IRS, Treasury Release Proposed Regulations on Racial Nondiscrimination for Private Schools

If finalized, the proposed regulations would go into effect for taxable years beginning after May 31, 2027, and would apply to both newly formed private schools seeking exemption and current private schools seeking to maintain their exemption. The IRS and Treasury have requested comments on the proposed regulations. Written or electronic comments must be received on or before November 3. A public hearing is scheduled for December 2 at 10:00 AM ET regarding the proposed regulations.

Proposed Regulations 

The proposed regulations would add a new Section 1.501(c)(3)-2 to the existing regulations under Section 501(c)(3). Under Section 1.501(c)(3)-2, a private school would not be described in Section 501(c)(3) if the school “adopts, maintains, or enforces any policy or practice that discriminates on the basis of race, color, or national or ethnic origin in the administration of any educational policy, admissions policy, scholarship or loan program, athletic program, or other school-administered or school-supported program.” The regulations further provide that “discrimination on the basis of race, color, or national or ethnic origin includes any discrimination on the basis of race, color, or national or ethnic origin for any purpose.” 

The regulations define a “private school” as an organization described in Section 501(c)(3) (determined without the nondiscrimination requirement) and classified as an “educational organization” under Section 170(b)(1)(A)(ii). An “educational organization” under Section 170(b)(1)(A)(ii) is an organization that normally maintains a regular faculty and curriculum and has a regularly enrolled body of students in attendance where its educational activities are conducted. 

The term does not include “a governmental unit, an agency or instrumentality of a governmental unit, or an organization that is owned or operated by an agency or instrumentality of a governmental unit.”¹

The preamble to the proposed regulations indicates that they would not preclude a private school from maintaining a religious mission, curriculum, or program of observance, or from selecting students on the basis of religious affiliation, even if members of the particular religious community may also share ancestry or ethnic characteristics, so long as the selection criteria is based solely on religion and not on shared ancestry or ethnic characteristics.

Remedial and Diversity-Related Objectives Prohibited

A stated purpose of the proposed regulations is to “provide that all forms of racial discrimination in education, regardless of the intent behind or the legality of such discrimination (for example, where such discrimination is defended as serving remedial or diversity-related objectives), are against a fundamental public policy of the United States and thus preclude a school’s exemption from Federal income tax under section 501(c)(3).” The proposed regulations would modify Rev. Proc. 75-50, which was issued by the IRS following litigation concerning segregation and racial discrimination in tax-exempt private schools. Rev. Proc. 75-50 sets forth how private schools can demonstrate that they are not racially discriminatory and requires that private schools adopt a nondiscriminatory policy. Rev. Proc. 75-50 currently provides that: 

• “[A] policy of a school that favors racial minority groups with respect to admissions, facilities and programs, and financial assistance will not constitute discrimination on the basis of race when the purpose and effect is to promote the establishment and maintenance of that school’s racially nondiscriminatory policy as to students.” 
• “[S]cholarships and loans that are made pursuant to financial assistance programs favoring members of one or more racial minority groups that are designed to promote a school’s racially nondiscriminatory policy will not adversely affect the school’s exempt status. Financial assistance programs favoring members of one or more racial groups that do not significantly derogate from the school’s racially nondiscriminatory policy similarly will not adversely affect the school’s exempt status.”

The proposed regulations would delete these sentences from Rev. Proc. 75-50 as they “would be incompatible with the new rules,” according to the preamble to the proposed regulations. The preamble also states that the regulations would “eliminate ambiguity and ensure consistent application across all private schools” and “provide administrative certainty for IRS personnel and ensure that Federal income tax exemption does not benefit racially discriminatory practices in education.”

Expected Impact on Private Schools and Students

Economic Effects Acknowledged by Treasury and the IRS

Treasury and the IRS estimate that the proposed regulations may affect approximately 18,000 private schools currently qualifying for tax-exempt status, as well as approximately 750,000 students attending those schools who may qualify for scholarships allocated on the basis of racial, ethnic, or national identity. 

