Frequently Asked Legal Questions
Endowment Funds
Q1
What is an endowment fund?
An endowment fund is a fund held by a charitable organization in which the donor has imposed a restriction that prohibits some or all of the fund from being spent currently. This would include, for example, a gift that is to be held "in perpetuity," or one that must be held for 25 years before it can be spent.
Q2
How is an endowment fund created?
An endowment fund may be created by virtually any means that indicates that the donor intended to create an endowment fund. Such means include a direct instruction from the donor, a donor's gift designated for an existing endowment fund, or an otherwise undesignated gift that is received in response to a request for an endowment gift.
Q3
How must an endowment fund be invested?
In general, the board members of a foundation must perform their duties, including their investment duties, with the care an ordinarily prudent person in a like position would exercise under similar circumstances.
Various laws governing the investment of charitable assets — including the Uniform Management of Institutional Funds Act (UMIFA), the Uniform Prudent Investor Act (UPIA), and the Third Restatement of Trusts — all embrace the concept of modern portfolio theory. Under modern portfolio theory, prudent investment policy is based on diversification of assets, long-term performance benchmarks and the importance of a portfolio's total return on investment.
Q4
How much may be spent from an endowment?
Unless the donor specifies a particular percentage or dollar amount that is to be spent periodically from the endowment, the governing body of the foundation is responsible for determining the amount that may be spent currently from an endowment. In doing so, the board must act reasonably, and must take into account the short- and long-term needs of the institution in carrying out its charitable mission, its present and anticipated future financial needs, the expected total return on its investments, inflation and general economic conditions. Unless authorized by the gift instrument, the foundation may not spend down an endowment fund to a level below its "historic dollar value" (see next question).
Q5
What is "historic dollar value"?
"Historic dollar value" is the sum of all the contributions to the endowment fund from its beginning to the present, without any adjustment for investment performance, inflation or other factors.
Q6
What happens if the current value of an endowment is below its historic dollar value?
As a general rule, the board may not authorize distributions from an endowment if the fund is below its historic dollar value; however, many lawyers are of the view that "ordinary income" (dividends, interest, rents and royalties) may be spent even under these circumstances as long as the governing board determines that doing so is prudent. Private foundations must always comply with the 5-percent payout requirement imposed by federal tax law, even if distributions at that level would cause the endowment fund to fall below its historic dollar value. The historic dollar value limit also does not apply if the gift instrument expressly authorizes the foundation to make distributions in accordance with its spending policy as in effect from time to time, and the spending policy permits spending below historic dollar value.
Q7
How does the historic dollar value limit affect the 5-percent payout requirement for private foundations?
A private foundation must meet the 5-percent payout requirement that is imposed by federal tax law even if distributions at that level would cause the endowment fund to fall below its historic dollar value.
Note: The 5-percent payout requirement applies only to private foundations.
Q8
How do "board-restricted" endowment funds differ from "donor-restricted" endowment funds?
If, at the time a contribution is made to a foundation, the donor restricts the type or manner of investing the assets of the gift, or restricts the time or manner of making distributions of earnings from the gift, such restrictions normally can be modified or eliminated only with the written consent of a living donor or pursuant to a court proceeding. This includes restrictions establishing the contribution as part of the permanent endowment funds of the foundation. Restrictions placed on assets of the foundation by its governing board, however, such as designating a portion of the foundation's assets as permanent or endowment funds, may usually be released or modified by resolution of the board acting alone.
Q9
Can the amount available for spending be determined by looking at the "unrestricted funds" column on a foundation's financial statement?
Generally, no. In most cases, financial accounting standards treat as unrestricted assets any portion of an endowment fund that exceeds the fund's historic dollar value. For legal purposes, this entire amount may or may not be available for current expenditure, depending on the board's determination of what is prudent.
Q10
Can endowment principal be used as a last resort if the foundation becomes insolvent?
Generally, no. Insolvency does not excuse a foundation from its obligation to maintain an endowment fund as such. As a general rule, the portion of an endowment fund that constitutes its historic dollar value is not available to creditors and may not be voluntarily expended unless a court authorizes the expenditure based on certain extraordinary circumstances.
Q11
What responsibilities does the board have with respect to the endowment?
The governing board of a foundation is generally responsible for all aspects of the administration of an endowment fund, including its investment and determination of how much can be spent from year to year. In making these decisions, each board member must act in a manner he or she reasonably believes to be in the best interests of the foundation, and with the care of an ordinarily prudent person in a similar position under similar circumstances.
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PLEASE NOTE:
None of the material in this publication should be construed as offering legal advice. Seeking legal counsel is recommended before acting on any matter described in this publication.
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