An endowment fund is a pool of donated money or property that a nonprofit — a university, hospital, museum, or charitable foundation — invests permanently so that a small share of the returns can be spent each year on the organization’s mission. The original gift, called the corpus, stays invested. Only a portion of investment earnings, typically four to five percent of the fund’s average market value, is distributed annually. That structure lets a single gift support scholarships, research, or operations for decades or centuries, and it is governed by a specific set of state prudence laws, federal tax rules, and reporting requirements.
The institution holding an endowment acts as a fiduciary. It has a legal duty to manage the assets carefully, follow the donor’s instructions, and prioritize the fund’s long-term health over any short-term spending pressure. Endowment assets are accounted for separately from the general operating budget, which keeps the organization from draining them to cover emergencies or routine expenses.
The Three Types of Endowment Funds
Endowments fall into three categories based on who created the restriction and how strong it is. The category matters because each carries different spending flexibility and different legal protections.
- Permanent (donor-restricted) endowment. A donor creates the fund through a written gift agreement requiring the principal to remain invested in perpetuity. Only the income can be spent, and the donor can further limit that income to a specific use, such as scholarships in one department. These carry the strongest legal protections, and violations can be enforced by the state attorney general.
- Term endowment. A donor sets restrictions like a permanent endowment, but the principal only has to stay invested for a fixed period or until a specific event occurs. After that, the organization may spend the remaining assets as the gift agreement allows.
- Board-designated (quasi) endowment. The organization’s own board sets aside surplus funds to function like an endowment, but no outside donor restriction applies. The board can reverse the designation and spend the principal whenever it chooses.
For federal tax reporting, permanent and term endowments are classified as net assets with donor restrictions; board-designated endowments are net assets without donor restrictions. The percentage breakdown across all three types must be reported on IRS Form 990, Schedule D, and those percentages have to total 100 percent.1IRS.gov. Instructions for Schedule D (Form 990)
How Much Can Be Spent Each Year
Most endowments distribute between four and five percent of the fund’s fair market value annually. To keep payouts steady when markets swing, institutions usually calculate the spending amount from a rolling average of the fund’s value over three to five years. A single bad year does not gut program funding, and a single boom year does not create commitments the fund cannot sustain.
Donor intent controls the details. A gift instrument can set exact spending limits, restrict distributions to specific programs, or require that some percentage of earnings be reinvested. When the agreement is silent, the board sets the rate under the prudence standards described below.
Institutions also charge the fund an annual administrative fee for oversight and management, typically a modest percentage of market value deducted from investment returns before the spending amount is calculated. Some gift agreements address whether such fees may be charged to a particular fund.
Inflation is the quiet threat. A five percent payout only preserves purchasing power if returns exceed both the payout and inflation combined, which is why institutions set return targets well above the spending rate.
The Prudence Rules That Govern Endowments
The main legal framework is the Uniform Prudent Management of Institutional Funds Act, known as UPMIFA. Nearly every state has adopted a version of it. UPMIFA replaced an older law that tied spending to the “historic dollar value” of each gift, which created rigid problems during downturns.
Under UPMIFA, anyone managing an institutional fund must act in good faith and exercise the care that a reasonably careful person in a similar position would use. When deciding how much to spend or accumulate, the institution has to weigh seven factors:
- Duration and preservation of the fund
- Purpose of the institution and of the specific fund
- General economic conditions
- Possible effect of inflation or deflation
- Expected total return from income and investment appreciation
- Other resources of the institution
- The institution’s investment policy
UPMIFA itself does not set a fixed spending cap. Some states have added a rebuttable presumption that spending more than seven percent of the fund’s total value in a year is imprudent, which functions as an outer boundary.
Spending When a Fund Is “Underwater”
An endowment is underwater when its current market value falls below the original gift amount. Under the old law, institutions generally could not spend from a fund in that state. UPMIFA allows continued spending if the institution determines it is prudent after weighing the same seven factors, provided the decision is made in good faith and documented. Organizations that spend from underwater funds must disclose the aggregate deficiency in their financial statements, along with the original gift amount that must be maintained and the board’s policy on continued spending.
Changing a Donor’s Restrictions
Restrictions can outlive their usefulness. A scholarship tied to a program that no longer exists, or a research fund aimed at a disease that has been cured, may become impossible to administer. UPMIFA offers two paths. The institution can seek the donor’s written consent to modify the terms. If that is not possible, it can petition a court under the doctrine of cy pres to redirect the fund to a purpose “as near as possible” to the original intent. Courts approve these changes when the original purpose has become unlawful, impossible, or impracticable. The state attorney general must be notified and has the right to weigh in on behalf of the public.