Expected economic effects on private school financial aid policies acknowledged by Treasury and the IRS include: (1) legal and administrative costs to comply, particularly where race-based scholarships were endowed by donors whose gift agreements expressly include race-based eligibility criteria, (2) the distribution of scholarship and loan funds among students, altering the composition of the recipient pool, and (3) charitable giving behavior of donors who wish to provide scholarships or loans where race, ethnicity, or national origin are included in the set of eligibility criteria. 

Ambiguities and Open Questions

The proposed regulations leave a number of significant questions unanswered. While the regulatory text establishes a broad prohibition, it does not define several key terms, does not provide transition rules or safe harbors, and does not address how the nondiscrimination requirement applies to common institutional arrangements such as donor-restricted endowments, multi-year student aid commitments, and programs administered by affiliated organizations. The following are among the most significant open questions.

Donor-Restricted Scholarships and Endowments

Treasury and the IRS acknowledge in the preamble that, for race-based scholarships endowed by a restricted gift from a donor that include race-based criteria, schools may need to work with the donors or take other steps as necessary in compliance with applicable state law to modify donor restrictions. However, the regulations do not address the practical difficulties of doing so. Modification of donor restrictions can be time consuming and potentially costly, and the regulations do not address whether a school that is actively pursuing legal modification of a restricted fund but has not yet obtained it would be deemed noncompliant during the pendency of that process. Because the proposed regulations have not been finalized, schools may find themselves needing to begin taking steps toward compliance — and incurring significant costs in doing so — before knowing whether the regulations will go into effect in their current form.

Impact on Students Receiving Race-Based Financial Aid

For students currently receiving student aid under a program that includes race-based criteria, the regulations do not expressly allow those students to continue receiving those awards, potentially leaving students with a funding gap to complete their education if their awards are terminated. The preamble to the proposed regulations provided no insight as to how those awards may be impacted by the proposed regulations and whether schools may need to reevaluate them under revised criteria before providing further funding.

Undefined Key Terms

The regulations also do not define “discriminates.” It is unclear whether “discriminate” requires intentional discrimination (disparate treatment) or also reaches policies with disparate impact (i.e., facially neutral policies that disproportionately affect certain racial or ethnic groups). The preamble does, however, suggest schools can use “alternative criteria, such as income, geography, or first-generation student status,” and states these criteria have “a weaker relationship with race and ethnicity and a stronger relationship with other indicators of disadvantage such as income.”

The regulations also do not clarify what constitutes a “school-supported program,” and the preamble offers no examples or safe harbors. It is unclear, for example, whether independent and separately incorporated organizations (e.g., alumni organizations, outside scholarship providers, student-run organizations, or community mentoring programs) would be covered if the school provides funding, staffing, facilities, branding, or other forms of institutional support.

Impact on Affiliated Organizations and Third-Party Scholarship Providers

It is also unclear how these regulations, if finalized, would impact organizations that are not themselves schools but that operate race-based scholarship programs and make scholarship grants to private schools on behalf of students, and whether schools accepting those grants would be at risk. Some schools may also have affiliated organizations that are not educational organizations within the meaning of Section 170(b)(1)(A)(ii) but that operate scholarship programs for the benefit of the school or its students, and the regulations do not address whether such arrangements would fall within the scope of the nondiscrimination requirement.

Given the significance and impact of the proposed regulations, extensive comments and legal challenges are expected. A public hearing is scheduled for December 2 at 10:00 a.m. Eastern Time regarding the proposed regulations. To speak at the public hearing, the IRS must receive speakers’ outlines of the topics to be discussed by November 3 electronically via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-119986-25) or mailed to CC:PA:01:PR, (REG-119986-25), Room 5503, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

ArentFox Schiff’s Nonprofits & Associations team is closely monitoring these proposed regulations. For additional guidance, please contact your AFS attorney or any of the authors of this alert. 

[1] Governmental units do not hold their tax-exempt status under Section 501(c)(3) and are subject to constitutional and statutory nondiscrimination requirements (e.g., the Equal Protection Clause and Title VI of the Civil Rights Act of 1964, which prohibits discrimination based on race, color, and national origin in any program or activity that receives federal financial assistance).