Are Endowments Really Taxable? Avoid this Mistake + FAQs

U.S. college endowments hold over $800 billion that mostly grows tax-free.

Yet in 2022, a handful of wealthy universities paid the first-ever 1.4% “endowment tax” – a shock to many 🎓💰.

So, are endowments taxable? The short answer:

Mostly no, thanks to charities’ tax-exempt status – but some endowments do face taxes under specific conditions.

Below we immediately answer this question and then dive deep into federal and state tax laws governing all types of endowments.

In this article, you’ll discover:

• Which endowments are completely tax-free – and which ones aren’t (covering universities, nonprofits, religious funds, private foundations, public charities, donor-advised funds, and more)

• Federal tax law secrets that let endowments grow tax-exempt, plus the IRS exceptions (like a new 1.4% tax hitting big college endowments, Form 990 requirements, and hidden tax traps)

• How state taxes and local laws can throw curveballs at endowments (from state-level UBIT rules to proposed taxes on giant university funds and property tax battles)

• Key concepts and pitfalls: Unrelated Business Income Tax (UBIT), donor-advised funds, payout requirements, common mistakes that could jeopardize an endowment’s tax status, and real-world examples of what not to do ⚠️

• Pros and cons of taxing endowments, with a breakdown of arguments on both sides – plus an expert FAQ answering the most common yes-or-no questions on endowment taxation

Let’s unravel the complex world of endowments and taxes, so managers, tax/legal professionals, and curious readers can navigate these rules with confidence.

Endowments 101: Definition and Types of Endowments

Endowments are pools of money or assets set aside to support an institution or cause in perpetuity. They’re typically invested long-term, and the earnings fund the organization’s mission year after year.

Many nonprofits – from universities and colleges to museums, hospitals, churches, and foundations – rely on endowment income to pay for scholarships, operations, research, charitable programs, and more. Before diving into tax treatment, it’s important to understand the types of endowments out there and who manages them:

• University and College Endowments: These are funds held by higher education institutions (public and private colleges, universities, and sometimes private K-12 schools). For example, Harvard, Yale, and Stanford each have endowments tens of billions of dollars large. Endowments help schools fund financial aid, faculty positions, facilities, and ensure long-term financial stability for education. Universities often have multiple individual endowment funds (some restricted by donors for specific purposes, like a scholarship endowment or a professorship) that together form the total endowment.

• Nonprofit and Public Charity Endowments: Many nonprofit organizations such as charitable foundations, hospitals, libraries, museums, and social service charities maintain endowment funds. These endowments might not be as massive as a university’s, but they serve a similar purpose – providing steady investment income to support the nonprofit’s mission (be it healthcare, arts, poverty relief, etc.). Public charities (the IRS term for most nonprofits that rely on broad public support) can grow their endowments over time through donations and investment gains.

• Religious Institution Endowments: Churches, synagogues, mosques, and other religious organizations may also have endowments (often called trust funds or reserve funds) funded by bequests or donations from members.

• A religious endowment might support the maintenance of a place of worship, charitable outreach programs, or clergy salaries. These funds benefit from the organization’s 501(c)(3) religious tax-exempt status. Notably, churches are automatically considered tax-exempt and even have special treatment (they generally aren’t required to file annual IRS information returns), but their endowment funds operate under the same general tax-exempt principles.

• Private Foundation Endowments: A private foundation is typically a charity set up by a single donor, family, or corporation to grant money to other charities or causes. Classic examples include family foundations (like the Ford Foundation or Gates Foundation) or corporate foundations (like the Coca-Cola Foundation).

• These foundations usually have a significant endowment (often funded initially by a large gift from the founder) that generates income. The foundation then grants out funds each year from its endowment earnings (and principal, if needed) to fulfill charitable purposes. Private foundation endowments have a unique tax regime, as we’ll explore – with special taxes and required payout rules.

• Donor-Advised Funds (DAFs): Donor-advised funds are a bit different – they’re not tied to one institution’s mission in the same way, but they function as charitable investment accounts. A donor-advised fund is established when a donor gives money to a public charity sponsor (for example, a community foundation or a charity affiliated with an investment firm like Fidelity Charitable).

• The donor gets an immediate tax deduction, and the funds are held and invested by the sponsor for charitable distribution later. In practice, DAFs act like mini-endowments: the money can grow tax-free, and donors can recommend grants to operating charities over time. DAFs have become hugely popular, holding tens of billions of dollars nationwide, and raise their own tax questions (especially around whether they should be forced to pay out or face penalties for sitting too long). We’ll discuss how DAFs are treated in the tax code along with other endowments.

In short, “endowment” can refer to any invested fund supporting a nonprofit purpose. No matter the type, endowments share a common trait: they’re part of organizations that enjoy tax-exempt status. Now, the big question: does that mean endowment money is never taxed? Let’s dig into federal tax law to see why most endowments are tax-free – and the important exceptions where taxes kick in.

Federal Tax Law: Endowments’ Tax-Free Status and IRS Rules

At the federal level, most endowments are not taxable on their earnings. That’s because the institutions holding them are typically 501(c)(3) organizations (charities, educational institutions, religious orgs, etc.) which are exempt from federal income tax.

When a nonprofit university’s endowment earns interest, dividends, or capital gains, those earnings are generally not subject to corporate income tax as they would be for a regular for-profit business. This tax-exempt treatment is a deliberate choice by Congress to encourage and support charitable, educational, and religious activities – allowing endowment funds to grow faster and provide more support for their missions.

However, “tax-exempt” doesn’t mean anything goes. The IRS has laid out specific rules and exceptions in the Internal Revenue Code to prevent abuses and to impose taxes in certain scenarios.

Below, we break down how federal tax law treats endowments, including special taxes for certain types of endowments, what counts as taxable income vs. exempt income, and the reporting requirements organizations must follow.

