Why Can't Donors Choose Recipients of their Scholarships?
- Matt Borden
- Jul 26, 2023
- 10 min read
Updated: Aug 16, 2023
Funding a scholarship is humbling. It demonstrates the impact that higher education can have on lives and for many donors, it reflects their own experiences in college. In this reflection, donors many times see themselves—or a loved one—in the scholarship they fund and restrict scholarships in the mold of themselves. Some donors, though, want even greater control of the process and involvement in selecting the final recipient. As many fundraisers know, though, selecting the recipients of one’s scholarship—or the use of any charitable fund—is a step that is prohibited by federal law and not allowable.
While many charities understand that donors cannot choose the ultimate recipient of their scholarships, the intricate federal statutory scheme that governs this prohibition is less understood. This article walks through the reasons why donors may not select the recipients of their donor-funded scholarships (or other donor-directed funds) and what the consequences are if so.
A. The Prohibition Around Donor Control Rests in the Statute Governing the Deductibility of Charitable Contributions.
The prohibition of donor-directed scholarships lives in the Internal Revenue Code and specifically, the section of the code that governs the deductibility of charitable contributions. As a starting point, the Code states that donations to qualified charities are deductible.[1] However, after this general statement, the Code outlines exceptions where this general allowance does not apply. As part of this, it outlines what a charitable contribution is,[2] outlines how deductions for non-cash assets are to be accounted for,[3] and the limits on the total deduction one can take,[4] among other things. If the contribution does not meet the elements for any of these sections, the contribution is either limited or prohibited altogether.
If the gift is to a "donor-advised fund," then the gift is not deductible and the fund is not allowable.
The Code also outlines instances in which no deduction is allowed for specific circumstances. At the end of this list is contributions to “donor advised funds.”[5] This is the section that prohibits donors from selecting their scholarship recipients. In the world of philanthropy, donor advised funds are most-often thought of in the context of community foundations, or perhaps funds administered by private financial firms.[6] But, for the purposes of donor restrictions, the term is much broader.
"Donor advised funds are most-often thought of in the context of community foundations . . . but for the purposes of donor restrictions, the term is much broader."
Donor-advised funds are defined by a separate section of the IRC.[7] Congress created a three-prong test to determine whether a contribution was to a donor-advised fund.[8] If all three parts of the test are answered affirmatively, then the fund itself is a donor-advised fund and any contribution to it is not deductible as a charitable contribution.[9] In other words, to make sure that a donation is deductible, donors and charities will want to make sure that the answer to at least one of the three questions is “no.”
The statutory test for donor advised funds asks three questions: 1) is the fund separately identified by reference to contributions of a donor or donors; 2) is the fund owned and controlled by a sponsoring organization; and 3) does the donor expect to have advisory privileges with respect to the distribution of the assets?[10] The following paragraphs explore each of the questions in turn and how organizations can structure gifts and funds to comply with the statute.
Three-part donor-advised fund test (most charities will want to answer at least one of the questions "no" for each of their funds):
1. Is the fund separately identified by reference to donor contributions?
In essence, what this means is did the charity create the fund at issue because of donations from a specific donor or donor(s)? General funds and annual funds in which the fund is created by the charity and receivie gifts from a large and broad number of donors will generally answer "no" to this question.
More often than not, endowed funds will often answer "yes" to this question.
2. Is the fund held by a sponsoring organization?
3. Does the donor have power over the distribution of the funds?
1. Question One: Is the Fund Separately Identified By Reference to Donor Contributions?
The first question asked in the test to determine whether a fund is a donor-advised fund and whether contributions to that fund are deductible as charitable gifts is whether the fund itself is separately identified by reference to contributions of a donor.[11] A simpler way of putting this is to determine whether the fund was established by donors, or whether the fund was established by the charity to solicit contributions from a much broader group of donors.
The first question does not encompass general or unrestricted funds established by charities. As a result, annual funds or general unrestricted funds, which solicit contributions from many donors are not caught under the test and any contributions to those funds are deductible as charitable contributions. Moreover, if a charity, for whatever reason, wants to engage donors who contribute to those general funds in determining how those funds may be spent or allocated, those donors may advise and direct those funds on behalf of the charity without compromising the status of their donations or subjecting those funds to any tax liabilities on behalf of the charity.
