IRS DENIES EXEMPTION TO LOCAL FOUNDATION

Sean Callan & John Christopher, Dinsmore & Shohl

Ever since 1956, Greek organizations have understood that a tax-exempt IRC § 501(c)(3) educational fraternity foundation could award scholarships to members of its related fraternity without jeopardizing its tax-exempt status as an educational foundation.  That long-standing understanding is grounded in a 1956 Revenue Ruling from the IRS which determined that simply because a fraternity foundation awarded scholarships only to members of a specific fraternity, that foundation would not be precluded from tax exemption under IRC § 501(c)(3).  Rev. Rul. 56-403.  The IRS shook that understanding in a recent Private Letter Ruling denying exemption to a local fraternity foundation formed to award scholarships to members of the local chapter of that fraternity.  PLR  201017067.  However, upon critical examination, this recent IRS ruling does not change the legal framework within which foundations comfortably grant scholarships.  Rather, the ruling enunciated in the recent PLR demonstrates the care foundations must take in designing scholarship programs.  The facts underlying both the 1956 Revenue Ruling and the 2010 PLR are instructive to proper construction of a fraternity scholarship program.

The 1956 Revenue Ruling.

The foundation at issue in 1956 was organized to “foster intellectual excellence through scholarships and other means, to further cultural growth through publishing literary papers, to cultivate useful citizenship and amicable relationships between individuals, student groups and others, to promote and encourage religious, moral, civic and social responsibility, and to carry out such purposes through contributions to tax-exempt organizations in those fields…”.  In other words, awarding scholarships to members of a particular fraternity was only one of its exempt purposes.

Moreover, in the 1956 case, scholarships were open to seniors in all chapters of the fraternity; the potential benefited class was relatively large and unknown.  Any senior in the fraternity could have earned the scholarship.  Finally, the scholarships at issue were truly earned and were awarded based on scholarship, character and service to the institution.

On these facts, the IRS found the foundation to be a tax-exempt organization under IRC § 501(c)(3).  Specifically, the IRS found that even though the foundation’s scholarships were limited to fraternity members, the foundation was nevertheless an exempt educational foundation because (i) the foundation’s scholarships did not specifically designate persons eligible for scholarships and (ii) the purposes of the foundation were not so personal, private or selfish in nature that they lack the elements of public usefulness and benefit which are required of organizations qualifying for exemption under § 501(c)(3).  In short, the Revenue Ruling established two critical criteria:

1) The foundation was formed with a mission beyond  granting scholarships; and

2) While the potential benefited class was known generally, the actual scholarship recipients were unknown at the time of the award.

The 2010 PLR.

The facts as described in the recent PLR were markedly different from the 1956 case.  In the 2010 case, the foundation at issue was formed specifically to provide tuition and room and board scholarships to members of a local fraternity chapter.  Unlike the foundation in the 1956 case, the foundation at issue here had no other educational purpose.

Unlike the foundation in the 1956 case, the foundation under review in 2010 granted scholarships without regard to any criteria.  Although potential recipients were ranked based on need and academic performance, that ranking had little to do with actually earning a scholarship.  The foundation simply began at the top of the list and granted scholarships as far down the list as its resources allowed. Under this system, a scholarship award had nothing to do with the student’s relative achievement; rather, the scholarship award turned solely upon foundation fundraising success in a given year.  In fact, the IRS found that it was conceivable, perhaps likely, that in some years, every member would receive a scholarship.

Complicating the case, the foundation did not appear to be completely altruistic in its “educational” grants.  In the 2010 case, all of the trustees of the foundation were members of both the fraternity and the local house corporation. The foundation planned to solicit funds from members of the house corporation, which, due to its ownership of the chapter house, had a vested interest in scholarships for room and board expenses.

Based upon these circumstances, the IRS determined the foundation was not exempt.  The principal reason for the IRS determination was that the class of beneficiaries was too restricted to confer the public benefit required by Code Section 501(c)(3).  In other words, the foundation’s benefits were overly directed toward a narrowly designated group, the single chapter at issue.  Compounding this problem, the foundation acknowledged that typically about ½ of the members of that chapter would receive a scholarship, which acknowledgment led to other problems.

For instance, because nearly ½ of members would receive scholarships in a normal year, the IRS found an unacceptably high level of pre-selection of scholarship recipients.  In short, donors would know, in advance, that their donations would assist only certain applicants from a small pre-identified pool.

Finally, the fact that some or all of the room and board portion of the scholarships would be paid to or for the benefit of the house corporation resulted in a significant private benefit to the house corporation.

Lessons learned.

What to do:

a)Ensure your educational foundation is multi-faceted and not formed solely to grant scholarships to a single chapter; all foundations can have other equally important educational missions;

b)Establish a finite and specific number of scholarships that must be earned through some sort of demonstrable achievement; and

c)Ensure that potential recipients remain anonymous to awarding committee.

What not to do:

a)Limit the foundation’s educational mission to granting scholarships to single chapter;

b)Tie number or amount of scholarship grants to fundraising successes;

c)Establish scholarship programs that allow grant money to be used for non-educational purposes, particularly if the non-educational and non-charitable entity receiving the grant funds is a related house corporation.