Why Most Endowment Earnings Are Tax-Free (The 501(c)(3) Benefit)

The majority of endowments belong to organizations recognized as tax-exempt under IRS code section 501(c)(3). This section covers charities, religious organizations, educational institutions, and other nonprofits serving the public good.

The tax code grants these entities exemption from federal income tax on income that is related to their exempt purpose. Crucially, that includes investment income and donations, which form the lifeblood of endowments.

Here’s why endowment funds usually escape taxes:

• Donations to the endowment are tax-free gifts to the nonprofit. When a donor contributes $1 million to a university’s endowment, the university doesn’t pay income tax on that donation. In fact, the donor likely gets a tax deduction for giving to a qualified charity. So the principal entering the endowment is untaxed (and deductible for the giver under Section 170, encouraging charitable giving).

• Investment returns are generally exempt as long as they support the charity’s mission. If that $1 million endowment gift is invested in stocks and bonds and earns $50,000 in dividends and interest next year, the university does not pay corporate income tax on those earnings. The earnings become part of the endowment and will eventually be spent on scholarships or other educational purposes, which aligns with the tax-exempt purpose.

• No capital gains tax on portfolio sales: Endowments frequently buy and sell investments. Unlike a for-profit investor, a charitable endowment doesn’t pay capital gains tax when it realizes a profit on selling an asset (again, because the gain is treated as part of the tax-exempt organization’s income). This allows endowment managers to rebalance and grow funds without the drag of taxes – a powerful advantage for long-term growth 📈.

In essence, the federal government treats a qualified nonprofit’s endowment earnings as tax-exempt income, under the rationale that those funds will be used for charitable or educational activities. This is a cornerstone of how big endowments have grown so large over time – compounding investment returns without tax erosion is extremely effective.

That said, the IRS places guardrails on tax-exempt status. Organizations must ensure the endowment’s proceeds are used for legitimate exempt purposes, not for private gain. They must avoid excessive lobbying or political campaigning.

And importantly, they must file annual informational returns (Forms 990) to remain compliant and transparent. We’ll cover these requirements soon, but first, let’s look at the major exceptions where Uncle Sam does levy taxes on endowments.

The New 1.4% Excise Tax on Wealthy College Endowments (Private Universities)

For centuries, colleges and universities paid no tax on their endowment earnings. That changed in 2017, when Congress passed the Tax Cuts and Jobs Act (TCJA) and tucked in a surprising new provision: a federal excise tax on investment income of certain large college endowments. This was essentially a new “endowment tax” aimed at the richest private schools, a response to political pressure to make wealthy universities contribute more or spend more of their hoard.

Here’s how this college endowment tax works:

• It applies only to private (non-government) colleges and universities with at least 500 students and endowment assets that exceed $500,000 per student. In other words, only extremely wealthy institutions hit this threshold (think elite Ivy League and similar schools). The law intentionally carved out smaller colleges and public universities (public institutions, as government entities, aren’t subject to this tax at all).

• If an institution meets the criteria, it must pay a 1.4% excise tax on its net investment income each year. Net investment income includes things like interest, dividends, and capital gains from the endowment, minus certain expenses – basically the same concept used for private foundation taxes (discussed later). The 1.4% rate may sound low, but on multi-billion-dollar endowments with strong returns, it can equate to millions of dollars in tax.

• Example: Suppose a wealthy private university has 1,000 students and an endowment of $1 billion. That’s $1,000,000 per student, well above the $500,000/student threshold. If the endowment’s investments earn $50 million this year, the university will owe 1.4% of $50 million = $700,000 in excise tax to the IRS. That’s $700k less kept for its mission – a relatively small bite out of $50m earnings, but symbolically significant since traditionally no tax was due at all.

• This tax is reported and paid on Form 4720 (Return of Certain Excise Taxes) by the affected institutions. The threshold ($500k per student) is not indexed to inflation, so over time more colleges could fall into the taxable zone as endowments grow and inflation increases costs.

When first implemented, this tax affected only an estimated 25 to 40 colleges nationwide (the exact number varies with market values; in 2022 about 50-60 institutions paid it). It raised roughly $200+ million per year in revenue initially – not huge in federal budget terms, but certainly noticeable to those colleges. Schools like Harvard, Yale, Princeton, and MIT have had to budget for this new tax hit.

It’s worth noting that public universities (state universities) are exempt from this because they are considered part of state government and not private 501(c)(3) charities. So a large endowment at a public school (e.g. University of Michigan or University of Texas, which have sizable endowments) does not pay the 1.4% excise tax, even if equally wealthy per student. This discrepancy raised some debate about fairness, but that’s how Congress wrote the law.

This college endowment tax is still relatively new. Universities subject to it must carefully calculate their net investment income and pay the IRS accordingly. There have been discussions in Congress about modifying it – some politicians have even proposed raising the rate dramatically or broadening it – but as of now it remains a modest 1.4% levy on a small group of institutions.

Private Foundations: The 1.39% Tax and 5% Payout Rule

While the college endowment tax is new, private foundations have long operated under special tax rules. A private foundation (often just referred to as a “foundation endowment”) is usually a pot of money from one source that invests and gives grants. The IRS subjects private foundations to a couple of key requirements not imposed on other public charities:

1. Excise Tax on Investment Income (1.39%): Every private foundation must pay a small excise tax on its net investment income each year. Historically this was a two-tier tax (2% or 1% if the foundation paid out a little more), but in recent years it was simplified to a flat 1.39% rate on net investment income. Net investment income for foundations includes interest, dividends, rents, and capital gains (minus related expenses). The foundation calculates this tax annually on Form 990-PF and pays it to the IRS. This effectively means foundation endowments aren’t completely tax-free – they pay this modest toll to the government on their earnings.

