Scholarship foundation denied exemption for serving private interests

Plain-English summary

A private foundation sought section 501(c)(3) exemption for a scholarship limited to National Merit Finalists from one high school who enrolled at a college about 3,000 miles away. The founders controlled and funded the organization, served as its selection committee, and made its only scholarship award to their son. The IRS found that the criteria created a virtually nonexistent pool of eligible applicants and that the program served the founders' private interests. It denied exemption because the organization's earnings inured to the founders' benefit and its operations did not primarily further an exempt public purpose.

Ruling snapshot

• Question: Did the scholarship foundation qualify for exemption under section 501(c)(3)?
• Outcome: denied
• Key authorities: IRC §§ 170, 501(c)(3), 7428; Treas. Reg. § 1.501(c)(3)-1

Full text (IRS public release)

Department of the Treasury
Internal Revenue Service
P.O. Box 2508
Cincinnati, OH 45201
Date: September 26, 2016

Employer ID number:

Number: 201652029
Release Date: 12/23/2016

Contact person/ID number:
Contact telephone number:
Form you must file:

Tax years:

UIL: 501.00-00, 501.03-22, 501.33-01

Dear

This letter is our final determination that you don’t qualify for tax-exempt status under Section 501(c)(3) of the
Internal Revenue Code (the Code). Recently, we sent you a proposed adverse determination in response to your
application. The proposed adverse determination explained the facts, law, and basis for our conclusion, and it
gave you 30 days to file a protest. Because we didn’t receive a protest within the required 30 days, the proposed
determination is now final.

Because you don’t qualify as a tax-exempt organization under Section 501(c)(3) of the Code, donors can’t
deduct contributions to you under Section 170 of the Code. You must file federal income tax returns for the tax
years listed at the top of this letter using the required form (also listed at the top of this letter) within 30 days of
this letter unless you request an extension of time to file.

We'll make this final adverse determination letter and the proposed adverse determination letter available for
public inspection (as required under Section 6110 of the Code) after deleting certain identifying information.
Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the instructions in the Notice
437 on how to notify us. If you agree with our deletions, you don’t need to take any further action.

We’ll also notify the appropriate state officials of our determination by sending them a copy of this final letter
and the proposed determination letter (under Section 6104(c) of the Code). You should contact your state
officials if you have questions about how this determination will affect your state responsibilities and
requirements.

Letter 4038 (Rev. 7-2014)
Catalog Number 47632S

If you have questions about this letter, you can contact the person listed at the top of this letter. If you have
questions about your federal income tax status and responsibilities, call our customer service number at
1-800-829-1040 (TTY 1-800-829-4933 for deaf or hard of hearing) or customer service for businesses at
1-800-829-4933.

Sincerely,

Jeffrey I. Cooper
Director, Exempt Organizations
Rulings and Agreements

Enclosures:

Notice 437

Redacted Letter 4036, Proposed Adverse Determination Under IRC Section 501(c)(3)
Redacted Letter 4038, Final Adverse Determination Under IRC Section 501(c)(3) - No Protest

Letter 4038 (Rev. 7-2014)
Catalog Number 47632S

Department of the Treasury
Internal Revenue Service
IRS P.O. Box 2508
Cincinnati, OH 45201
Date: August 1, 2016
Employer ID number:
Contact person/ID number:

Contact telephone number:

Contact fax number:

Legend: UIL:

B = High School 501.00-00
C = College 501.03-22
D = Board member 501.33-01

E = Board member

F = Scholarship recipient
G = Date of formation

H = State

j dollars = Amount

k dollars = Amount

Dear

We considered your application for recognition of exemption from federal income tax under Section 501(a) of
the Internal Revenue Code (the Code). Based on the information provided, we determined that you don’t qualify
for exemption under Section 501(c)(3) of the Code. This letter explains the basis for our conclusion. Please
keep it for your records.

Issues
Do you qualify for exemption under Section 501(c)(3) of the Code? No, for the reasons stated below.

Facts

You were formed by Articles of Incorporation on G in the State of H. Your articles, in part, state that your
purpose is to distribute an annual educational scholarship to graduating seniors of B high school who are
incoming freshman to C College, assuming certain underlying merit-based criteria are met.

You are seeking exemption as a private foundation. Your governing body members are D and E, husband and
wife. D and E are also your selection committee. Relatives of the selection committee, officers, directors and
substantial contributors are eligible for your scholarship. D and E anticipate spending approximately one hour
each per year on operating the scholarship program. Their duties include writing checks to C College and
interacting with the high school counselor’s office.

To qualify for a scholarship, an applicant must be a graduating senior from B high school who has been selected
as a National Merit Finalist and are newly admitted to C College. C College is approximately 3000 miles from
B high school.

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The scholarship may be awarded for four years of undergraduate studies or completion of baccalaureate degree
requirements, whichever occurs first. Recipients must enter C College no later than the fall following
graduation from B high school. Scholars must remain in good academic and disciplinary standing at C College.
Transfer students are not eligible.