On the other hand, many charities engage donors who establish specific funds to provide more-direct support or that reflect the donor’s close relationship to the institution. These funds often reflect the names of the donor or have a specific name that reflects the donor’s specific relationship or interest. Moreover, the donor’s contributions to these funds are paramount to the fund existence and separately accounted for by the charity. These funds are the one’s that are of greatest concern for the three-prong test. But, given that the test requires an affirmative answer to each of its prongs, the fact that the fund itself is separately accounted for in and of itself does not dispositively negate any contributions to it.
2. Question Two: Is the Fund Held by a Sponsoring Organization?
For most 501(c)(3) nonprofits the answer is likely "yes."
The second question in the three-prong test for determining whether a specific fund is donor-advised is whether the fund is owned and controlled by a “sponsoring organization.”[12] In the context of the statute, a “sponsoring organization” is defined as any organization that is qualified under Section 170(c) of the Internal Revenue Code, with exceptions for private foundations and organizations that do not allow donors to establish individual funds.[13] Section 170(c) defines organizations that can receive charitable contributions, which in turn makes those gifts deductible.[14] Organizations that qualify as a 501(c)(3), as well as a few rare others, thus will generally be subject to the donor-advised fund statute.
The purpose of the second question is scope. The question exempts private foundations, which are subject to their own regulations and tax restrictions.[15] It also excludes coverage to organizations with limited focuses, who may solicit charitable funds for narrow scopes and who, in turn, do not maintain donor-directed funds.[16] The end result, though, excludes only a small portion of charitable organizations, and most larger nonprofit organizations qualify as sponsoring organizations under the statute.
3. Question Three: Does the Donor Have Power Over the Distribution of the Funds?
The final prong of the donor-advised fund test looks at the power that the donor (or close relatives) has over the fund itself. If the donor expects, or reasonably expects, to have the power to determine how the funds are used after they make the gift, and the other two questions in the donor-advised fund test have been answered affirmatively, then the fund is a donor-advised fund and their gift to the charity is not deductible as a charitable contribution. In most instances in which the three-prong test is used, the ultimate determination of whether the fund is donor-advised will rest in the final question.
Importantly, Question Three looks at control after the gift has been accepted by the charity. As a result, predetermined restrictions, such as requiring that a scholarship be awarded to a specific type of student or a gift be used to support a specific program at a charity are not covered by the statute.
Question three ultimately looks at the expectations of the donor and those expectations around control after they make the gift and that expectation can either be explicit or reasonably implied. The most obvious instance of donor control is the explicit kind. If the donor, as a contingency or requirement of their contribution keeps for themselves the power to select the recipient (or has veto power) after the gift is accepted by the charity, then the fund is donor-advised.
The implied situations are more difficult to determine. For instance, if a donor or other supporter withholds additional contributions and those contributions are significant and influence the actions of the charity in selecting ultimate recipients, the fund and those contributions may thus be donor-advised and in turn subject to the statute. Other forms of donor influence that are more subtle may also subject future contributions to donor-advised status. Ultimately, looking at the intentions of the donor and whether the influence would reasonably affect the actions of the charity in making a distribution to a directed place, will determine the character of the donation and of the fund itself.
There are several steps that the charity can take to remove any impression of donor influence in making a distribution from a separately accounted for fund. The best way to maintain that independence is to demonstrate institutional control over the funds. Standardized and formal gift agreements between a donor and the charity can be an important part of the process. By predetermining expectations around a distribution—including the amount, timing, and designation criteria of any distribution—can remove a significant amount of donor influence from the process. Of course, organizations should be careful not to allow a donor’s influence to stray from the predetermined criteria or otherwise influence the organization’s discretion if the criteria allows for discretion in any particular parameter, such as the award of a scholarship to a specific student, when multiple students meet all previously-outlined criteria.
a. The Donor May Participate on a Committee that Determines the Distribution of Funds.
Of course, if a donor provides a significant amount of support, a charity may, as part of stewarding their philanthropy, wish to involve a donor as part of awarding funds. Doing so deepens the donor’s relationship to the institution and more-intimately see the impacts of their investments.[17] The statutory scheme around donor-advised funds provides such an exception and allows the donor to participate in this process, but the exception is narrow in scope and all elements must be met.[18] First, the donor may only participate in the determination of the use of funds if she is part of a larger committee, of which the charity makes all appointments. As a result, the donor, by way of making the gift, cannot make their membership on the committee a necessary condition and cannot control nominations of other individuals to the committee, either.[19]
Second, the donor(s) and their relatives may not control the committee directly or indirectly. This means that charities pursuing this option should make any committee that has discretion over the use of donor funds sufficiently large enough so that any donor or their family cannot have majority voting control. It also means that the donor(s) or members of their family should not have any veto power over the decisions of the committee.
