IRS DEI Proposal Creates Legal Double Bind for Private Schools

A proposed rule that could deny tax benefits to private schools that discriminate based on race, including through DEI efforts, doesn’t just raise tax questions. It creates a collision between tax law and employment law that schools, colleges, and universities will need to manage simultaneously — or risk solving one problem by creating another.

For private schools, colleges, and universities, tax-exempt status is becoming another enforcement tool in the federal government’s heightened scrutiny of race-conscious practices. The institutions that move first and most carefully will be best positioned when the final rule arrives.

Significant Rule Shift

The IRS has conditioned tax-exempt status on racial nondiscrimination since 1971, when it published its position in Revenue Ruling 71-447. The US Supreme Court affirmed that authority in Bob Jones University v. United States in 1983, which involved a school that prohibited interracial dating and marriage.

But the framework that followed, built largely on Rev. Proc. 75-50 and related guidance, focused on exclusionary discrimination, in part to avoid inquiries into subjective intent. Its silence on affirmative uses of race left room for schools to maintain race-conscious scholarships or diversity-focused admissions criteria without jeopardizing its exemption.

The proposed regulation would largely eliminate that ambiguity with a uniform nondiscrimination standard under which any use of race, color, national or ethnic origin — regardless of direction or purpose — could jeopardize a school’s tax-exempt status. Under this standard, a race-restricted scholarship and a policy that excludes minority students would be treated identically.

The IRS cites Brown v. Board of Education, Bob Jones, and the Supreme Court’s 2023 decision in Students for Fair Admissions, Inc. v. President and Fellows of Harvard College, which addressed race-conscious admissions under the Equal Protection Clause, not the Internal Revenue Code, as its legal foundation.

The proposal isn’t limited to admissions. The nondiscrimination standard would reach scholarships and financial aid, athletics, educational policies, and “any other school-administered or school-supported program.”

The compliance pressure may push institutions toward modifying, restructuring, or eliminating race-conscious programs. But many of these programs are woven into the institution’s employment infrastructure — hiring commitments, contract terms, faculty governance roles, and collectively bargained obligations. Changes undertaken without parallel employment-law planning can create new legal exposure; the very steps a school takes to preserve its tax-exempt status could trigger discrimination claims, labor grievances, or breach of contract suits.

Employment Law Problem

Institutions have long built infrastructure around a framework of diversity, equity, and inclusion: employment contracts, collective-bargaining agreements, faculty governance structures, and donor-funded programs all reflect commitments that were, until now, consistent with IRS expectations.

The proposed rule would change the rules underneath those commitments. Unwinding them would create uncertainty for tax-exempt entities that has nothing to do with the tax code.

Discrimination and retaliation. The Equal Employment Opportunity Commission has long supported employer efforts to implement lawful and appropriate efforts to remove barriers to equal employment opportunity and the cultivation of a diverse workforce. Tax-exempt organizations would now have to modify or eliminate such programs that, if properly administered, have been permitted under Title VII to maintain their tax-exempt status.

Collective bargaining. Where DEI commitments are embedded in collective-bargaining agreements, institutions cannot simply remove them. Unilateral changes to bargained-for terms risk grievance proceedings or unfair labor practice charges — even when the changes are driven by tax compliance.

Breach of contract. Where employment contracts or offer letters include DEI-related responsibilities — such as serving on a diversity committee or administering a minority fellowship — unilateral elimination of those duties could give rise to breach of contract claims.

All these risks are foreseeable — and avoidable with proper planning. Before modifying any program, institutions should assess whether the change implicates existing employment contracts, collective-bargaining agreements, or established workplace practices that employees may have relied upon. A privileged, cross-functional review involving tax, employment, and higher education counsel is the necessary first step.

Scholarship Wrinkle

Scholarships present a particular challenge. The Treasury and the IRS acknowledged that schools may need to revise race-based scholarship criteria and offered examples of race-neutral alternatives.

But modifying donor-restricted scholarships isn’t straightforward. Under existing law, exempt organizations generally can’t unilaterally change donor-imposed restrictions.

Modifying them typically requires donor consent or judicial action through doctrines such as cy pres or equitable deviation, and in some states, attorney general involvement. Some institutions have already begun this process in the wake of the Supreme Court’s SFFA decision.

This matters because many institutions hold endowments with race-based restrictions that predate modern nondiscrimination standards. Scholarship administrators cannot simply rewrite these criteria. Depending on the terms of the gift and applicable state law, modification may require donor renegotiation, judicial approval, or other steps that take time. Starting that assessment now gives institutions more room to maneuver.

Course of Action

The IRS expects to finalize the rule before May 31, 2027, with it applying to taxable years beginning after that date. But waiting for the final rule before acting carries risk.

Schools already make annual representations to the IRS concerning racial nondiscrimination, and the IRS will be able to look beyond an institution’s written policies to how its programs actually operate.

The ongoing comment period gives institutions an opportunity to advocate for transition periods or safe harbors, and the regulation is likely to face legal challenges on overbreadth and First Amendment grounds.

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