Your Questions About the Federal Scholarship Tax Credit Proposed Regulations, Answered

On October 8, FACTS Compass hosted a webinar, “What Treasury’s Proposed FSTC Rules Mean for Your Organization,” with policy experts Peter Murphy of Invest in Education and Jacque Mosely of Nelnet on Treasury’s proposed regulations for the Federal Scholarship Tax Credit (FSTC), also called the Education Freedom Tax Credit (EFTC). Here are the highlights and the 10 most commonly asked questions.

These rules are proposed, not final. Comments are due around December 1, so details may change.

Individuals and businesses can contribute to qualified Scholarship Granting Organizations (SGOs), but only eligible individual taxpayers can claim the federal scholarship tax credit. Corporations and other business entities cannot claim the credit.

The credit is up to $1,700 per individual annually, or up to $3,400 for married couples filing jointly when both spouses make qualifying contributions. Each spouse does not need to have a separate federal income tax liability; the credit is applied against their combined federal income tax liability on the joint return.

The credit is nonrefundable, meaning it cannot exceed the applicable federal income tax liability. Unused credits may be carried forward for up to five years.

Yes. Donors may qualify for both state and federal scholarship tax credits through a single contribution, but the same dollars cannot be used to claim both credits.

Under the proposed federal regulations, the state tax credit is applied first, and the amount eligible for the federal credit is reduced by the state credit received.

For example, a $2,000 contribution that generates a $300 state tax credit could also qualify for a $1,700 federal tax credit

A disqualified person includes an officer, director, or trustee of the SGO (or an individual with similar powers or responsibilities), a substantial contributor, any individual participating in the selection of scholarship recipients, including as a member of a committee, and certain family members of these individuals. Scholarships cannot be awarded to disqualified persons or their covered family members.

A substantial contributor is an individual whose contributions during the taxable year exceed $5,000 AND represent more than 2% of the total contributions received by the SGO or its applicable §25F segregated account. Contributions from spouses are combined. Substantial contributor status applies for the year the thresholds are met and the following taxable year.

Students must be members of households with income at or below 300% of area median gross income, adjusted for family size, based on the calendar year preceding the scholarship application. They must also be eligible to enroll in a public elementary or secondary school, although they are not required to attend one. Treasury estimates that approximately 95% of U.S. children fall below the income threshold. SGOs may establish lower income limits.

Students must reside in a state that has opted into the program and be eligible for scholarships through an SGO listed in that state. Eligibility is based on the student’s state of residence, not the location of the school they attend. Limited exceptions apply to military dependents and dependents of individuals residing on Indian Lands.

SGOs must verify household income and family size to determine student eligibility. The proposed regulations provide several verification methods and safe harbors:

• Direct income verification: Review prior-year tax returns, IRS transcripts, W-2s, pay stubs, or other relevant income data.
• Categorical eligibility: Accept documentation dated within the past 12 months confirming that someone in the household currently qualifies for SNAP, TANF, WIC, Section 8 housing assistance, or SSI.
• Foster children: Automatically satisfy the household income requirement without individual income verification.
• Tutoring and special needs safe harbor: Students receiving individual academic tutoring or special needs services may satisfy the income requirement without individual household income verification if their school is located in a qualified census tract (QCT), or at least 80% of the school’s students reside in QCTs. Students must be selected by the school based on their individual academic or special needs, and additional documentation and annual third-party audit requirements apply.

Household size generally includes everyone living in the household, and household income generally includes cash income from all household members age 18 or older, not just parents or guardians. This includes income from other adults living in the home, subject to certain exclusions. Child support and alimony are included when applicable, while noncash benefits are excluded.

Schoolwide free or reduced-price lunch eligibility cannot be used to verify an individual student’s household income. Treasury is seeking feedback on whether additional needs-based programs should qualify for categorical eligibility.

Yes. Families can apply to and receive scholarships from more than one SGO, and schools can partner with multiple SGOs. Multiple SGOs can contribute toward the same expense, such as tuition, as long as the combined scholarship payments do not exceed the actual cost. For example, if one SGO covers only part of a student’s tuition, another SGO may cover some or all of the remaining balance. The proposed regulations require SGOs to establish procedures to prevent and detect duplicate payments for the same costs.

Donors cannot earmark contributions for a specific student, although SGOs may allow donors to designate a school. The proposed regulations do not expressly establish a mechanism for one SGO to transfer qualified contributions to another SGO for scholarship distribution.

What an SGO must be

An SGO must be a 501(c)(3) public charity, not a private foundation, and be authorized to operate in each participating state where it is listed. A physical presence in the state is not required. It must also be included on the state’s approved SGO list and recognized by the IRS.

