Nonprofit endowment funds are investment pools that hold donated or set-aside capital, invest it for the long term, and release only a portion of the returns each year to support the organization’s work. They come in three types: permanent endowments, where a donor requires the principal to be held forever; term endowments, where the donor’s restriction lifts on a set date or event; and board-designated endowments, where the nonprofit’s own board decides to treat unrestricted money as endowment. The type controls what the organization can legally do with the money, so the distinctions matter well beyond labeling.
Permanent Endowments
A permanent endowment, sometimes called a true endowment, is created when a donor gives money on the condition that the principal be held forever. The original gift amount, known as the corpus, cannot be spent. Only the investment returns are available for the organization’s use, and often only for the specific purposes the donor named in the gift agreement.
In nearly every state, these funds are governed by the Uniform Prudent Management of Institutional Funds Act, usually shortened to UPMIFA. The law requires board members to act in good faith and with the care an ordinarily prudent person would exercise. Before approving any distribution, the board must weigh the fund’s duration and purpose, general economic conditions, the effects of inflation, expected investment returns, the organization’s other financial resources, and its investment policy. These are not optional considerations. They form the legal standard a court will apply if a board’s decisions are ever challenged.
One question that trips up many boards is whether they can still spend from a permanent endowment when its market value has dropped below the original gift amount. UPMIFA eliminated the old rule that treated the original gift as an absolute spending floor. An organization may continue distributions from an “underwater” endowment if doing so is otherwise prudent. The organization must, however, disclose underwater endowments on its financial statements, including the fair value, the original gift amount, and the shortfall.
Term Endowments
A term endowment works like a permanent endowment but with an expiration date. The donor restricts the principal for a set period or until a specific event occurs. During the restricted period, the organization invests the assets and spends only the returns. Once the term ends, the remaining principal becomes available for general spending.
Common triggers include a fixed number of years, the completion of a building project, or the achievement of a fundraising milestone. The gift instrument needs to spell out the trigger precisely. Ambiguous language invites disputes. If an agreement says the restriction lifts after “substantial completion” of a facility without defining the phrase, the nonprofit and the donor’s heirs may disagree years later about when the money became available.
When the restriction expires, the fund is reclassified on financial statements from net assets with donor restrictions to net assets without donor restrictions. Under generally accepted accounting standards, the reclassification happens in the period the last remaining restriction is satisfied. Tracking the timeline carefully matters for accurate reporting and to avoid any appearance of spending restricted money early.
Board-Designated Endowments
Board-designated endowments, also called quasi-endowments, are not created by donors. The nonprofit’s governing board voluntarily sets aside a portion of unrestricted funds and treats them as an endowment. The money is invested alongside true endowments, but no external legal restriction prevents the board from reversing course and spending the principal whenever it chooses.
That flexibility is the defining feature. A board-designated fund can serve as a strategic reserve: it generates investment income during good years and provides liquidity during bad ones. Because the funds remain unrestricted, the board can tap the full balance without donor consent or court approval. Spending a donor-restricted endowment’s principal without authorization, by contrast, can trigger an investigation by the state attorney general.
Accounting standards require these funds to be reported separately from donor-restricted endowments. On IRS Form 990, Schedule D, organizations must break out the percentage of their total endowment held as board-designated, permanent, and term.1Internal Revenue Service. Schedule D (Form 990) The disclosure prevents stakeholders from confusing board-designated reserves with legally restricted funds.
How Endowment Spending Rates Work
The spending rate determines how much the organization draws from the endowment each year. Most nonprofits apply a rate between 3.5% and 5% of the fund’s market value, calculated as a moving average over three to five years rather than against the current balance. The moving average smooths out market volatility so the budget does not swing with every quarterly report. The most recent national data on university endowments pegged the average effective spending rate at 4.8%.
UPMIFA does not mandate a specific percentage. It requires the board to exercise prudence by weighing the factors already described, including inflation, performance, and the fund’s intended duration. A board that sets its spending rate at 7% during a bull market and depletes the fund within a decade has likely breached its fiduciary duty, even if returns briefly supported that level.
Private foundations face a different rule entirely. Federal tax law requires them to distribute roughly 5% of net investment assets each year. The penalty for falling short is steep: an initial excise tax of 30% of the undistributed amount, escalating to 100% if the shortfall is not corrected.2Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income Public charities with endowments are not subject to this minimum distribution requirement, which is one reason many donors prefer giving to public charities rather than establishing private foundations.
