Endowments work for nonprofits by turning a one-time gift into a permanent income stream: the organization invests the donated principal, leaves it largely untouched, and each year spends a small percentage of the fund’s value, usually 4% to 5%, on the mission. State law, in nearly every state a version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA), governs how the board invests those assets, how much it may spend, and what happens when circumstances change. The specific rules depend on who imposed the restriction: a donor who required the principal be kept forever, a board that voluntarily set surplus funds aside, or, in the case of private foundations, a separate federal payout mandate.
The Three Types of Endowments
How much flexibility a nonprofit has over the money depends entirely on how the fund was created.
A permanent (or true) endowment comes from a donor who gave the money with an explicit instruction that the principal must be maintained forever. The organization invests the corpus and spends only from the returns. These carry the strongest legal restrictions because the donor’s intent, not the board’s judgment, controls what happens to the principal.
A quasi-endowment is board-designated. The board takes unrestricted surplus funds and voluntarily treats them like an endowment. Because the limitation came from the board rather than a donor, the board can reverse the designation and spend down the principal whenever it decides circumstances justify it. On financial statements, quasi-endowments appear as unrestricted net assets.
A term endowment is a donor-restricted gift that lasts for a set number of years or until a specific event. Once the term expires, the organization can access the full balance, including the original principal.
The line between a true endowment and a purpose-restricted gift trips up many organizations. A donor who gives $50,000 “for the scholarship program” has made a purpose-restricted gift that should be spent on scholarships, but there is no requirement to preserve the principal. A donor who gives $50,000 “to be held as an endowment, with income used for scholarships” has created an actual endowment where the $50,000 must be invested and only the returns flow to scholarships. Misclassifying one as the other creates compliance problems with donors, auditors, and state regulators.
How Much a Nonprofit Can Spend Each Year
Most nonprofits calculate the annual payout with a formula rather than spending whatever income the investments happened to earn. The standard approach applies a spending rate, typically between 4% and 5%, to the fund’s average market value over the preceding three years, measured quarterly so the calculation draws on twelve data points. Averaging smooths out market swings and gives the organization a predictable revenue stream.
The board sets the rate in a written spending policy, and UPMIFA requires the decision to account for inflation’s effect on purchasing power. A 5% spending rate during high-inflation years can quietly erode the endowment’s real value even while the nominal balance holds steady. Some boards lower the rate to 4% or build in an explicit inflation adjustment. Investment management fees, typically running 1% to 1.75% of assets for a diversified endowment, also cut into returns and belong in the spending calculation.
The distribution itself is an internal accounting transfer. Money moves from the restricted endowment account to the unrestricted operating fund, or to a specific program fund if the donor designated a purpose. Most organizations process the transfer quarterly or annually.
Some states that adopted UPMIFA included an optional provision creating a rebuttable presumption that spending more than 7% of the fund’s value in one year is imprudent. Spending below 7% is not automatically safe; spending above it just shifts the burden to the board to prove the decision was reasonable.
What Happens When an Endowment Is Underwater
When market value falls below the original gift amount, the fund is “underwater.” Older law flatly prohibited spending from underwater endowments, which forced nonprofits to cut programs exactly when economic conditions made those programs most needed.
UPMIFA changed that. Boards may continue spending from an underwater fund if they determine the expenditure is prudent after weighing the same factors required for any spending decision. The law does not require the fund to recover its original value before distributions resume. Boards should still treat underwater spending as a higher-stakes decision and document their reasoning more carefully. Some gift agreements specifically address underwater scenarios, and donor-imposed terms override the default UPMIFA rules.
The Board’s Legal Duties Under UPMIFA
Forty-nine states plus the District of Columbia have adopted some version of UPMIFA. It replaced the rigid “historic dollar value” rule, which prohibited spending any amount that would drop the fund below its original gift value, with a flexible prudence standard.
Board members owe two core duties when managing endowment assets. The duty of care requires informed decisions after reasonable investigation. The duty of loyalty requires acting in the organization’s interest rather than personal interest. Every spending and investment decision must weigh the fund’s purpose, the organization’s overall financial picture, the expected total return from income and appreciation, general economic conditions, the possible effect of inflation or deflation, the fund’s expected duration, and any other resources available to the organization.
