Education Equals Indebtedness?

We’re more than halfway through the month of August and many college students are returning to their campuses where they will resume their studies. It should be a time of great expectation for these students and for their families.[i]

Unfortunately, for all too many of these young adults, the prospect of expanding one’s mind, and of improving one’s chances for success in the “real world,”[ii] may be overshadowed by the likelihood of also increasing one’s indebtedness to the point where a preferred career path is supplanted by a better-paying (but less satisfying) job, or where one’s debt burden may foreclose other opportunities (like starting a business or purchasing a property).

According to an article in Forbes earlier this year,[iii] “There are more than 44 million borrowers who collectively owe $1.5 trillion in student loan debt in the U.S. alone. Student loan debt is now the second highest consumer debt category – behind only mortgage debt – and higher than both credit cards and auto loans.”

There is no hyperbole in stating that the issue of student debt has become one of the greatest challenges to our economy and society. As legislatures and academia argue over where to assign blame for this state of affairs, and as they debate –without progress – over possible solutions, many closely held businesses and their owners have already taken tangible steps toward alleviating the college debt burden for at least for some of their employees.

The vehicle that is often utilized for this job is the company foundation.[iv]

“Corporate Charity”

Many successful business owners attribute some part of their financial success to their community. The term “community” may have a different meaning from one business owner to another, but it usually includes the community in which the business operates and from which it draws its workforce, though it may also extend to those areas to which it sells its services or products, as well as those locales in which its vendors are located.

For some of these business owners, it is not enough to simply acknowledge a “debt” to their community; rather, they feel an obligation to share some of their financial success with the community. Some owners or businesses will make contributions to local charities,[v] schools, and hospitals. Others will provide grants to local residents who otherwise could not afford living or medical expenses. Still others will solicit the voluntary assistance of their workforce to support a local charity in a fundraising or public awareness event.

These endeavors are commendable, but they are of an ad hoc nature, which means they are also of limited duration. This is because such activities are not necessarily institutionalized and they are dependent, in no small part, upon the business owner, who is usually the catalyst for the charitable activities of the business.

Private Foundations

Recognizing these limitations, some business owners will establish a private foundation – typically, as a not-for-profit corporation (separate from the business),[vi] that may be named for the owner, the owner’s family, or the business – which they will fund with an initial contribution of cash or property, either personally or through the business. In later years, an owner may contribute additional amounts to the foundation, often culminating with a significant bequest to the foundation upon the death of the owner.[vii]

With this funding, the foundation – which consequently will not be financially dependent upon contributions from the general public (thus a “private” foundation, as distinguished from a “public” charity) – will have the wherewithal to conduct its charitable activities.

In most cases, the foundation’s activities will be limited to making grants of money to other not-for-profit organizations that are directly and actively engaged in charitable activities (i.e., not grant-making) – within and without the business’s community – and that have been recognized by the IRS as tax-exempt, publicly supported charities.[viii]

However, some company-sponsored foundations will also provide scholarships to fund the education of certain students.[ix] There is considerable flexibility in the design of such a scholarship program; for example, it may require that a student be enrolled at a particular school in order to qualify for a grant, or that they attend a school within a designated geographic area, or that they pursue a particular field of study.

In fact, the program may even be limited to students who are lineal descendants of employees of the business that organized the foundation, as was illustrated by a recent IRS private letter ruling[x] in which the IRS considered a private foundation’s request for approval of its employer-related scholarship program[xi]to fund the education of qualifying students.

Employer-Related Scholarships

Foundation’s general purpose was to make distributions for charitable and educational purposes within the meaning of Section 501(c)(3) of the Code.

However, Foundation also sought to operate an employer-related scholarship program (the “Program”), the purpose of which was to provide educational scholarships to the lineal descendants of employees of Business by selecting qualified individuals to receive grants to advance their education.