Setting Up an Endowment
The Gift Instrument
Every donor-restricted endowment begins with a gift instrument, the written agreement defining the terms. It needs to cover the donor’s name, the amount or description of the assets, the type of endowment, any restrictions on how income can be spent, and the spending policy that will govern distributions.
Vague language is where most endowment problems start. A donor who writes “for scholarships” without specifying the department, eligibility criteria, or what happens if the program is discontinued leaves the nonprofit guessing decades later. The instrument should also address administrative fees. Community foundations and other managers typically charge an annual fee against the fund’s assets, and the agreement should state whether those fees apply even when the fund is underwater.
Accepting the Gift
Before receiving the gift, the board should pass a formal resolution accepting it and authorizing the fund. The resolution gets recorded in the official minutes and serves as the internal record that the board understood and approved the terms.
Organizations that accept noncash assets such as real estate, closely held stock, or partnership interests need a written gift acceptance policy. Not every asset is worth taking. Real property can carry environmental liability, closely held securities may be difficult to liquidate, and partnership interests can generate unrelated business taxable income. A sound policy requires legal review before the organization commits to accepting complex assets.
After the Transfer
Once the board approves the gift, the assets move into a dedicated investment account separate from operating funds. The separation is not optional. Commingling restricted endowment assets with unrestricted operating cash is one of the fastest ways to produce audit findings and regulatory scrutiny.
The nonprofit must also send the donor a written acknowledgment. For any charitable contribution of $250 or more, the IRS requires the acknowledgment to include the amount of cash received or a description of noncash property, a statement of whether the organization provided any goods or services in exchange, and if so, an estimate of their value.3Internal Revenue Service. Charitable Organizations – Substantiation and Disclosure Requirements Without that letter, the donor cannot claim a tax deduction.
Modifying or Releasing Endowment Restrictions
Endowments created decades ago sometimes outlive their original purpose. A scholarship fund restricted to students in a program that no longer exists, or a maintenance endowment for a building the organization has sold, creates a restriction that is impossible to honor as written. UPMIFA provides several paths to modify or release these restrictions.
The simplest route is donor consent. If the donor is still living and agrees, the organization can modify the restriction in writing, as long as the funds continue to serve a charitable purpose. When the donor is unavailable or deceased, the organization can petition a court to modify a restriction that has become impracticable, wasteful, or impossible to fulfill. The court will reshape the restriction to match the donor’s probable intention as closely as possible. The state attorney general must be notified and given an opportunity to weigh in.
For small, old funds, UPMIFA offers a streamlined process. The exact thresholds vary by state, but the uniform act’s default allows an organization to modify a fund valued below a specified dollar amount that has existed for more than 20 years, provided the organization notifies the attorney general in advance and uses the money in a manner consistent with the donor’s original charitable purpose. Some states have set the threshold as low as $75,000, while others allow it for funds up to $375,000.
Courts can also apply a legal principle called cy pres, which translates roughly to “as near as possible.” When a charitable gift’s original purpose has become entirely impossible, a court can redirect the funds to a similar charitable purpose rather than invalidating the gift. Cy pres comes into play most often when a named beneficiary organization has dissolved or when the specific need no longer exists. The key requirement is that the donor must have had a general charitable intent, not merely a desire to benefit one specific institution.
Form 990 Reporting and Accounting
Nonprofits that hold endowments report them on Schedule D of IRS Form 990. The schedule requires a five-year history of endowment activity, including beginning balances, new contributions, net investment gains or losses, grants distributed, administrative expenses, and ending balances.1Internal Revenue Service. Schedule D (Form 990) The organization must also break out the percentage of its endowment held in each category. The breakdown gives donors, grantors, and regulators a clear picture of how much is legally restricted versus internally designated.
On the financial statements, current accounting standards require nonprofits to classify assets as either net assets with donor restrictions or net assets without donor restrictions. Permanent and term endowment principal belongs in the first category. Board-designated endowments, despite the label, belong in net assets without donor restrictions because no external party imposed the restriction. When a term endowment’s restriction expires, or when endowment income is appropriated for spending, the organization records a reclassification from restricted to unrestricted net assets in the period the restriction is satisfied.