   • Why this tax? Congress instituted it decades ago (1970s) partly to fund IRS oversight of charities and to ensure foundations contribute something. At 1.39%, it’s low enough not to severely hamper growth, but it does generate significant revenue given the many foundations out there. For instance, a foundation with a $100 million endowment earning $5 million would owe about $69,500 in excise tax for the year.

   • Some private operating foundations (foundations that actively run charitable programs themselves, rather than just giving grants) can be exempt from this excise tax if they meet certain criteria as “exempt operating foundations.” But the typical grant-making family foundation does pay the 1.39% each year.

2. 5% Minimum Annual Payout Requirement: To prevent foundations from just hoarding money indefinitely, tax law requires that a private foundation distribute at least 5% of the value of its assets each year for charitable purposes (grants to charities or expenses of conducting its own charitable programs). If a foundation fails to meet this 5% payout, it can face penalty excise taxes on the shortfall. Essentially, foundations must steadily spend a portion of their endowments for the public good. This isn’t a tax in the sense of money to the government, but it’s a legal mandate tied to their tax-exempt status.

   • For example, if a family foundation has a $20 million endowment, it generally needs to spend at least $1 million on grants or charitable activities that year (5% of $20M). If it only spent $500k, it would be $500k short of the requirement and could incur an IRS penalty on that undistributed amount. Ultimately, if a foundation consistently fails to pay out enough, it could even jeopardize its exemption.

   • The combination of the 1.39% tax and the 5% payout rule means private foundation endowments are under more pressure to pay out money than a university endowment (which might choose to spend only 4% or less and face no direct penalty). The 5% rule ensures charitable dollars actually hit the streets, not just sit in investment accounts.

3. Other Restrictions: Private foundations are also subject to stricter rules on certain activities – for example, they face limits on holdings in private businesses, cannot do any lobbying, and laws against self-dealing (financial transactions with insiders) are tougher. These don’t directly impose taxes on the endowment’s earnings, but violations can result in excise taxes. For instance, if a foundation endowment improperly loans money to a disqualified person (like its major donor or trustee), a hefty excise tax penalty can apply to the individuals and the foundation. So foundation managers must be careful – their endowment’s tax benefits come with compliance strings attached.

In summary, private foundation endowments enjoy tax-exempt growth except for a light 1.39% skim by the IRS, and they are legally required to disburse a minimum amount annually. This contrasts with public charity endowments (like universities or hospitals), which generally have no mandated payout rate and (aside from the new college tax) no excise tax on earnings. The trade-off is that to be a public charity you need broad public support; a private foundation can be one family’s controlled endowment but then is subject to these extra taxes and rules.

Public Charities & Religious Endowments: Tax-Exempt but Transparent

Public charities (a category including most nonprofits like universities, hospitals, museums, community foundations, etc.) with endowments do not pay a specific federal tax on their endowment earnings (except the special cases we covered like certain private colleges). Their main obligations are to use the funds for charitable purposes and to report their finances to the IRS and the public.

Key points for public charity endowments:

• No excise tax on investment income: Unlike private foundations, public charities (which include most universities and nonprofits) do not pay the 1.39% investment tax. Their endowment interest, dividends, and gains are fully tax-exempt federally. This encourages donations to public charities and acknowledges that these organizations typically depend on many donors, not just a single wealthy family.

• No fixed payout requirement: Public charities are not required by tax law to spend a set percentage of their endowment annually. Many nonprofits voluntarily have a spending policy (often around 4-5% of endowment value per year, to balance supporting current needs with preserving funds for the future). But the IRS doesn’t impose a minimum distribution like it does for private foundations. One exception: Donor-advised fund sponsors (which are public charities) and supporting organizations have certain payout expectations in practice, but no strict statutory percentage.

• Annual reporting on Form 990: Virtually all public charities with significant assets must file an annual Form 990 (Return of Organization Exempt from Income Tax). This public document includes information about the charity’s finances, programs, and governance. There is a section in Schedule D of Form 990 where organizations with endowments provide details: the beginning and end-of-year value of the endowment, contributions in, earnings, grants or distributions out, and so forth. This transparency is meant to let the IRS and public see how the endowment is being managed (e.g., is the charity drawing too much or too little? How did the investments perform?).

• Religious organizations: Churches and certain religious entities are classified as public charities but are uniquely exempt from filing Form 990. So a church could have an endowment (say a trust fund for church upkeep or missions) and it would neither pay taxes on the earnings nor have to publicly report it on a 990. However, the church still must use those funds for religious and charitable purposes. The IRS can theoretically audit a church if there’s cause, but in general churches have a lot of autonomy. For other religious nonprofits (like a religious hospital or school that’s separately incorporated), they would file 990 like any charity. Important: Just because churches don’t file 990 doesn’t mean they can mismanage funds – they still risk loss of exemption if they, for example, use endowment money for private gain or political campaigns.

• Government endowments: While not exactly “public charities,” it’s worth noting that public universities and government-run charities (like a state university’s foundation or a municipal library fund) are usually government entities or have a special status. Their endowments are not taxed (as governments are tax-exempt by nature), and these may not file 990s either since they report through government accountability mechanisms. For example, a big state university’s endowment might be managed by a separate nonprofit foundation that does file a 990, or by the school itself which as a state entity doesn’t file IRS forms. In either case, federal tax isn’t applied to their earnings.

In short, most public charity and religious endowments operate tax-free federally, with oversight coming in the form of reporting requirements and general IRS regulations for charities. As long as the endowment’s funds are used for the public good and not diverting to insiders, the IRS is content not to tax that income.

However, even tax-exempt organizations can run into taxable situations when they step outside purely charitable investment income. That’s where the concept of Unrelated Business Income Tax (UBIT) comes in – a crucial topic for endowment managers to understand.