Eligible Recipients

“Lineal descendants” included, but were not limited to, children, step-children, adopted children and grandchildren of eligible employees of Business. An eligible employee was one who had completed one year of continuous full-time service with Business prior to the date the scholarship would be awarded. Eligibility was not based upon the employee’s position or title within Business, nor was it conditioned upon the employee’s continued employment with Business.

All students who had graduated from high school and planned to attend an accredited post-secondary educational institution were encouraged to apply for a scholarship. All students were considered regardless of their sex, race, age, color, national origin, religion, marital status, handicap, veteran status or parental status.

The post-secondary educational institution had to be accredited by a regional accreditation organization, or an equivalent, as determined by the Scholarship Committee.

The Committee and the Awards

The Scholarship Committee consisted of five community representatives who were separate and independent from Business.

The size of the scholarship award would be determined by the Scholarship Committee.

The number of scholarship awards would be dependent upon the number of students who were eligible or who applied for an award. In each year, the number of awards would not exceed the lesser of: (i) twenty-five percent of the number of students who were considered by the Scholarship Committee; or (ii) ten percent of the number of individuals who could be shown to be eligible for the awards. If more than one scholarship award was granted in a given year, each award would be in identical amounts.

In any year that the above percentages tests were not met, awards would not be granted, and the funds would accumulate for the following year.

Each award was granted for a one-year period, with possible renewals. Awards did not automatically renew. Students had to reapply every year. When reapplying, a student recipient in a prior year would be considered eligible even if the student’s “employee-sponsor” was no longer employed by Business.

Awareness

Foundation’s Program was communicated through employees’ newsletters, mailings to employees’ homes, company bulletin boards, presentations at employees’ meetings, inserts in employees’ checks, news releases to the media, and any other reasonable form of communication.

In all communications, the scholarship was not to be portrayed as an independent incentive or recruitment device for prospective employees, or as additional employee compensation.

Application

Selection of award recipients was based on financial need, scholarship, recommendations, test scores, class ranking, and extracurricular involvement.

The scholarship application requested the following items:

1. A one-page essay detailing the applicant’s high school years (or if re-applying, post-secondary years) and activities, as well as plans for the future. The essay also included extra-curricular activities.
2. Copy of the applicant’s most recent IRS Form 1040 (individual income tax return).
3. Copy of the applicant’s college acceptance letter (graduating high school seniors).
4. Copy of the applicant’s most recent high school or college grades, showing all years attended.
5. Two letters of recommendation – one from a teacher and one from an individual who was not a teacher or a relative.

After the applications had been reviewed, the applicants were rated by the Scholarship Committee based on various factors, including academic performance, extracurricular and community activities, financial need, full-time status, personal interview, and an essay designed to show the applicant’s motivation, character, ability and potential.

Award recipients were required to provide the Scholarship Committee a progress report at the end of the first semester of the academic year, and at the end of the academic year. The progress report had to include a copy of the student’s transcripts for the academic year, and a letter summarizing the student’s progress and the importance of the award to the student’s academic progress.

Supporting Records

The Scholarship Committee maintained the following records for each scholarship grant awarded:

1. Statement of the objective and non-discriminatory procedures used to select recipients;
2. Adequate information regarding each applicant, including all information that the Scholarship Committee secured to evaluate the qualifications of the applicant;
3. Identification of the applicant;
4. Specification of the award amount and demonstration of the qualifying purposes for which the award was used (qualified tuition and related expenses);[xii]
5. Verification of the appropriate publication of the scholarship award program and results; and
6. Information which the Scholarship Committee obtained regarding follow-up investigation, including follow-up reports required from all recipients.

Safeguards

Scholarship funds would be disbursed to the educational institution which the award recipient was attending, rather than to the student.

The Scholarship Committee would investigate any misuse of funds and withhold further payments, to the extent possible, if the Scholarship Committee did not receive a required report, or if reports or other information indicated that grant proceeds were not being used for the purpose for which the grants were made. The Scholarship Committee would take all reasonable and necessary steps to recover grant funds, or to ensure restoration of the funds and their dedication to the purposes the grant funds were financing.

