Have you heard about scholarship trusts but aren’t entirely sure what they are or how they work? You’re not alone. Scholarship trusts can seem confusing at first glance due to their complex nature and many technical details. However, with the right information, scholarship trusts start to make more sense.
What is a Scholarship Trust?
At its core, a scholarship trust is a financial vehicle established to fund future education expenses. However, there are some key details that distinguish scholarship trusts from other education savings options:
- Legal Structure: Scholarship trusts are set up as irrevocable trusts with a non-profit purpose of funding education. This non-profit structure has important tax implications.
- Funding: Scholarship trusts are typically funded by substantial gifts or transfers of assets, usually during the trust settlor’s lifetime. The donated assets are then invested long-term to grow tax-free.
- Beneficiaries: The beneficiaries are typically children, grandchildren, or other relatives of the trust settlor. The trust outlines criteria for awarding scholarship funds to qualifying beneficiaries.
- Educational Purpose: Monies disbursed from the trust must be used solely for Qualified Education Expenses as defined by the Internal Revenue Code, such as tuition, books, fees, and supplies. Personal expenses do not qualify.
- Administration: A trustee, often a financial institution or trust company, oversees investment management and distributions according to the trust terms. Beneficiaries have no access or control over trust assets.
So in summary, a scholarship trust is an irrevocable, non-profit trust designed to invest gifted assets tax-free for long-term growth, with disbursements restricted to the qualified education expenses of designated beneficiaries. Let’s explore the key components in more depth.
Establishing the Scholarship Trust
The process of establishing a scholarship trust starts with drafting a formal trust document that specifies important details like:
Trustee and Successor Trustees
The original trustee, often a bank trust department, manages and invests the trust assets according to the terms. Successor trustees are named in case the primary trustee is no longer able or willing to serve in the role.
Trust Settlor and Secondary Settlors
The trust settlor establishes and initially funds the trust. Secondary settlors may contribute additional assets later. Both receive income tax deductions for eligible gifts to the trust.
Trust Beneficiaries
The trust names potential beneficiaries, typically family members, and outlines criteria they must meet to qualify for distributions, such as enrollment in an accredited educational institution.
Distributions to Beneficiaries
The trust dictates how scholarship funds will be awarded, such as annually or upon request for verified education expenses. It may specify award amounts, rules if beneficiaries do not use funds, and what happens to remaining funds after all beneficiaries are done with school.
Investment Management
The trust grants authority to the trustee to prudently invest trust assets for growth according to fiduciary standards of care. It may outline an investment philosophy or place restrictions on certain investments.
Notification and Reporting Procedures
Beneficiaries and secondary settlors often have rights to information like annual accountings of trust activity from the trustee. The trust addresses communication logistics.
Amendment and Termination Provisions
While irrevocable, the trust may permit some changes to be made to ensure it continues functioning as intended. It specifies how the trust closes out upon termination.
An attorney experienced in tax and estate law ensures the trust document is properly structured to fulfill its purpose before it is signed and funded by the initial gift or transfer of assets from the trust settlor.
Tax Benefits of Scholarship Trusts
One of the main advantages of a scholarship trust is the benefit of tax-free growth on gifted assets, which can substantially increase the overall payout over time. This stems from the trust’s irrevocable, non-profit legal structure.
Income Tax Savings
As an irrevocable trust with a qualified education purpose, a scholarship trust is exempt from income tax on its annual earnings, interest, and capital gains. All investment profits compound without taxation each year.
Gift & Estate Tax Deduction
Contributions to the scholarship trust qualify for the annual gift tax exclusion amount, which allows trusts to receive up to $15,000 tax-free from each donor annually. Any amount above the exclusion reduces the donor’s lifetime gift & estate tax exemption.
Taxation of Distributions
Qualified distributions from the scholarship trust to beneficiaries for education expenses are not taxed as income. However, any excess payments not used must be included in the student’s taxable income.
The triple tax benefit of avoiding income, gift, and estate taxes on the long-term growth of gifted assets inside the scholarship trust makes it a powerful tool for funding future education costs in a tax-advantaged manner. Asset compounding occurs at a significantly faster rate without taxes, reducing returns each year.
Investing Scholarship Trust Assets
Once funded and established, the trustee takes over the management of the scholarship trust’s investment portfolio according to their fiduciary duty of care. Their goals are to prudently grow the assets for the benefit of future students within the trustee’s understanding of acceptable risk thresholds.
Diversified Approach
Most trustees follow a diversification strategy similar to an endowment fund, blending multiple asset types like stocks, bonds, and alternatives. This aims to achieve stable, long-term growth suitable for the trust’s intergenerational time horizon while balancing risks.
Low Fees
Mutual funds, ETFs, and separately managed accounts provide cost-effective exposure across different markets. Index funds predominate to minimize expenses, though some active funds may also be included.
Income Focused
Generating sufficient income is crucial to fund scholarships. The portfolio emphasizes dividends, interest payments, and preferred stocks, which yield high current income alongside growth of capital over time.
Liquidity Reserve
A certain allocation remains in short-term investments like money markets that provide immediate cash availability when distributions to students are requested.
Through diligent stewardship, a prudent investing approach under the guidance of experienced trust managers has the power to multiply initial gift amounts into tremendous scholarship opportunities over many generations.
Awarding Scholarship Funds
Once trust beneficiaries begin higher education, the process of awarding scholarship funds commences according to the terms in the trust document.
Notifications and Applications
The trustee notifies eligible family members of the opportunity. Beneficiaries submit applications with proof of enrollment and education costs. Awards are made to qualified individuals based on objective selection criteria.
Timing of Distributions
Some trusts release a set amount annually upon request, while others provide lump sums for large expenses like tuition payments. Multi-year awards ensure continuous support throughout a degree program.
Verifying Qualified Expenses
Prior to distribution, the trustee must validate that submitted expenses meet the IRS definition of “qualified education expenses” and are eligible to receive untaxed scholarship funds. Books, fees, and supplies qualify, but personal living expenses do not.
Award Options When Not in School
The trust may permit young beneficiaries to defer awards if not yet in school or allow unused funds to accumulate interest for future semesters. Awards may resume later if education is pursued.
Trust Continuation or Termination
What happens when all originally named beneficiaries complete their education? Well-drafted trusts continue making awards to extended families or may terminate, with the remaining principal distributed to designated charities serving similar education missions.
By adhering to IRS rules and trust terms, scholarship trusts empower students and ease financial burdens through multi-year support tailored specifically to qualifying education costs. The meaningful impact resonates for generations.
Additional Scholarship Trust Case Studies
To better illustrate the mechanics and long-term potential of scholarship trusts, consider two hypothetical case studies:
The Johnson Family Scholarship Trust
In 2009, Jenna and Jeff Johnson gifted $500,000 in appreciated stocks to a scholarship trust for their children and grandchildren. Over 12 years, the portfolio grew 80% to $900,000. Two daughters earned $150,000 each for graduate school. Three grandchildren received $50,000 each for college. The remaining $300,000 continues funding future education while growing assets.
The Wilson Legacy Education Fund
In 1980, William Wilson gifted a vacation property valued at $300,000 to a trust. A lifetime of prudent management by professional trustees grew the assets 15-fold to $4.5 million over 40 years. The fund awarded $3 million total to 20+ family members pursuing post-secondary education. With three more generations left eligible, it will continue making meaningful impacts for decades to come.
These examples demonstrate how even moderate initial gifts can achieve tremendous scale through long-term trust stewardship, becoming enduring philanthropic resources exceeding all expectations far into the future. Scholarship trusts unlock enduring intergenerational education opportunities.
