that awards scholarships to employees of a related entity, where involvement of the related employer in the scholarship recipient selection process could suggest the organization's primary purpose is to provide benefits to the related employer and its employees rather than to a broad charitable class of individuals. This IRS revocation underscores the need for grant-making charities to develop written selection criteria and procedures to ensure that their scholarships substantially further charitable, rather than private, purposes.

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RELATED RESOURCES

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