What an SGO must do

An SGO must:

• Award scholarships to at least 10 eligible students who do not all attend the same school, meeting this requirement separately in each state where it operates.
• Spend at least 90% of its income on scholarships for eligible students by the end of the following taxable year.
• Maintain separate accounts for qualified federal contributions, including separate accounts for each state if operating in multiple states.
• Verify student eligibility and ensure scholarship funds are used only for qualified education expenses.
• Give priority to returning scholarship recipients, followed by siblings of scholarship recipients.
• Prevent contributions from being earmarked for specific students and avoid awarding scholarships to disqualified persons.
• Meet annual reporting, recordkeeping, and audit requirements.

The proposed regulations distinguish between single-state and multistate SGOs.

Single-state SGOs: Organizations with at least 85% of their activities devoted to scholarship granting may use a safe harbor that allows them to apply the operational requirements, including the 90% spending requirement, to their separate §25F account rather than the organization as a whole.

Multistate SGOs: Organizations operating in more than one participating state must meet the 85% scholarship-granting activity test across the entire organization. They must also maintain a separate §25F account for each state where they are listed and independently satisfy the operational requirements in each state’s account, including awarding scholarships to at least 10 eligible students attending more than one school and spending at least 90% of qualified contributions and earnings on scholarships within the required timeframe.

For both models, scholarship-granting activities may include administration, fundraising, governance, investment, compliance, and outreach when those activities support scholarship granting. The 85% activity test is separate from the 90% spending requirement.

Treasury has requested comments on how the 85% test should be measured, including whether to use expenditures, receipts, staff time, or other measures.

Yes. The proposed Treasury regulations expressly recognize after-tax payroll deductions as an eligible method of making qualified cash contributions to scholarship granting organizations (SGOs).

This allows employees to contribute directly from each paycheck throughout the year. Employees can also adjust their Form W-4 to account for the anticipated federal scholarship tax credit, reducing federal income tax withholding and increasing take-home pay to help offset their contributions.

This creates an opportunity for donors to spread their contributions throughout the year and realize the tax benefit through their paychecks rather than waiting until they file their annual tax return.

No. Federal Scholarship Tax Credit scholarships are funded through private charitable contributions to scholarship granting organizations (SGOs), not federal appropriations. The fact that donors receive a federal tax credit does not make scholarship payments themselves federal grants or direct federal financial assistance.

For private schools: Accepting SGO scholarships does not, by itself, make a private school a recipient of federal financial assistance or change its status as a private institution. It also does not automatically reduce other funding or financial assistance.

For public schools: Public schools already receive federal funding, but FSTC scholarships provide an additional, privately funded source of support for eligible students. Accepting these scholarships does not automatically reduce existing state or federal funding. However, state funding formulas and requirements of other funding programs may affect how scholarship payments are treated.

For both public and private schools, FSTC scholarships must be used for qualified educational expenses, and schools remain subject to applicable federal, state, and local requirements.

While some operational requirements remain proposed, Treasury has issued temporary regulations establishing the registration and reporting framework. Organizations don’t need to wait for every rule to be finalized to begin preparing for January 1, 2027.

Five areas deserve attention:

• Organizational structure: Evaluate whether your organization meets the requirements to qualify as an SGO, including the 85% scholarship-granting activity test and 90% spending requirement. Single-state and multistate SGOs have different requirements, so existing education foundations should consider whether their current structure is appropriate.
• Registration: Prepare to register electronically with the IRS and ensure your organization is included on the appropriate state SGO list. Gather your EIN, tax-exempt documentation, and organizational information needed to demonstrate eligibility.
• Donor management and reporting: Establish processes to track qualified contributions, maintain separate §25F accounts, issue donor acknowledgments and unique donor identification numbers, and complete required IRS reporting. Reporting for 2027 contributions begins in early 2028, but accurate recordkeeping must begin with the first contribution.
• Scholarship administration: Plan how you will verify household income, family size, residency, and student eligibility; manage applications and awards; prevent duplicate payments; and distribute funds for qualified educational expenses.
• Compliance and audits: Establish processes to monitor scholarship spending, document eligibility and awards, track the 90% spending requirement, and prepare for annual reporting and independent audits.

You can also help shape the rules. Treasury is accepting public comments through December 1, 2026, including feedback on measuring the 85% activity threshold, additional income-verification safe harbors, and multistate SGO requirements. Comments can be submitted through regulations.gov (docket IRS-2026-1354).

Additional Treasury guidance on qualified educational expenses is expected by the end of 2026.

Watch the on-demand recording of the webinar to hear Peter Murphy and Jackie Mosely walk through the proposed rules.

The Federal Scholarship Tax Credit starts January 1, 2027, and the details are still taking shape. FACTS Compass is here to help you navigate it and to provide the infrastructure behind your program, from donor contributions to family applications and eligibility to fund management. Visit FACTS Compass to learn more.