Unrelated Business Income Tax (UBIT): The Hidden Tax on Certain Endowment Earnings

Even though a charity’s endowment earnings are generally exempt, not all income is treated equally. If a nonprofit (and its endowment) earns money in ways that are unrelated to its charitable purpose and akin to a regular business, the IRS says: we’re going to tax that income. This is the Unrelated Business Income Tax, or UBIT, which applies to most tax-exempt entities including universities, charities, foundations, and retirement plans.

UBIT in a nutshell: If a nonprofit generates net income from a trade or business activity that is regularly carried on and not substantially related to its exempt purpose, that income is taxable at corporate tax rates (currently 21%). Essentially, the IRS wants to prevent charities from having unfair advantage competing with for-profit businesses in unrelated arenas. For endowments, UBIT most often comes into play in the investment context or any revenue-generating ventures beyond passive investing.

Here are common scenarios where an endowment might incur UBIT:

• Debt-Financed Investment Income: One big trap is debt-financed property. Normally, rental income or gains from real estate held in an endowment is tax-free. But if the endowment purchased the property using a loan or mortgage, a portion of that income is considered unrelated debt-financed income (since borrowing to invest is viewed as a commercial activity). Example: A university endowment buys an apartment building for investment, taking out a mortgage for part of the purchase. The rental income that corresponds to the debt percentage is taxable UBIT. So if it’s 50% debt-financed, half the rental profits are taxable. The same goes for investments in certain private equity or hedge funds that use leverage – the share of income attributable to leverage can flow through as UBIT to the nonprofit investor. Endowment managers carefully monitor this; some choose to avoid debt-financed deals or use blocker corporations to avoid UBIT.

• Operating Businesses Owned by the Endowment: If an endowment (or the nonprofit itself) owns and runs a business not related to its mission, those profits are taxable. For example, say a charitable foundation’s endowment buys a local coffee shop or starts a tech company as an investment. If the shop or company is run regularly and isn’t directly furthering the charity’s purpose, any net income from it will be taxed as unrelated business income. Fun historical fact: The whole concept of UBIT arose in the 1950s when some nonprofits started buying commercial businesses (like a famous case of a university owning a pasta manufacturing company) to fund their charity – Congress decided to tax such business profits to stop a potential loophole of endless tax-free corporations.

• Regularly Selling Goods/Services for Profit: If a university endowment fund regularly profits from something like a commercial venture (outside the educational sphere), it’s taxable. For instance, if a college’s endowment invests in an office building and actively manages it renting to normal businesses – that’s likely UBIT (except for the portion of any debt-free passive rental, which can be exempt). Another example: A museum gift shop selling art replicas might be considered related (educational) and not taxed, but if the museum runs a full-fledged online retail business selling generic gifts nationwide, that could cross into unrelated business territory.

• Licensing and Royalties – usually not taxed, unless… Royalties from patents, intellectual property, etc., are generally exempt passive income. However, if a nonprofit actively markets something, it can become taxable. For instance, a university might have a trademark on its logo – letting a company use it on merchandise for a royalty is typically not taxed. But if the university itself starts a sideline of manufacturing and selling products, that’s business income.

UBIT is reported on Form 990-T. Nonprofits must file this if they have gross unrelated business income of $1,000 or more. The tax is computed similarly to corporate tax (including allowing deductions directly connected to the unrelated business activity).

Important nuance: Investment income from traditional stocks, bonds, dividends, interest, and gains is specifically excluded from UBIT (unless debt-financed). That’s why endowments can invest in publicly traded securities freely without worrying about UBIT. The tax mainly hits when nonprofits stray into active business or leveraged investments.

Impact of UBIT on endowments: While UBIT is an extra tax, many large endowments take it in stride as a cost of certain investments. For example, some university endowments invest in lucrative private equity funds that use debt; they accept paying some UBIT because the net return (after tax) is still worthwhile. However, if an endowment were to generate too much UBIT relative to its overall activities, it could raise red flags. One extreme scenario: If a charity’s operations become dominated by a business enterprise, the IRS could question whether it’s truly operating as a charity or should lose tax-exempt status entirely. That’s rare, but it underscores the need to ensure unrelated businesses remain a sideline, not the main show.

IRS Reporting and Compliance: Form 990, 990-PF, 990-T, and More

To maintain their tax-exempt status and inform the IRS (and public) of their activities, organizations connected to endowments have crucial reporting requirements. These aren’t taxes per se, but failing to comply can lead to penalties or even loss of exemption (which would make the endowment taxable like a regular fund – a disaster scenario for a nonprofit).

Key filings and compliance points:

• Form 990 (Annual Information Return): Virtually all tax-exempt organizations (except small ones under $50K gross receipts and most churches) must file some version of Form 990 each year. This includes universities, public charities, and donor-advised fund sponsoring organizations. The Form 990 is a comprehensive report of finances, including revenues (donations, investment income, program revenue), expenses, executive compensation, lobbying activities, and balance sheet items. For endowments, Schedule D of the 990 asks for details on endowment funds – beginning balance, contributions, investment earnings, grants or distributions made, and ending balance. The 990 is public, meaning anyone can look up a nonprofit’s form and see the size of its endowment and how it changed. This transparency puts some public pressure on institutions with large endowments to justify their use of funds. Failure to file Form 990 for three consecutive years leads to automatic revocation of tax-exempt status by the IRS (under a law passed in 2006 to clean up inactive nonprofits). That would mean the organization is no longer exempt and would have to pay taxes on income (including endowment earnings) until it regains status – clearly a situation to avoid. So, endowment managers make timely 990 filings a top priority.