Investment Standards and Delegation
Two fiduciary duties shape investment decisions. The duty of loyalty requires decisions to serve the institution’s charitable mission, not the personal interests of any board member or manager. The duty of care requires the diligence a reasonably careful person would use in similar circumstances.
UPMIFA applies modern portfolio theory: investments are judged in the context of the whole portfolio rather than one at a time. An asset that looks risky alone may be appropriate if it offsets risk elsewhere. Diversification is expressly required. Mission-aligned investing (a medical research foundation buying health-sector stocks, for example) is permitted, but it still has to satisfy the overall prudence standard.
Most institutions do not run their portfolios entirely in-house. UPMIFA lets them delegate investment management to outside agents such as investment offices, advisors, and fund managers, as long as the institution uses reasonable care in selecting the agent, defining the scope of the work, and reviewing performance periodically. An institution that follows those steps is generally not liable for the agent’s individual decisions. The agent owes a duty to the institution and submits to the state’s courts for any disputes.
Fees matter. External investment management typically costs between 0.25 and 2.00 percent of managed assets per year, depending on fund size and strategy. UPMIFA imposes an express cost-management obligation: fees and expenses must be reasonable relative to the assets and services involved. Excessive fees reduce what is available for the charitable purpose and can themselves be a breach of fiduciary duty.
How Endowment Income Is Taxed
Endowment investment income generally escapes federal income tax because the holding institution is tax-exempt. Dividends, interest, royalties, and capital gains from endowment investments are specifically excluded from unrelated business taxable income under the Internal Revenue Code.2Office of the Law Revision Counsel. 26 U.S. Code 512 – Unrelated Business Taxable Income If an endowment generates income from an active trade or business unrelated to the institution’s exempt purpose, such as running a commercial restaurant open to the public, that income may be subject to unrelated business income tax.
A separate excise tax applies to certain large private colleges and universities. Under Section 4968 of the Internal Revenue Code, a private institution is subject to the tax if it enrolls at least 3,000 tuition-paying students, with more than half located in the United States, and holds endowment assets of at least $500,000 per student. The rate is tiered:3Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
- 1.4 percent of net investment income for a per-student endowment between $500,000 and $750,000
- 4 percent for a per-student endowment between $750,000 and $2,000,000
- 8 percent for a per-student endowment above $2,000,000
Assets used directly for the institution’s exempt purpose, such as campus buildings and equipment, are excluded from the per-student calculation. State colleges and universities are not subject to this excise tax.
What Institutions Have to Report
Nonprofits that hold endowments report under both accounting rules and IRS rules. The Financial Accounting Standards Board requires balance sheets to present two categories of net assets: those with donor restrictions and those without.4Financial Accounting Standards Board. Accounting Standards Update No. 2016-14 – Presentation of Financial Statements of Not-for-Profit Entities Donor-restricted endowments belong in the first; board-designated endowments belong in the second.
On the tax side, any organization that reports holding endowment funds on Form 990 must complete Part V of Schedule D. That section requires beginning and ending balances, contributions received, investment earnings and losses, distributions for grants and programs, and administrative expenses, all broken out for the current year and the prior year. It also requires the percentage of the total endowment held in each of the three fund types.1IRS.gov. Instructions for Schedule D (Form 990)
Who Enforces the Rules
State attorneys general are the primary enforcement authority for charitable endowments. Under longstanding legal principles reinforced by UPMIFA, the attorney general represents the public’s interest in seeing that donated funds are used as intended. If an institution invests or spends imprudently, diverts funds from a restricted purpose, or otherwise mismanages an endowment, the attorney general can bring legal action.
Available remedies include requiring a detailed accounting, seeking an injunction to stop improper spending, ordering the return of improperly spent funds, removing fiduciaries, and in extreme cases requesting appointment of a new trustee. Donors themselves generally cannot sue to enforce the terms of a charitable gift; that authority rests with the attorney general, who acts on behalf of the public as the ultimate beneficiary.
Investment advisors managing endowment assets face separate regulatory exposure. The Securities and Exchange Commission can bring enforcement actions against registered advisors who breach their fiduciary duties, including overcharging management fees or failing to disclose conflicts of interest. Penalties can include disgorgement, civil fines, and cease-and-desist orders. Board members who fail to exercise appropriate care, loyalty, or oversight may face personal liability for resulting losses.