In a recent case, the Tax Court denied charitable deductions for scholarship payments made by a trust to students for use in their studies. The case is a good opportunity to discuss the different options out there for awarding scholarships, and issues to consider before making a selection.
The taxpayers at issue had set up an irrevocable memorial trust with the proceeds of life insurance from their late son. They didn’t apply for recognition of 501(c)(3) status for the trust, and did not take the trust’s income into their taxable income. The trust then made scholarship payments directly to three students, and the taxpayers attempted to claim those payments as charitable deductions on their returns.
There were several missteps here. Because the trust was not a recognized 501(c)(3) entity, the taxpayers could not take deductions for amounts they put into the trust. Further, because the irrevocable trust is an entity separate from the taxpayers, any proper charitable contributions paid out from the trust could be taken by the trust only—in other words, the taxpayers cannot take the trust’s tax attributes as their own (the taxpayers recognized this as far as trust income goes, because they didn’t attempt to claim the trust’s taxable income on their returns). And finally, because payments were made directly to students rather than to a qualifying 501(c)(3) organization, there were no deductible charitable contributions in any event.
However, there are several options for taxpayers interested in setting up a scholarship fund—and being able to get an associated tax deduction. There isn’t a one-size-fits-all approach, and the right option will depend on the taxpayer’s resources, ability to be actively involved, and desire to participate in selection of recipients:
- Donor-advised fund: This allows taxpayers to set up a fund at a sponsoring organization (often a community foundation) to award scholarships. This provides an upfront deduction opportunity for the taxpayers, at the higher limits available for public charities. However, there are rules in this context that will limit how much input the donating taxpayers can have in selecting scholarship recipients. For more information on this, check out our most recent presentation on scholarship options.
- Private foundation: This allows taxpayers to set up a charitable, 501(c)(3) entity that awards scholarships as its primary purpose (or perhaps as one of several purposes). The donating taxpayers can have more control over selection of recipients, though there are certain rules they will have to comply with in the private foundation context about selecting recipients on an objective and nondiscriminatory basis. Setting up and maintaining a private foundation can be time-consuming and expensive, however, so taxpayers considering this should carefully evaluate the amount of money available for funding the foundation, and how they will be able to meet the compliance requirements on an ongoing basis.
- Fund at a school: Taxpayers, if they have a connection to a particular school, may find it simplest to establish a scholarship fund at that school. Policies will vary on how involved the donating taxpayers can be in recipient selection, and the donor-advised fund rules discussed above may come into play.
Additionally, taxpayers can make deductible contributions to established scholarship funds at a variety of 501(c)(3) organizations, which is the simplest option if the donating taxpayers aren’t concerned about designing a particular program or being involved with selection. If the taxpayers at issue had created a grantor trust (whose tax attributes are reportable on their individual returns) and then had made payments to a scholarship fund at a university, they would have been able to deduct those payments.
The case at issue is Gust Kalapodis v. Commissionr, TC Memo 2014-205.
Check out our additional resources on scholarships here.