• Form 990-PF (Private Foundation Return): Private foundations have their own version of the return, which is also public. The 990-PF not only reports basic financial info but also is where the foundation calculates its 1.39% excise tax on investment income each year. It includes a detailed list of investment income items, expenses, and a section to ensure the foundation met the 5% payout distribution requirement. If a foundation endowment doesn’t meet the requirement, the form calculates an undistributed income amount that could be subject to hefty penalty taxes if not corrected. The 990-PF also lists grants the foundation made that year, providing transparency into how endowment funds are being used charitably. Like the 990, failing to file a PF return can result in penalties and eventually loss of exemption (though it’s rare a foundation would forget, since they often have professional accountants handling it).

• Form 990-T (Exempt Organization Business Income Tax Return): If an endowment has UBIT, the nonprofit must file a 990-T to report that income and pay the tax. This form is somewhat like a mini corporate tax return for the unrelated business segment of the charity’s activities. For example, if a museum had $200,000 of net income from a parking garage it runs for the public (an unrelated business to its mission of education), it would compute tax on that $200k at 21% (~$42,000 tax) on the 990-T. Notably, starting in recent years, 990-T filings of nonprofits are also publicly available (with certain donor info redacted) – so one can see if a charity is engaged in taxable businesses. Charities try to minimize needing to file 990-T, both to reduce taxes and to avoid perceptions they’re off mission.

• State filings and compliance: (We’ll detail state taxes in the next section, but note here) nonprofits often have to file separate state charitable registration or state tax-exempt paperwork, plus any state tax forms if they have unrelated business income in that state. Keeping track of federal and state compliance is a must for endowment managers – missteps can cost money or even the organization’s good standing.

• Governance and operational compliance: Beyond forms, the IRS expects good behavior. If an endowment is misused – say, to overly benefit a donor or a board member (what IRS calls “private inurement” or “excess benefit transactions”) – the IRS can impose intermediate sanctions. These are excise taxes on the individuals who got the undue benefit and on organizational managers who approved it. In severe cases, repeated or egregious abuses could cause the IRS to revoke the charity’s tax exemption entirely. For example, using endowment funds to buy a luxury condo for the founder or paying above-market fees to a trustee’s investment firm could trigger such penalties. These rules keep endowment funds serving the public interest, as intended.

In summary, federal tax law mostly shields endowment assets from taxation, but demands accountability and taxes certain out-of-bounds activities. Managers of endowments should celebrate the tax-free compounding but also stay vigilant about the exceptions: if you oversee an endowment, you need to know if any part of your fund’s activities might incur the 1.4% college tax, the 1.39% foundation tax, or UBIT – and file the right forms and pay what’s due. The IRS is generally friendly to nonprofits, but not if you ignore the rules. ✅

Now that we’ve covered the federal landscape, let’s turn to how state and local taxes come into play. Could your state tax your endowment even if the feds don’t? It’s time to explore state-level nuances in endowment taxation.

State-Level Nuances: When States Eye Endowments for Taxes

Federal law provides the overarching rules for endowment taxation, but state laws also have a say – especially when it comes to state income taxes, property taxes, and other local levies. Generally, states follow the federal lead in exempting nonprofit organizations from state income taxation. But there are important nuances and occasional efforts by states to target large endowments or ensure nonprofits contribute to local coffers.

Let’s break down the key points for state and local taxation of endowments:

State Income Tax: Do Nonprofits Pay State Tax on Endowment Earnings?

In most cases, no – nonprofits that have federal 501(c)(3) status are also exempt from state corporate income taxes on their charitable activities (including endowment income). States usually incorporate federal exemption status into their own tax codes. For example, if the IRS recognizes a charity as tax-exempt, a state like California or New York will likewise not tax that charity’s income. However, there are a few catches:

• State Exemption Application: Some states require a separate application or registration for a charity to be recognized as tax-exempt at the state level. For instance, California mandates that nonprofits submit an exemption request (Form 3500A) to be exempt from California franchise and income tax, even if they have an IRS determination letter. This is usually a formality, but an endowment-holding entity should ensure it’s properly registered in any state where it operates or earns significant income, or it could inadvertently be considered taxable there.

• Unrelated Business Income at the State Level: Many states tax a nonprofit’s unrelated business income similarly to the federal government. That means if your endowment had UBIT federally, you might also have to file a state income tax return and pay state tax on that UBI portion. States often use federal Form 990-T as a starting point to calculate state UBIT. For example, a nonprofit in New York that earns taxable advertising income would pay federal UBIT and also pay New York’s corporate tax rate on that income. State rates vary, so it’s another layer of tax to watch when engaging in taxable activities.

• Different Thresholds or Definitions: A few states might have their own tweaks on what counts as unrelated business or how much is taxable. But broadly, there’s harmony with federal definitions to keep things simple. It’s wise for endowment managers to consult state tax regs for any state in which they have property or business income. For example, if your endowment owns real estate in multiple states, you could have to allocate UBIT to each and file multiple state returns.

• State Excise or Endowment Taxes: It’s uncommon, but there have been political attempts at the state level to impose special taxes on large endowments. One notable case is Connecticut, where lawmakers at times proposed a tax specifically targeting Yale University’s giant endowment (for instance, a tax on investment earnings or a per-student endowment tax in excess of a threshold, somewhat mirroring the federal approach). These proposals recognize that mega-endowments are untapped tax sources and that universities like Yale benefit from city services without paying property taxes. As of this writing, no state-level endowment income tax has been enacted, but it’s a space to watch. If a state did pass such a tax, it could face legal challenges (possibly contending that it interferes with nonprofit status or, in the case of private universities, perhaps even implicating federal law). So far, these remain just proposals.

In summary, state income tax generally doesn’t soak endowments beyond what federal law does, except to collect taxes on any unrelated business chunk. Nonprofits should still register in each state and ensure compliance to avoid surprises.

Property Tax and Local Levies: The Town vs. Gown Endowment Debate

One major area where endowments feel a tax impact at the state/local level is property tax. While not a tax on the endowment’s income, property taxes can indirectly affect endowment spending if an institution has to shell out money for local taxes on its assets.