You will pay the funds to C College over four years with the award amount to be established in the first of the
four years as to each recipient. You will fund a minimum of j dollars per year, per recipient. The amount of the
recipient’s first year award shall be renewed in subsequent years if the fund has sufficient value, except that the
award will be reduced by j dollars per each additional recipient. Despite indicating a minimum-award of j
dollars and indicating that “ideally” you would fund the scholarship for j dollars, your expenses for last year
show a distribution of k dollars, the entirety of your income. Further, no projections were given for the current
year and beyond even though this is a four year award.

B high school has a graduating class which fluctuates yearly but is usually approximately 500 students. Two
years ago there were four individuals graduating from B high school that were National Merit Finalists. You do
not know if any attended C College. Last year there were two individuals graduating from B high school who
were National Merit Finalists. One was F, the son of founders D and E. The other individual was not related to
the founders. F went on to attend C College and was awarded your scholarship. The other individual did not
attend C College and, therefore, did not meet the qualifications for your scholarship.

This year there was one individual graduating from B high school who was a National Merit Finalist. It is
unknown if he will attend C College. If he attends C College, he will be awarded a scholarship.

Based on historical data, you said that between 1- 4 students annually will be National Merit Finalists
graduating from B high school, of which 0-1 will apply to C College. You said that C College historically
admits about 10% of their applicants. Therefore, there will be between 0-1 eligible applicants annually.

A student must apply for the scholarship at least two business days before B high school’s award night, which is
typically a few weeks prior to graduation. To apply, the applicant must email you with proof of graduating
senior status from B high school, proof of National Merit Finalist status, and proof of enrollment at C College.
The proof of graduating senior status and National Merit Finalist status can alternatively verified through B high
school’s counseling office. You indicated the scholarship is publicized through the high school counselor’s
office and there is no actual application form.

You are funded by your founders, D and E. You will only exist as long as the donors, in their discretion, fund
the award; it is not a perpetual fund. As was indicated earlier all your funds were paid out last year for the
scholarship awarded to F.

Law

Section 501(c)(3) of the Code provides, in part, for the exemption from federal income tax organizations
organized and operated exclusively for charitable, religious or educational purposes, no part of the net earnings
of which inures to the benefit of any private shareholder or individual.

Treasury Regulation Section 1.501(c)(3)-1(a)(1) states that, in order to be exempt as an organization described
in Section 501(c)(3) of the Code, an organization must be both organized and operated exclusively for one or
more of the purposes specified in such section. If an organization fails to meet either the organizational test or
the operational test, it is not exempt.

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Treas. Reg. Section 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as operated exclusively
for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of
such exempt purposes specified in Section 501(c)(3). An organization will not be so regarded if more than an
insubstantial part of its activities in not in furtherance of an exempt purpose.

Treas. Reg. Section 1.501(c)(3)-1(c)(2) provides that an organization is not operated exclusively for one or
more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or
individuals.

Treas. Reg. Section 1.501(c)(3)-1(d)(1)(ii) states that an organization is not operated exclusively for one or
more exempt purpose unless it serves a public rather than a private interest.

Rev. Rul. 67-5, 1967-1 C.B. 123, describes a foundation controlled by the creator's family was operated to
enable the creator and his family to engage in financial activities which were beneficial to them, but detrimental
to the foundation. It was held that the foundation was operated for a substantial non-exempt purpose and served
the private interests of the creator and his family. Therefore, the foundation was not entitled to exemption from
federal income tax under Section 501(c)(3).

In Charleston Chair Company v. United States, 203 F. Supp. 126 (E.D.S.C. 1962), exemption was lost by a
foundation that spent a large part of its funds on a scholarship grant to the son of a foundation trustee, which
resulted in inurement.

In Wendy Parker Rehabilitation Foundation, Inc. v. Commissioner, T.C. Memo 1986-348, 52 T.C.M. (CCH) 51
(1986), the organization was created by the Parker family to aid an open-ended class of “victims of coma.”
However, the organization stated that it anticipated spending 30 percent of its income for the benefit of Wendy
Parker, significant contributions were made to the organization by the Parker family, and the Parker family
controlled the organization. Wendy Parker's selection as a substantial recipient of funds substantially benefited
the Parker family by assisting with the economic burden of caring for her. The benefit did not flow primarily to
the general public as required under Treas. Reg. Section 1.501(c)(3)-1(d)(1)(ii). Therefore, the Foundation was
not exempt from federal income tax under Section 501(c)(3).

Application of law

You are not as described in Section 501(c)(3) of the Code and Treas. Reg. Section 501(c)(3)-1(a)(1) because
you do not satisfy the operational requirements. More than an insubstantial part of your activities do not further
exempt purposes.

You do not meet the provisions of Treas. Reg. Section 1.501(c)(3)-1(c)(1) because more than an insubstantial
part of your activities are not in furtherance of an exempt purpose. You are operating to pay the tuition of the
child of your founders. This arrangement affords substantial tax benefits to your founders who are obligated as
parents to pay these expenses and serves private rather than public purposes.