Finally, the committee must have a pre-determined and objective process for determining grants and that process must be pre-approved by the charity’s board of directors. As with the process of determining members of a committee, if the donor serves on the charity’s board of directors, it may be wise to request that a donor abstain from the vote and discussion of this process to eliminate any illusion of control or influence.
B. Consequences for Charities and for Donors if a Fund is Donor-Advised.
The question of whether a charitable fund is donor-advised rests on a three prong test that asks whether the fund is separately accounted for by reference to the donor’s contributions, whether the fund is held by a sponsoring organization, and whether the donor expects, or reasonably can expect, to have authority over how the funds are allocated by the charity. If all three of the prong questions are answered affirmatively, then the fund, and donations made to it, will qualify as donor-advised.
There are three tax consequences for donor advised funds and gifts made to those funds that affect both charities and donors. For charities, if any donor advised fund it holds makes a distribution, the statute assesses two taxes—one on the charity and one on an officer of the charity.[20] The tax assessed to the charity is equal to twenty percent (20%) of the amount distributed, and that amount is paid in addition to the distribution that is made.[21] Additionally, an additional five percent (5%) tax is levied on any officer of the organization that authorizes that the distribution be made, and this tax is required to be paid by that individual.[22]
Charities and officers who make distributions from donor-advised funds can be subject to an excise tax.
Donors to donor advised funds also face tax consequences, the primary among them is the deductibility of their gifts to their funds. The Internal Revenue Code does not allow for a charitable deduction for any gifts made to a fund that qualifies as donor-advised. This removes a significant donor incentive for charitable gifts when the donor maintains control over use.
C. What if my Charity has Funds that are "Donor-Advised?"
If your charity has funds that are donor-advised, you can work to shift the funds so that the donor's influence in how the funds are directed is removed. And there are a few ways that charities can go about this. The first, and in many cases, the easiest, is to have a conversation with the donor. A donor can, in most cases, modify the requirements of their gift so that the charity has complete discretion over the funds. It is advisable that this modification be done in writing, signed by the donor.
In some instances, though, charities may not be able to work with the donor to modify funds that are donor-advised. A donor may be deceased or may not acquiesce to the shift that a charity seeks. In these cases, charities may work to amend the fund through a cy pres action. The exact requirements and steps for cy pres vary state-to-state, but in most states, the action can be accomplished by either approaching the Attorney General, or by filing a motion with an appropriate court.
[1] 26 U.S.C. § 170. [2] 26 U.S.C. § 170(c). [3] 26 U.S.C. § 170(e). [4] 26 U.S.C. § 170 (d). [5] 26 U.S.C. § 170(f)(18). [6] See Treas. Reg. § 1.170A-9(e)(10-11). [7] 26 U.S.C. § 4966. [8] 26 U.S.C. § 4966(d)(2). [9] 26 U.S.C. § 170(f)(18). 26 U.S.C. § 170(f)(1) states that “[n]o deduction shall be allowed under this section for a contribution to or for the use of an organization or trust. . . subject to the conditions specified in such sections.” [10] 26 U.S.C. § 4966(d)(2). [11] 26 U.S.C. § 7966(d)(2)(i). [12] 26 U.S.C. § 4966(d)(2)(ii). [13] 26 U.S.C. § 4966(d)(1). [14] See 26 U.S.C. § 170(c)(2-5). [15] 26 U.S.C. § 4966(d)(1)(B). [16] 26 U.S.C. § 4966(d)(1)(C). [17] [18] 26 U.S.C. § 4966(d)(2)(B)(ii). [19] If the committee itself ultimately establishes a nominating process for future members, the charity should think deliberately about excluding the donor from this nominating process so as to eliminate the illusion of donor-control over future appointments. [20] 26 U.S.C. § 4966(a)(2). [21] 26 U.S.C. § 4966(a)(1). [22] The statute imposes a maximum tax of $10,000 on any individual officer. 26 U.S.C. § 4966(b)(2). There is no maximum tax assessed to the charity who makes a distribution from the donor advised fund. Id.
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