A charitable endowment is governed by a stack of rules that work together: a written gift instrument locks the principal in place, a 501(c)(3) organization holds and invests it under the prudent-management standard set by the Uniform Prudent Management of Institutional Funds Act (UPMIFA), and federal tax law requires annual reporting on Schedule D of Form 990, with extra taxes on unrelated business income and, for private foundations, on net investment income. The legal requirements and tax rules for charitable endowments come from three sources at once — the donor’s instrument, state fiduciary law, and the Internal Revenue Code — and a board that ignores any one of them puts the fund and its own members at risk.
What Legally Creates an Endowment
An endowment starts with a written instrument that says the donated principal is not available for spending. That document might be a gift agreement between donor and organization, a trust agreement, or a formal board resolution. The label matters less than the restriction: without a written bar on spending principal, what looks like an endowment is really just a reserve fund the organization can tap at will.
The organization holding the fund must be tax-exempt, almost always under Internal Revenue Code Section 501(c)(3), which covers entities organized for religious, charitable, scientific, literary, or educational purposes.1Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc. The organization has to be both organized and operated exclusively for one or more of those exempt purposes.2eCFR. 26 CFR 1.501(c)(3)-1 – Organizations Organized and Operated for Religious, Charitable, Scientific, Testing for Public Safety, Literary, or Educational Purposes Lose the exemption, and the legal foundation for the endowment collapses.
Donors who give to an endowment held by a qualified 501(c)(3) can generally claim an income tax deduction under IRC Section 170, subject to the usual percentage-of-income limits and substantiation rules.3Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts
The Three Types of Endowment Funds
How the restriction was imposed, and by whom, determines what the organization can legally do with the money.
Permanent Endowments
A permanent endowment (sometimes called a “true” endowment) exists because a donor said in the gift instrument that the principal must be preserved forever. The organization spends only investment income and appreciation. Under FASB ASC 958, these funds are reported as net assets with donor restrictions. Older financial statements may still use the retired label “permanently restricted net assets,” which FASB replaced for fiscal years beginning after December 2018.
Term Endowments
A term endowment works the same way but ends when a stated date arrives or a stated event happens. A donor might restrict the principal for 25 years, until a capital project finishes, or until a named beneficiary dies. Once the condition is met, the principal becomes unrestricted and the organization can spend it.
Board-Designated Endowments
Also called a quasi-endowment. The organization’s own board sets aside unrestricted funds to be invested and spent like an endowment. No donor restriction applies, so the board can reverse the designation whenever it wants. These are net assets without donor restrictions, and that classification difference is what separates them legally from donor-restricted endowments.
How the Board Must Invest the Money
Board members become fiduciaries the moment they manage endowment assets. UPMIFA, adopted in 49 states, sets the standard: manage and invest in good faith and with the care an ordinarily prudent person in a comparable position would use. In practice that means three things.
Diversify unless there is a documented reason not to. Weigh the charitable purpose of the organization, balancing current distributions against preserving purchasing power for later. Keep investment costs reasonable relative to the size of the fund and the expertise available.
The board can delegate day-to-day management to an outside advisor, and most organizations with significant assets do. Delegation does not transfer fiduciary responsibility. The board still has to exercise reasonable care in choosing the manager, defining the scope of the engagement, and reviewing performance and fees on an ongoing basis. Hiring a manager and forgetting about them is not compliance.
How Much Can Be Spent Each Year
UPMIFA replaced the older “historic dollar value” rule with a total-return approach. The board can spend a prudent portion of both income and capital appreciation, rather than being frozen out whenever the market dips below the original gift amount.
Seven factors have to be weighed when the board sets the annual spending rate:
- Duration and preservation: how long the endowment is meant to last and the importance of maintaining its value.
- Institutional purpose: the mission of the organization and the specific purpose of the fund.
- Economic conditions at the time of the decision.
- The effect of inflation or deflation on the fund’s real value.
- Expected total return from the portfolio.
- Other resources available to the organization.
- The institution’s investment policy.
Some states adopted an optional UPMIFA provision creating a rebuttable presumption that spending more than 7% of the fund’s average fair market value is imprudent. The average is calculated using at least quarterly valuations across the preceding three years. “Rebuttable” is the key word: the board can spend above 7%, but it carries the burden of showing why the higher rate was prudent.
Underwater Endowments
An endowment is underwater when its market value falls below the original gift. UPMIFA permits spending from underwater funds if the board decides it is prudent after considering the seven factors. That was a real change from prior law, which effectively stopped distributions the moment a fund dipped below historic dollar value. A donor who wants to bar underwater spending has to say so in the gift instrument.