You are not described in Treas. Reg. Section 1.501(c)(3)-1(c)(2) because your net earnings inure to the benefit
of your founders. Last year 100% of your income was awarded as a scholarship to the family member of an
insider. This is illustrated by the fact you are funding a scholarship only benefitting the child of your founders.
Your founders are also your donors and will realize significant tax benefits to pay their child’s tuition.

You are not described in Treas. Reg. Section 1.501(c)(3)-1(d)(ii) because you are serving the private interests of
your founders. Your selection criteria are so narrow that only one applicant qualified and was awarded the

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scholarship since your formation, and over the study of a four year period only one would qualify. It is apparent
from the criteria you have been established to award the scholarship to F.

Like the organization described in Rev. Rul. 67-5, you are controlled by your founders and operated for their
benefit. You are operated for a substantial non-exempt purpose, precluding you from exemption. D and E fund
you, set scholarship criteria, control the total amount of funds awarded and any oversight of the award. The criteria
created to award the scholarship are so narrow that only one individual, the son of the founders, has qualified
for the scholarship. Even if a graduating senior of B high school is a National Merit Finalist and wishes to
attend C College, which is approximately 3000 miles away, there is only a 10% admittance rate by C College.
The pool of eligible applicants annually is virtually zero. Your founders are also your selection committee and
they selected their own son as the recipient of the award. This creates private inurement, precluding you from
exemption.

You are similar to Charleston Chair Company because all of your funds since your inception have been
expended for a scholarship granted to the son of your founders. This results in inurement and precludes you
from exemption under Section 501(c)(3) of the Code.

Like the organization described in Wendy L. Parker, you are not exempt because your selection of a family
member as a substantial beneficiary of your disbursements violates the prohibition against using the funds of a
tax-exempt organization to inure to the benefit of private individuals.

Conclusion

Based on the facts presented, you are operating for the substantial non-exempt purpose of operating a
scholarship program with selection criteria which are too narrow to benefit the general public. Your scholarship
program was set up to benefit the founders, as their son was the only recipient since your inception. Therefore,
your earnings inure to the benefit of your founders and you do not qualify for exemption as an organization
described in Section 501(c)(3) of the Code.

If you don’t agree
You have a right to file a protest if you don’t agree with our proposed adverse determination. To do so, you
must send a statement to us within 30 days of the date of this letter. The statement must include:

• Your name, address, employer identification number (EIN), and a daytime phone
number

• A copy of this letter highlighting the findings you disagree with
• An explanation of why you disagree, including any supporting documents
• The law or authority, if any, you are relying on

• The signature of an officer, director, trustee, or other official who is authorized to sign for the
organization, or your authorized representative

• One of the following declarations:

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For an officer, director, trustee, or other official who is authorized to sign for the organization:
Under penalties of perjury, I declare that I examined this protest statement, including

accompanying documents, and to the best of my knowledge and belief, the statement contains all
relevant facts and such facts are true, correct, and complete.

For authorized representatives:

Under penalties of perjury, I declare that I prepared this protest statement, including
accompanying documents, and to the best of my knowledge and belief, the statement contains all
relevant facts and such facts are true, correct, and complete.

Your representative (attorney, certified public accountant, or other individual enrolled to practice before the
IRS) must file a Form 2848, Power of Attorney and Declaration of Representative, with us if he or she hasn’t
already done so. You can find more information about representation in Publication 947, Practice Before the
IRS and Power of Attorney.

We’ll review your protest statement and decide if you provided a basis for us to reconsider our determination. If
so, we’ll continue to process your case considering the information you provided. If you haven’t provided a
basis for reconsideration, we’ll forward your case to the Office of Appeals and notify you. You can find more
information about the role of the Appeals Office in Publication 892, How to Appeal an IRS Decision on Tax-
Exempt Status.

If you don’t file a protest within 30 days, you can’t seek a declaratory judgment in court at a later date because
the law requires that you use the IRS administrative process first (Section 7428(b)(2) of the Code).

Where to send your protest
Please send your protest statement, Form 2848, if needed, and any supporting documents to the applicable
address:

U.S. mail: Street address for delivery service:
Internal Revenue Service Internal Revenue Service

EO Determinations Quality Assurance EO Determinations Quality Assurance
Room 7-008 550 Main Street, Room 7-008

P.O. Box 2508 Cincinnati, OH 45202

Cincinnati, OH 45201

You can also fax your statement and supporting documents to the fax number listed at the top of this letter. If
you fax your statement, please contact the person listed at the top of this letter to confirm that he or she received
it.

If you agree

If you agree with our proposed adverse determination, you don’t need to do anything. If we don’t hear from you
within 30 days, we’ll issue a final adverse determination letter. That letter will provide information on your
income tax filing requirements.

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You can find all forms and publications mentioned in this letter on our website at www.irs.gov/formspubs. If

you have questions, you can contact the person listed at the top of this letter.

Sincerely,

Jeffrey I. Cooper
Director, Exempt Organizations
Rulings and Agreements

Enclosure:
Publication 892