I am the CEO of a 501(c)(3) nonprofit that has accumulated a large cash balance by having fundraising events. We would like to have it as an endowment that can contribute 4-5% annually to the budget. However, since it is presented as cash reserves in our financial reports, we feel that it hurts us getting grants. Is it advisable to create a separate entity to house and manage that endowment and contribute annually to the operating nonprofit? Will it also protect those funds from liability?
It would be worth checking with potential donors who have not responded favorably to your grant applications whether your cash reserves have actually cost you funds. Anything less than six months of your operating budget held in reserve should not be a problem, especially in the current environment of competition for funding.
If you do transfer the funds to a separate entity, you will want to be sure that you control the new entity to protect against its board trying to run away with the money. When you have control of the entity, your accountants will probably want to consolidate the financial statements so that the combined assets are still shown on your consolidated financial statement. Accountants can issue separate statements, but it costs more and they are not always enthusiastic about doing so. There will also be additional costs to set up the entity, apply for its separate exemption, and pay for annual administration.
Keeping reserve funds in a separate entity is often a way to protect them from liability incurred by the operating organization. (See Ready Reference Page: “Charities Often Restructure to Protect Corporate Assets”) If the existing nonprofit has activities that could create liability greater than normal insurance can cover, it can be a prudent thing to do. One key protection is to make the purpose of the separate entity to support the same mission as the parent, but not to earmark its assets for the benefit of the parent. If the parent organization has a direct call on the funds of the separate entity, a creditor of the parent would gain the same right to claim benefit of the assets. Ultimately, the parent will probably use at least some of the assets of the separate entity to help settle a claim against the parent, but the creditor won’t be able to demand payment.
All of this is a lengthy way of saying the answer to your original question is: it depends. Only you can determine whether the cost of setting up a separate entity to hold your reserves is worth the benefit.
I would add there is a critical consideration beyond donor impressions and matters that are technically in compliance or money management realms. Specifically, a 501c3 has the obligation to deliver on mission and should be ploughing its resources into mission and not accumulating them without clear mission delivery purpose. If an organization has 6 months of reserves (or even 8 in these dangerous political times) and is not saving for a known and specific mission delivery campaign, accumulating additional surplus is withholding mission impact, and worse, with tax exempt dollars (i.e. withheld from tax otherwise used for public purpose). Most donors responding to a nonprofit fundraising campaign are not deeply focused on this type of nonprofit existential and ethics consideration, so even if they are not sounding concern, hoarding resources vs ploughing them into mission delivery is wrong.