• Property Tax Exemption for Charities: All states have some form of property tax exemption for property used for charitable, educational, or religious purposes. For example, a university’s academic buildings, dorms, and even campus land are typically exempt from city property taxes because the university is a charitable/educational institution. This is a significant benefit – large universities would owe tens of millions in property taxes annually without it. If an endowment owns property directly and uses it for the nonprofit’s mission (like a conservation charity owning a wildlife preserve), that property is usually exempt as well. Similarly, church-owned property used for worship or ministry is exempt in most jurisdictions.

• Property Used for Investment: A gray area arises if a nonprofit holds property primarily as an investment rather than for its own use. Some localities argue that such property should be taxable. For instance, if a university endowment owns a shopping mall purely as an investment, a city might say that property isn’t being used for an exempt purpose and therefore shouldn’t get a free ride. In practice, nonprofits often structure investments via taxable subsidiaries or just accept paying property tax on those particular properties to avoid fights. Laws vary by state on whether all property owned by a charity is exempt or only property used for exempt functions.

• “PILOT” Agreements: In cities with large nonprofit footprints (e.g., colleges, hospitals), local governments sometimes seek Payments In Lieu of Taxes (PILOTs). These are voluntary agreements where the nonprofit agrees to pay the city a certain amount annually to offset the lost property tax revenue, without legally giving up exemption. Endowments often fund these PILOT payments. For example, Yale University, which is exempt from property tax in New Haven for its main campus, has historically made voluntary payments to the city and in recent years agreed to increase its contributions by millions, acknowledging the strain on city finances. PILOTs can be seen as a compromise: the nonprofit maintains its tax-exempt status officially, but the community gets some revenue to support services.

• Local resentment and proposals: There is an ongoing town-gown tension in some places. Residents and officials in cities with wealthy universities or hospitals sometimes feel those institutions should contribute more financially, given their large endowments. High-profile endowments like Yale’s (over $40 billion) or Princeton’s have drawn attention. Princeton University faced a lawsuit from local residents a few years ago claiming that parts of its property (like a commercial hotel the university owned, or patent income it earned) were not used for educational purposes and thus should be taxable. Princeton ultimately reached a settlement including more voluntary payments. These kinds of skirmishes highlight that even if endowment income isn’t taxed, the presence of huge untaxed wealth can spur attempts to tax something else (property, or creating new fees).

• State-level property tax moves: Occasionally, state lawmakers float ideas like allowing cities to tax certain nonprofit properties or endowment funds. As noted, Connecticut legislators proposed letting the city of New Haven tax Yale’s endowment directly – essentially a state law override of the usual exemption. So far, these have not succeeded, partly due to concerns that taxing nonprofit assets could undermine charities and perhaps face constitutional issues. But the pressure is real, especially in states with budget issues or cities struggling with a thin tax base due to many tax-exempt properties.

In conclusion, state and local taxation doesn’t directly levy income tax on endowments, but property tax exemption is a critical benefit that some communities challenge. Endowment-rich institutions should be mindful of community relations – sometimes contributing voluntarily or justifying their exemptions by highlighting public benefits (scholarships, free clinics, etc.) – to ward off more drastic measures.

State Regulations on Endowment Management

Beyond taxes, states also regulate how endowments are managed and spent through laws like the Uniform Prudent Management of Institutional Funds Act (UPMIFA), adopted in nearly every state. While this isn’t about taxation, it’s a state-level nuance worth a quick mention:

• UPMIFA provides guidelines on investing endowment funds prudently (considering risk, return, diversification) and allows nonprofits to spend from an endowment even if it’s below original gift value, under certain prudent guidelines. It replaced older laws that forbade spending below the “corpus” of a gift. This ensures that in down markets, charities can still use some endowment funds to continue their mission.

• Donor restrictions: State law enforces donor intent on endowments. If a donor gave money for a restricted endowment (say, only to fund cancer research), the nonprofit must honor that. Misusing endowment funds could lead to state Attorney General action or donor lawsuits. Again, not a tax issue directly, but mismanagement could jeopardize donor trust and ultimately the survival of a nonprofit (which could indirectly affect its tax status if the org dissolves or changes purpose).

The key takeaway is that state oversight complements federal tax law: the feds mostly care about tax and broad compliance, while states ensure charities aren’t abusing the privilege and are using funds properly. From a tax perspective, though, states largely align with federal rules, with a few localized attempts to tap into those endowment riches.

Now that we’ve covered both federal and state dimensions of endowment taxation, let’s illustrate some of these principles with real-world examples and common mistakes to avoid.

Real-World Examples and Common Pitfalls in Endowment Taxation

Understanding the rules in theory is one thing – seeing how they play out in practice really drives the lessons home. In this section, we’ll explore examples of different endowment scenarios, and highlight common mistakes/pitfalls that can trip up even well-meaning organizations.

Case Study 1: Ivy League University vs. Small College – Who Pays the “Endowment Tax”?

Elite Private University (Large Endowment): Consider Harvard University, with an endowment of about $50 billion. Harvard well exceeds the $500,000 per student threshold (Harvard has roughly 20,000 students; per student its endowment is in the millions). Under current law, Harvard’s net endowment investment income is subject to the 1.4% excise tax each year. If we assume Harvard’s endowment earns a 10% return (about $5 billion) in a good year, a 1.4% tax on that could be around $70 million paid to the IRS. That’s a hefty tax – though Harvard would still net $4.93 billion to support its programs. The university complies by calculating this tax and paying it (likely in quarterly estimated payments) just like a private foundation would. Harvard also files a Form 990 each year detailing its endowment and a Form 4720 for the excise tax.

