Endowment vs. Foundations: Key Differences to Understand
Due to their similarities, endowment funds and foundations are often used interchangeably. However, several features make them distinct from each other — they require specialized structures and strategies to ensure long-term sustainability and stability.
If you’re looking to establish an endowment fund or a foundation, it’s essential to understand the key differences between the two concepts, including their purposes, structures and legal requirements.
What Is an Endowment?
An endowment is a financial asset pool donated to a nonprofit organization or an institution such as a university. These donations may include cash and investments, which serve as principal and are legally required to be preserved, while the earnings generated from them are used for specific purposes. An endowment fund is typically used for purposes specified by the donors — however, this will depend on the type of endowment.
Types of Endowment
There are four types of endowments, each with distinct characteristics, operations and structures:
- Unrestricted endowment: Funds donated to an unrestricted endowment can be spent, saved or invested at the discretion of the trustees of the nonprofit organization or institution receiving the donation. This type of endowment offers flexibility in the use of investment income, which is also considered unrestricted, and can be used to finance new initiatives and operational or emergency expenditures.
- Restricted endowment: A restricted endowment requires trustees of the receiving organization or institution to use the investment income from the principal held in perpetuity to strictly fund purposes specified by the donor. Failure to comply with this requirement may result in legal action, among other consequences.
- Quasi-endowment: Typically initiated by benefiting institutions, a quasi-endowment is one in which the principal is not held permanently, but can be distributed at a future date. The endowment’s purpose is determined by the governing body rather than the donors.
- Term endowment: This type of endowment is not permanent. It allows for the use of the principal after a fixed period or upon the occurrence of specific events, such as the death of the donor.
Guiding Policies of Endowments
The applicable policies guiding the operation of endowments are characterized into three distinct components:
- Investment policy: This policy outlines the types of investments permissible in an endowment. It also defines the extent of risk the investment manager is authorized to take in pursuit of target returns. The goal of an investment policy is to safeguard the asset pool against preventable losses and ensure longevity.
- Usage policy: A usage policy clearly defines the purposes for which the endowment fund should be used. These purposes can range from awarding merit scholarships to funding environmental initiatives.
- Withdrawal policy: Endowments usually have withdrawal policies that specify the amount that trustees can withdraw from the fund per installment or period.
What Is a Foundation?
A foundation is a stand-alone legal entity that provides funding for specific purposes, such as charitable causes. Donations from different sources, including individuals, families, government agencies and businesses, typically fund them. Foundations are managed by trustees or directors who distribute donated funds in alignment with specified missions.
Types of Foundations
There are several types of foundations, each with distinct functions and funding sources:
- Public foundation: A public foundation derives its support and funding from the public. Funding sources may include government agencies, private citizens and other foundations. Charitable organizations that fall into this category are tax-exempt and must pass the public support test, which confirms that they receive at least one-third of their funding from the public, rather than a single private source.
- Private foundation: A private foundation is a charitable organization operated solely by an individual, family or business, serving as the primary source of funding.
Endowments vs. Foundations: What Are the Differences?
Both endowments and foundations are designed to provide funding for charitable purposes. However, they differ in the following areas.
Fund Sources and Restrictions
Endowments and foundations have different funding sources and restrictions. Endowment funds are assets donated to generate investment income for specified uses. The initial assets are required to serve as principal and a permanent source of funding for the activities of a nonprofit organization or institution. Depending on the type of endowment, the principal may be unrestricted for use at a later date.
On the other hand, donations to a foundation are distributed directly to fund specified purposes. Unlike the funds donated to an endowment, those contributed to a foundation are not restricted, nor are they required to be a permanent source of funding.
Legal Structure and Governance
Endowments are not recognized as a separate legal entity. Instead, they are an internal fund within an existing legal entity. Consequently, they are governed by the guidelines and policies guiding the parent organization or institution. They also lack a specialized leadership structure, but receive supervision from the leadership of the organization they are affiliated with. Additionally, due to their legal structure, endowments are usually low-cost, as they require no ongoing legal fees and documentation.
Conversely, a foundation is a stand-alone legal entity that has its own personality and holds assets in its name — it can sue and be sued. As a legal entity, foundations typically have defined sets of bylaws and are governed by a board of directors or trustees. In terms of cost, setting up a foundation is more expensive because it involves completing legal documentation and offsetting the associated costs.
Reporting Requirements
The reporting requirements for endowment funds and foundations differ. While the law requires parent organizations or institutions to handle tax returns as part of their financial reporting, foundations are required to file their own separate tax returns.
Similarly, foundations must comply with more stringent disclosure requirements — they are strictly required to report on details such as capital gains and fair market value.
Flexibility
Except in the case of unrestricted and quasi-endowment types, receiving organizations and institutions in an endowment have less flexibility in choosing the purposes for which investment income is used. The donor’s wishes usually limit flexibility.
In contrast, foundations are separate legal entities, a title that gives them more flexibility to choose how they spend their funding to meet their mission.
Get Professional Help With Your Tax Filing
Learning the difference between endowments and foundations is a step in the right direction to ensure clarity in legal structure, operations and fulfillment of tax requirements. Whether you are establishing an endowment or a foundation, you need professional help to file your taxes properly and comply with other tax-related legal requirements.
For over 30 years, Marshall Jones’ Certified Public Accountants And Advisors have helped businesses and organizations with professional client support and tax services. For expert assistance with tax-related matters, contact us today.