Administrative Fees Count Against the Cap
Organizations often charge administrative and fundraising costs against the endowment. Under UPMIFA those charges count as part of the annual distribution for purposes of the 7% presumption. Investment management fees are treated separately, and unreasonably high investment fees can be imprudent on their own regardless of what total spending looks like. An institution charging 2% in administrative overhead and 5.5% in distributions is at a combined 7.5% and triggers the presumption in states that adopted the optional cap.
Changing a Restriction That No Longer Works
Donor restrictions can outlive their usefulness. A scholarship fund for a program that no longer exists, an endowment for research into a disease that has been eradicated. Two legal paths address the problem.
Cy Pres
The cy pres doctrine (French for “as near as possible”) lets a court redirect a charitable gift when the original purpose cannot be carried out. Rather than voiding the gift, the court picks a new purpose that comes as close as possible to the donor’s intent. The organization has to petition and show that the original purpose has become unlawful, impractical, or impossible.
UPMIFA Modification
UPMIFA is faster. With donor consent, modification is straightforward. Without it, the organization can petition a court to modify a restriction that has become unlawful, impractical, impossible, or wasteful. For small, older funds UPMIFA offers a streamlined process that avoids court entirely. The model act targets funds valued at $25,000 or less that are at least 20 years old, though states enacting the provision have sometimes set higher dollar thresholds. The organization typically has to notify the state attorney general before making the change.
Who Enforces These Rules
State attorneys general are the primary enforcers. Their authority reaches investigating mismanagement, suing board members for breach of fiduciary duty, and getting court orders to protect charitable assets. It rests on both common law and the statutes states have adopted.
Consequences for board members who mismanage endowment funds can be severe. The attorney general can seek personal liability for losses from a breach, force the return of profits a fiduciary made through improper use of fund assets, petition for removal of board members, and in extreme cases seek judicial dissolution of the organization. Courts can also appoint a receiver to take over management. UPMIFA violations, including imprudent investment or spending decisions, fall squarely within this enforcement authority.
Federal Tax and Reporting Duties
Holding an endowment adds specific federal obligations on top of the annual information return.
Form 990, Schedule D
Nonprofits that file Form 990 must complete Part V of Schedule D if they hold endowment funds.4IRS. Instructions for Schedule D (Form 990) The section calls for a detailed accounting of endowment activity for the current year and the four prior years: beginning and ending balances, new contributions, investment earnings (realized and unrealized), grants and scholarships paid out, and amounts spent on facilities and programs.5Internal Revenue Service. Schedule D (Form 990) The organization also reports the estimated percentage breakdown of the total endowment among permanent, term, and board-designated funds.
Unrelated Business Income Tax
Tax-exempt status does not shield income from activities unrelated to the charitable mission. If endowment investments produce unrelated business taxable income (UBTI) with more than $1,000 in gross income, the organization files Form 990-T and pays tax on it.6Internal Revenue Service. Unrelated Business Income Tax Organizations taxed as corporations pay a 21% rate.7Internal Revenue Service. Instructions for Form 990-T (2025) Estimated payments are required if the organization expects to owe $500 or more.
Private Foundation Excise Tax
Private foundations owe a tax public charities do not. Under IRC Section 4940 a domestic private foundation pays a 1.39% excise tax on net investment income, which includes interest, dividends, rents, royalties, and capital gains from endowment assets.8Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income It is reported and paid on Form 990-PF, the annual return every private foundation files.9Internal Revenue Service. 2025 Instructions for Form 990-PF
Excess Business Holdings
Private foundations that hold endowment assets in a business enterprise also watch ownership caps. A private foundation generally cannot hold more than 20% of the voting stock of any business enterprise, reduced by what disqualified persons own. The ceiling goes up to 35% if the foundation can show unrelated third parties maintain effective control. A foundation holding 2% or less of the voting stock and 2% or less of the total value of all stock classes is exempt from the limits.10eCFR. 26 CFR 53.4943-3 – Determination of Excess Business Holdings A private foundation cannot hold any interest in a sole proprietorship at all.
Public Disclosure
A 501(c)(3) has to make Form 990 and Form 990-T available for public inspection. The Form 990-T disclosure requirement applies to returns filed after August 17, 2006, and the organization keeps them available for three years from the filing deadline including extensions.11Internal Revenue Service. Public Inspection and Disclosure of Form 990-T The original application for exempt status and related IRS correspondence are also open to inspection. Donor gift instruments and internal endowment agreements are not on the list of documents that have to be disclosed.