Small Liberal Arts College: Now consider a small private college with 1,000 students and an endowment of $100 million. That’s $100,000 per student – well below the $500k/student tax threshold. This college pays no federal excise tax on its endowment. If it earns $5 million in investment income, it keeps all $5 million for its budget. It still files a Form 990 and discloses the endowment’s value, but there’s no special tax to pay. Both Harvard and the small college benefit from the general tax-exemption, but only the mega-endowment triggers the extra tax. This example shows how only the richest of the rich endowments currently face a direct federal tax on earnings, whereas a smaller school’s endowment remains fully untaxed (federally).

Pitfall to avoid: A college near the threshold must be cautious in planning. If our small college had a windfall donation that suddenly boosted its endowment per student above $500k, it could unexpectedly become subject to the tax. Therefore, finance officers at growing institutions should keep an eye on that ratio so they aren’t caught off guard by a new tax liability when crossing the line.

Case Study 2: Family Foundation Endowment – Meeting Payout and Avoiding Penalties

Imagine the Smith Family Foundation, endowed with $20 million by a wealthy family to support various charities. The foundation invests the $20M in a portfolio of stocks and bonds.

• In a given year, the foundation’s investments earn $1,000,000 in dividends and realized gains. The foundation will owe 1.39% excise tax on that $1M (approximately $13,900). They’ll report this on their Form 990-PF and pay it. That’s straightforward.

• More importantly, the foundation needs to make sure it distributes at least 5% of its assets for charitable purposes. 5% of $20M is $1M. If their operating expenses (e.g., a part-time director’s salary, admin costs) are $100k, and they gave $700k in grants to other charities, their total charitable expenditures are $800k – which is $200k short of the $1M required. If they end the year short, that $200k is considered undistributed income. The IRS gives a short grace period into the next year to make it up, but failing that, the foundation faces a penalty tax (up to 30% of the undistributed amount!). And if willful or prolonged, the foundation could ultimately be in jeopardy of involuntary termination.

• The Smith Foundation realizes in December that they have only spent 4% of assets. To avoid penalties, they issue additional grants of $250k, bringing their payout to $1.05M (slightly above 5%). They prefer to overshoot a bit to be safe. By doing so, they avoid the pitfall of an under-distribution penalty and also qualify for the lower excise tax rate (under old rules it would reduce to 1%, but with the flat 1.39% now it’s moot).

• Additionally, the Smith Foundation is careful about self-dealing rules: one family member wanted the foundation endowment to invest in her startup company – a big no-no because that could be seen as enriching insiders. Engaging in such a transaction could incur excise taxes on the participants and put the foundation at risk. They wisely decline that idea and keep investments arm’s length.

Lesson: Private foundation endowments, while enjoying tax-exempt growth aside from a small tax, require active compliance (making grants, avoiding insider deals). The family foundation in this example successfully navigated these requirements, but lesser-informed foundations sometimes slip – e.g., forgetting the payout requirement or paying a board member’s company for services – which can lead to IRS penalties.

Example 3: Unrelated Business Income Trap – University Endowment’s Venture Capital Investment

A university endowment invests $5 million into a venture capital fund that focuses on tech startups. The fund structure is such that it uses debt financing to leverage investments, and it passes through income and losses to its investors (including the university).

A few years in, the fund is wildly successful, and the university’s share of earnings is $2 million, mostly from selling startup equity (capital gains). Normally, capital gains are tax-exempt to the university. But, because the fund used leverage (debt) to amplify returns, a portion of those gains are considered debt-financed income. The fund reports that 50% of its gains are attributable to leverage.

Consequently, the university has $1 million of income subject to UBIT (the leveraged half). At a 21% corporate tax rate, the university owes $210,000 in tax on this income, reported via Form 990-T. The remaining $1 million (from the non-leveraged portion) is tax-free.

While $210k tax is not insignificant, the endowment still netted $1.79 million of the $2 million, which is excellent. The key is the university anticipated this outcome and was prepared. They file in their state as well for state UBIT on that $1M (some states tax it, some might not, but many do).

Common mistakes to avoid in UBIT scenarios:

• Not filing 990-T: Some nonprofits forget that earning unrelated business income, even once, triggers the need to file a tax return. This can result in back taxes, interest, and penalties if discovered later. It can also raise questions with the IRS about oversight. Always file the 990-T if required, even if the net income is small or zero after expenses.

• Misclassifying income: Sometimes organizations mistakenly treat something as related income when it’s not. For example, if a charity runs a regular cafe open to the public just to make money, they might convince themselves it supports their mission loosely. If it really doesn’t, they should report it as unrelated business. Being too aggressive in labeling businesses “mission-related” could be challenged by the IRS. It’s better to err on the side of caution or get a private letter ruling if unsure.

• Letting UBIT activities grow: If an endowment continually expands its unrelated business ventures (like more leveraged deals, more commercial enterprises), the tail can start wagging the dog. Remember, too much UBIT (especially if it becomes a majority of activities) could risk the organization’s tax-exempt status because the IRS may say the institution is no longer primarily charitable. Nonprofits should keep an eye on the percentage of their revenue that comes from UBIT and keep it in check.

Example 4: Losing Tax-Exempt Status – A Cautionary Tale

Nothing will make an endowment taxable faster than losing the organization’s tax-exempt status. It’s the ultimate pitfall to avoid. Consider a hypothetical charity, “Education4All,” which has a decent endowment of $10 million.

• Over a period of years, Education4All fails to file its Form 990 three times. Perhaps leadership changed and nobody was tracking compliance. After the third missed year, the IRS automatically revokes its 501(c)(3) status. All of a sudden, Education4All is no longer a recognized charity.

• What does this mean for its endowment? The income from the endowment is now fully taxable as if Education4All were a regular corporation or trust. So the next year, its $10M endowment earns $500k. Normally, as a charity, no tax. But because they lost status, that $500k could be subject to corporate income tax (~21%, so $105k tax bill). And any donations it receives in the interim are not tax-deductible for donors (so fundraising takes a hit).

