Nonprofit Law Jargon Buster: What is an Endowment?

Black’s Law Dictionary, 9th ed., defines an endowment as:

A gift of money or property to an institution (such as a university) for a specific purpose, esp. one in which the principal is kept intact and only the interest income from that principal is used.

This is the popular definition familiar to most nonprofit executives. However, in most jurisdictions, endowment funds are regulated by the state’s version of the Uniform Prudent Management of Institutional Funds Act (“Act”).

The Act serves as a set of default rules that govern an endowment gift when the donor does not communicate the terms of the gift to the organization. Under the Act, unless the donor specifies a shorter term, the default rules of the Act require endowment funds to be maintained in perpetuity.

The Act provides, in relevant part, as follows:[1]

C.         Terms in a gift instrument designating a gift as an endowment, or a direction or authorization in the gift instrument to use only income, interest, dividends or rents, issues, or profits, or to preserve the principal intact, or words of similar import:

1.         Create an endowment fund of permanent duration unless other language in the gift instrument limits the duration or purpose of the fund. [italics added]

The perpetual nature of most endowment funds is a revelation that has taken many well intentioned nonprofit organizations by surprise. The donor can stipulate a different term expressed as a term of years or as a condition that when met will trigger a release of the endowment restriction. Endowment funds that are not permanent are known as “temporary endowments”.

Another variation on the term occurs when a Board of Directors appropriate unrestricted funds from the organization’s general operating or reserve accounts and designates them as endowment funds. Such funds are not true endowments because they are not donor-restricted. The Board created the restriction and the Board can terminate the restriction. Appropriately, such funds are referred to as “quasi-endowments”.

Another key change the Act has introduced is a departure from the old rule that only the income from an endowment fund could be spent. This created problems in times of low or negative returns as funds went “underwater” and funding for programs disappeared. To address this problem, the Act permits expenditures from an endowment to be made based on a prudence standard that takes seven factors into consideration as follows:

  • the duration and preservation of the endowment fund;
  • the purposes of the institution and the endowment fund;
  • general economic conditions;
  • the possible effect of inflation or deflation;
  • the expected total return from income and the appreciation of investments;
  • other resources of the institution; and
  • the investment policy of the institution.

The idea is that in periods of economic decline the fund will deteriorate but in times of economic growth the fund will grow.  Over time, if the fund is managed according to these seven factors, funding can continue even if it dips somewhat below the amount of the original gift during economic downturns since it is building in times of growth.

It is important to understand what type of endowment is being solicited from a donor and what rules govern the management of the endowment. From the donor’s perspective, a permanent endowment gift permits their donation to have a much greater impact because it is invested to provide a permanent source of income for the organization. Therefore, violations of endowment restrictions are viewed as serious breaches of a donor’s trust in addition to legal violations.

Ellis Carter is a nonprofit lawyer licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.

 

 


[1] A.R.S. § 10-11803(C)(1).

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