Taxable Expenditures

Sounds challenging, doesn’t it? In fact, it is. That’s because the Code makes it difficult for a private foundation to simply write a check to a private individual, as opposed to making an unrestricted grant to a recognized public charity.[xiii]

Private foundations are not dependent upon the public for financial support and, so, are not to “answerable” to the public, at least in theory. For that reason, the Code provides a number of restrictions upon the use of foundation funds.[xiv]These restrictions seek to discourage, and hopefully prevent, certain activities by a private foundation that the IRS deems to be contrary to, or inconsistent with, the charitable nature, and tax-exempt status, of the foundation.

The IRS enforces these restrictions through the imposition of special excise taxes (i.e., penalties) upon the foundation, the foundation’s managers (e.g., its board of directors), and so-called disqualified persons (i.e., persons who are considered to be “insiders” with respect to the foundation).

Among the activities that the Code seeks to discourage is a foundation’s expenditure of funds for a proscribed purpose (a “taxable expenditure”); for example, a grant to a non-charitable organization or for a non-charitable purpose. The Code imposes a twenty percent excise tax on the taxable expenditures of a private foundation.[xv]

Grants to Individuals

A taxable expenditure also occurs when a private foundation pays a grant to an individual for travel, study, or other similar purposes.

However, a grant that meets all of the following requirements is not treated as a taxable expenditure:[xvi]

• The grant is awarded on an objective and nondiscriminatory basis.
• The IRS approves in advance the procedure for awarding the grant.
• The grant is a scholarship or fellowship subject to Section 117(a) of the Code.[xvii]
• The grant is to be used for study at a qualified educational organization.

Guidelines

Long ago, the IRS provided guidelines[xviii] to determine whether the grants made by a private foundation under an employer-related program to employees, or children of employees, were scholarship or fellowship grants subject to the provisions of Sec. 117(a) of the Code. If the program satisfied the seven conditions set forth in these guidelines,[xix] and also met the applicable “percentage tests” described in the guidelines, the IRS would assume the grants were subject to the provisions of Sec. 117(a) and, therefore, were not taxable expenditures.

These percentage tests require that:

• The number of grants awarded to employees’ children in any year won’t exceed 25 percent of the number of employees’ children who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants, or
• The number of grants awarded to employees’ children in any year won’t exceed 10 percent of the number of employees’ children who were eligible for grants (whether or not they submitted an application), or
• The number of grants awarded to employees in any year won’t exceed 10 percent of the number of employees who were eligible for grants, were applicants for grants, and were considered by the selection committee for grants.

In determining how many employees’ children are eligible for a scholarship under the 10 percent test, a private foundation may include as eligible only those children who submit a written statement or who meet the foundation’s eligibility requirements.[xx] They must also satisfy certain enrollment conditions.[xxi]

The IRS’s Ruling

Foundation represented that its procedures for awarding grants under the Program satisfied the seven conditions set forth in the guidelines:

• An independent selection committee, whose members were separate from Foundation, its creator, and the employer, would select individual grant recipients.
• Foundation would not use grants to recruit employees, nor would it end a grant if the employee left the employer.
• Foundation would not limit the recipient to a course of study that would particularly benefit Foundation or the employer.
• Foundation would not award grants to its creators, officers, directors, trustees, foundation managers, or members of selection committees or their relatives.[xxii]
• All funds distributed to individuals would be made on a charitable basis and further Foundation’s charitable purposes.
• Foundation would not award grants for a non-charitable purpose.
• Foundation would keep adequate records and case histories so that it could substantiate its grant distributions with the IRS if necessary.

On the basis of the foregoing, the IRS approved Foundation’s procedures for awarding employer-related scholarships to qualifying lineal descendants of Business’s employees. As a result, the expenditures to be made by Foundation under those procedures would not be subject to the excise tax.

The IRS also ruled that the awards made under those procedures were scholarship grants and, so, were not taxable as income to the recipients if used by them for qualified tuition and related expenses.