• Education4All can apply to get reinstated, and the IRS often will reinstate if the lapses were not egregious. But they may have to pay user fees, file all the missing 990s, and possibly pay taxes for the period they were non-exempt. It’s a costly, embarrassing mistake.

• Another scenario: Suppose Education4All wasn’t filing taxes and it engaged in other bad behavior – say, the board was funneling endowment money to their own businesses (private benefit). The IRS could not only revoke exemption but potentially levy excise taxes on those transactions (intermediate sanctions, or even termination taxes on a private foundation).

Lesson: Compliance and good governance are absolutely essential. Filing required forms, adhering to donor intent, avoiding conflicts of interest – these practices keep an organization’s golden tax status intact. The moment you slip on these, the door opens for taxes to come rushing in and draining your endowment’s value.

These examples underscore that while the laws around taxing endowments might seem complicated, they boil down to a few principles: stay within your nonprofit lane, report diligently, and know the thresholds and exceptions where taxes apply. Do that, and your endowment can remain a robust, tax-advantaged war chest for good.

Next, let’s step back and look at the broader picture: should endowments be taxed more? Less? We’ll consider some pros and cons of taxing endowments from a policy perspective, which often comes up in debates among lawmakers, donors, and the public.

Pros and Cons of Taxing Endowments

The question of taxing endowments isn’t just a technical one – it’s a matter of public policy and debate. Some argue that large endowments are an untapped source of government revenue or that tax-free hoards of wealth contradict the spirit of charity. Others say that taxing endowments would cripple nonprofits and reduce the benefits they provide to society. Let’s break down the arguments on both sides with a clear pros and cons analysis:

As shown above, there’s a balancing act. The current U.S. policy somewhat reflects this balance: for the most part, endowments are not taxed (to encourage charity and maximize charitable resources), but there are select taxes (like the private foundation excise tax and new college tax) to capture a bit of revenue and push some activity (like spending) without heavily burdening the nonprofit sector. Lawmakers continue to debate adjustments – for example, proposals to increase the college endowment tax rate or extend payout requirements to donor-advised funds have been floated.

From a manager’s perspective, the pros and cons debate is a reminder that tax laws can change. Endowment stewards should keep an ear to the ground on legislative developments. But they should also use this debate to guide their actions: demonstrating that their endowments are being used effectively for the public good can help disarm critics who call for taxation. Transparency, generous spending on mission, and clear communication of benefits (e.g., “our endowment funded $50M in student aid this year, easing the burden on families”) are the best defense against arguments that “they have all this money and pay no taxes.”

Now, let’s wrap up with a quick FAQ to answer some of the most common questions on this topic, and then a brief conclusion to reinforce what we’ve learned.

FAQ: Common Questions About Endowments and Taxes

Are endowment earnings taxable for a nonprofit?
No. For a 501(c)(3) nonprofit, endowment investment earnings (interest, dividends, capital gains) are generally not taxable. The nonprofit’s tax-exempt status shields those earnings, as long as they support the organization’s charitable purpose.

Do colleges pay taxes on their endowments?
Mostly no. The vast majority of colleges and universities pay no income tax on endowment earnings. However, a few dozen wealthy private universities now pay a 1.4% federal excise tax on investment income (if assets exceed $500k per student). Public universities do not pay this tax.

Do private foundations pay taxes on endowment income?
Yes. Private foundations must pay a 1.39% federal excise tax on their net investment income each year. This is effectively a small tax on their endowment’s earnings. They also are required to distribute at least 5% of assets annually, but that payout isn’t a tax to the government.

Are donor-advised funds taxed on their growth?
No. Donor-advised funds (held by public charity sponsors) grow tax-free. The contributions are treated like endowment funds of the sponsoring charity. There’s no income tax on the investment growth, and no payout requirement by law (though sponsors encourage grants). Donors already got a tax deduction when they put money in.

Can endowments generate Unrelated Business Income Tax (UBIT)?
Yes. If an endowment invests in unrelated businesses or debt-financed ventures, it can generate taxable income. Income from an active trade or leveraged investment not related to the nonprofit’s mission is subject to UBIT (taxed at ~21%). Passive income (stocks, bonds, etc.) is generally exempt from UBIT.

Are endowment donations tax-deductible for donors?
Yes. When donors give money or assets to a qualified nonprofit’s endowment, it’s typically tax-deductible for the donor (subject to IRS charitable deduction rules and limits). The organization doesn’t pay tax on receiving the gift, either.

Do churches pay tax on endowment funds?
No. Churches and religious organizations are tax-exempt, so their endowment earnings are not taxed. Churches don’t even have to file Form 990 annually. They must still use endowment money for religious or charitable works and avoid unrelated business activities to remain in good standing.

Does an endowment need to file a tax return?
Yes (through its organization). The organization managing the endowment files IRS returns. Public charities (including most with endowments) file Form 990 annually, and private foundations file Form 990-PF. If the endowment has unrelated business income, Form 990-T is filed. The endowment itself isn’t a separate taxpayer, but these filings ensure transparency and compliance.

Is a university endowment a public charity or private foundation?
A university (and its endowment) is usually classified as a public charity (an educational organization with broad support). Therefore, it doesn’t face the private foundation taxes or payout rules. It’s an important distinction: e.g., Harvard’s endowment is part of a public charity (Harvard University), not a private foundation.

Do states tax nonprofit endowment income?
No. States generally do not tax income of tax-exempt nonprofits, including endowment earnings. They do often tax any unrelated business income at the state level. States and cities might seek other ways to tax or get revenue from large nonprofits (like property taxes or special fees), but standard endowment investment income is exempt at the state level just like federal.