This is not a checklist to file away. State attorneys general have authority to investigate and take legal action against organizations that mismanage endowment funds. Enforcement can bring monetary penalties, dissolution of the nonprofit, and orders barring individual officers from leading charitable organizations. Documenting how the board weighed each factor at every spending decision is the single most important compliance step.
Changing or Releasing a Donor Restriction
Donor restrictions labeled “permanent” are not always permanent in practice. A restricted scholarship program might close, a research area might become obsolete, or the organization might merge. UPMIFA provides two judicial doctrines for modifying restrictions.
Under cy pres, a court can modify the charitable purpose of an endowment if the original purpose has become unlawful, impractical, impossible to achieve, or wasteful. The modification must stay consistent with the spirit of the original gift.
Under equitable deviation, a court can modify management, investment, or duration restrictions when they have become impractical or wasteful, or when circumstances the donor did not anticipate mean a change would actually further the fund’s purpose.
Both routes require a court proceeding, and the state attorney general is a necessary party. For smaller, older funds, UPMIFA offers an administrative shortcut: funds valued at less than $75,000 that have existed for 20 years or more may be modified without full court proceedings, though the attorney general must still be notified. UPMIFA does not require notice to the donor or the donor’s family.
Tax Consequences That Can Still Apply
Most nonprofits are tax-exempt, but endowment investments can trigger tax in two situations.
Unrelated Business Income Tax
If an endowment holds investments financed with borrowed money, a portion of the income becomes taxable as unrelated debt-financed income. The taxable share is proportional to the debt: if half of a property’s value was financed with a loan, roughly half the income from that property is taxable. Any tax-exempt organization with $1,000 or more in gross unrelated business income must file Form 990-T in addition to Form 990.1Internal Revenue Service. Unrelated Business Income Tax Passive investment income such as dividends and interest from a straight equity-and-bond portfolio generally does not trigger this tax, but leveraged real estate, certain hedge fund strategies, and partnership investments frequently do.2Office of the Law Revision Counsel. 26 USC 514 – Unrelated Debt-Financed Income
Private Foundation Payout Rules
Private foundations face burdens that public charities do not. Every private foundation pays a 1.39% excise tax on net investment income each year, regardless of how the money is invested.3Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income
More significantly, private foundations must distribute at least 5% of the fair market value of their non-charitable-use assets each year as qualifying distributions. Miss the threshold and a 30% excise tax applies to the undistributed amount. If the shortfall is not corrected by the end of the taxable period, the penalty rises to 100% of the remaining undistributed income.4Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income Public charities with endowments are not subject to this minimum payout, which is why the voluntary 4–5% spending rate at most public charities looks similar to the private foundation mandate but carries very different consequences for falling short.
Setting Up an Endowment
Two documents do the foundational work.
The gift agreement between donor and organization spells out whether the fund is permanent, term-limited, or unrestricted; defines the purpose of the distributions; addresses any naming rights; and states what happens if the original purpose becomes impractical. A well-drafted agreement also addresses underwater scenarios and whether the donor wants the fund consolidated with other endowment assets or invested separately. Organizations often work with legal counsel or a community foundation to draft these agreements, especially for gifts over $100,000.
The investment policy statement is the board’s internal document governing how endowment assets are invested. It sets target asset allocations, acceptable investment types, rebalancing triggers, and the spending rate formula. It should identify who has authority to make investment decisions, whether the full board, a finance committee, or an outside manager. Boards typically revisit the policy at least annually.
Reporting and Audit Exposure
Nonprofits report endowment activity to the IRS on Schedule D of Form 990. Part V requires five years of data, with line items for the beginning balance, new contributions, net investment earnings and losses, grants or scholarships distributed, other program expenditures, administrative expenses, and the end-of-year balance.5Internal Revenue Service. Schedule D (Form 990) – Supplemental Financial Statements The five-year window shows anyone reading the return whether the fund is gaining or losing ground against inflation.
Financial statements prepared under GAAP sort endowment assets into two categories: net assets with donor restrictions and net assets without donor restrictions. A permanent endowment sits in the first category. A board-designated quasi-endowment sits in the second, because the restriction came from the board rather than a donor.
Organizations with larger endowments should expect their annual audit to include detailed testing of endowment transactions: whether distributions matched donor restrictions, whether the spending rate was applied correctly, and whether underwater funds were handled in compliance with UPMIFA. The state attorney general’s office has standing to review these records at any time, which makes thorough documentation of every board spending decision the organization’s strongest defense against an enforcement action.