It’s Worth the Effort

A company-sponsored grant-making foundation is an effective, and tax-advantaged, tool that may be used by a closely held business to support, or engage in, charitable activities within its community.

With appropriate safeguards, like those described above, such a foundation may expand its charitable reach – and its impact on people’s lives – by also granting scholarships for education to qualifying members of its workforce and their families.

However, if a company’s foundation disregards these safeguards as too burdensome, the foundation’s grants will essentially be treated as extra pay, an employment incentive, or an employee fringe benefit, which will be taxable to the employee.[xxiii] What’s more, a compensatory scholarship program will cause the foundation to lose its tax exempt status because it is being operated for the private benefit of the employer-company.

The main purpose for the scholarships awarded by a private foundation to a company’s employees must be to further the recipients’ education rather than to compensate company employees. The incidental goodwill and employee loyalty generated for the business should not be underestimated.

[i] I have to confess, the sight of school buses in early September still makes me anxious.

[ii] According to the World Bank, workers with more education earn higher wages than employees with no post-secondary education. Those with only a high school degree are twice as susceptible to unemployment than workers with a bachelor’s degree. https://borgenproject.org/economic-benefits-of-education/

[iii] https://www.forbes.com/sites/zackfriedman/2019/02/25/student-loan-debt-statistics-2019/#1c699231133f

[iv] IRC Sec. 509(a).

[v] The word “charity” is interpreted very broadly under the Code.

[vi] Though a charitable trust may also be used. For example, see Article 8 of N.Y.’s EPTL. I prefer a not-for-profit corporation.

[vii] Either directly or through a split-interest trust.

[viii] IRC Sec. 501(a), Sec. 501(c)(3), and Sec. 509(a).

[ix] Several of our clients have done so.

[x] PLR 201932018 (Release Date: 8/9/2019). It should be noted that the IRS issues many such rulings, which means that many businesses are sponsoring such programs. Please also note that such rulings may not be cited as precedent, though they do give us an indication of the IRS’s position on a given issue.

[xi] Under IRC Sec. 4945(g).

[xii] See IRC Sec. 117.

[xiii] Note that more and more private foundations are restricting the purposes for which a public charity may use the foundation’s grant. A foundation will often identify the specific purpose that the grant seeks to accomplish, and it will hold the recipient public charity accountable for the use of the grant monies; for example, the foundation may require periodic progress reports from the public charity, or it may condition future grants on the charity’s “performance” under the restricted grant.

[xiv] The price for their tax-exempt status.

[xv] A tax equal to 20 percent of the amount of the expenditure, which is payable by the foundation. Other taxes may be paid by foundation managers. IRC Sec. 4945(a).

[xvi] IRC Sec. 4945(g). See also IRS Form 1023, Schedule H, Organizations Providing Scholarships, Fellowships, Educational Loans, or Other Educational Grants to Individuals and Private Foundations Requesting Advance Approval of Individual Grant Procedures. https://www.irs.gov/forms-pubs/about-form-1023

[xvii] IRC Sec. 117(a) provides that gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization described in section 170(b)(1)(A)(ii).The term qualified scholarship means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for tuition and fees required for the enrollment or attendance of a student at an educational organization described in section 170(b)(1)(A)(ii), and fees, books, supplies, and equipment required for courses of instruction at such an educational organization.

[xviii] Revenue Procedure 76-47.

[xix] See below.

[xx] Revenue Procedure 85-51.

[xxi] They are enrolled in or have completed a course of study preparing them for admission to an educational institution at the level for which the scholarships are available, have applied or intend to apply to such an institutions, and expect, if accepted, to attend such an educational institution in the immediately succeeding academic year; or they currently attend an educational institution for which the scholarships are available but are not in the final year for which an award may be made.

[xxii] Basically, insiders. Self-dealing under IRC Sec. 4941?

[xxiii] They may even be treated as a gift by the employee to the recipient.

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