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If we solicit for “endowment,” may we spend the principal?

Your Legal Questions Answered

If we solicit for “endowment,” may we spend the principal?

When a charity’s governing body establishes a fund in which they solicit money to create an "endowment" without other qualifying language, does this create a legal endowment in which the principal cannot be used? If they co-mingle unrestricted funds with permanently restricted funds, does the commingling of funds result in all funds being permanently restricted if there is no way of knowing how much of the funds were unrestricted?  

The Uniform Prudent Management of Institutional Funds Act, which has been adopted in some form by all states except Pennsylvania, defines an “endowment” as a fund that “under the terms of the gift instrument, is not wholly expendable by the institution on a current basis.”  In other words, it cannot all be expended at once.   A Comment to UPMIFA also provides that if new gifts are solicited and received for an “endowment” fund, they will be subject to the same restrictions.  (See Ready Reference Page:  “New UPMIFA Sets Rules for Management of Charitable Funds”)

UPMIFA sets the standards for determining how much of the endowment fund can be spent in any year, but the basic concept of the law is that the institution may spend only an amount in the nature of interest that is “prudent” under the circumstances.  It includes an optional provision, which a few states have adopted, that expenditure of more than 7% of the value of the fund in any year will be presumptively imprudent.  (In Pennsylvania, state law allows the directors to designate “income” as an amount between 2% and 7% of the average value of the fund for at least three years.)  UPMIFA assumes that the institution will preserve the “principal,” which it refers to as maintaining the “purchasing power” of the amounts contributed to the fund.  Therefore, I would treat all third-party additions as “endowment” and apply the prudent distribution rules to them all.

UPMIFA also provides that board-designated additions to the endowment are not permanently restricted because the additions were not limited by a third party donor.  These funds are not, therefore, subject to the spending limitations.  But if the funds have been mixed without any accounting segregation, I think the onus would be on the institution to determine how much was not permanently restricted so that it would not violate the law in spending “too much” from the endowed funds. 

Most institutions unitize their investment pool or otherwise separately account for each fund that is added, in part to make this distinction for future reference but also to know how much will be spent for any specific program that is separately endowed.  A university, for example, would want to know how much it could spend from an endowed fund for the benefit of the classics department as opposed to a fund for the benefit of the athletic department.  There is no other way to honor the intent of the different donors.  If the charity is not separately accounting for the gifts, it should do so immediately.

Tuesday, June 27, 2017

Comments all organizations I have worked with have their endowments set up separately both in funds and actual entities. My understanding is separating the endowed funds from the operations of the nonprofit (under a separate EIN and organization) protects the funds from being assets that could be included in the event the nonprofit were sued.

Normally, the principal of a permanently restricted fund like an endowment is protected from the claims of creditors, although the income may be subject to attachment by a creditor.  There is often an added layer of protection from separating reserve assets into a separate entity (See Ready Reference Page:  "Charities Often Restructure to Protect Corprate Assets") but it may not be practical for smaller organizations.  --Don Kramer

I am now rather confused. I thought one of the purposes of an endowment is to shield the organization from unexpected losses, or even to provide funds if a special opportunity arises. If the principal of an endowment cannot be used, how can it help if say a building is damaged and a deductible needs to be paid; or conversely if a building is needed and an excellent opportunity arises?

Your confusion may arise because organizations are not always precise in what they call endowment.  The purpose of a true endowment (i.e. donor-restricted gifts) is to provide permanent funding for charitable purposes from the income on the original gift.  Normally there is no provision for use of the principal in the case of an emergency.  The income could be pledged to support a loan to fix up the building, but the principal could not be invaded without the donor's approval or attorney general or court approval.  Many organizations set aside reserve funds that the board calls an "endowment," but the law is pretty clear that the board can also unrestrict those funds and spend whatever amount it deems appropriate to meet an emergency.  Those reserve funds are not considered true endowment.  --Don Kramer

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