Illinois Adopts UPMIFA: Historic Dollar Value Rule for Endowments Eliminated
Tax Exempt Organizations Alert 07/15/09
On June 30, 2009, Illinois Governor Quinn signed the Uniform Prudent Management of Institutional Funds Act ("UPMIFA") into law. UPMIFA replaces the Uniform Management of Institutional Funds Act ("UMIFA") and differs from UMIFA in a few key areas: It eliminates the historic dollar value rule with respect to endowment fund spending, it updates the prudence standard for the management and investment of charitable funds, and it amends the provisions governing the release and modification of restrictions on charitable funds.
UPMIFA's provisions are applicable immediately to institutional funds established before or after June 30, 2009. For institutional funds in existence prior to June 30, 2009, UPMIFA affects only decisions made or actions taken on or after June 30, 2009. All references to UPMIFA and UMIFA in this update are to the versions adopted in Illinois, which may vary from those adopted in other states.
UPMIFA applies to specified "institutions" and governs the management and investment of "institutional funds" held by them. Any corporation, trust, or other entity that is organized and operated exclusively for charitable purposes, such as a private foundation or other Code Section 501(c)(3) organization, is an "institution" within the meaning of UPMIFA and therefore is subject to its general provisions. An "institutional fund" is a fund held by an institution for charitable purposes. A fund held for an institution's benefit by a trustee that itself is not an institution (such as a fund held by an individual or corporate trustee) is not treated as an "institutional fund."
The new spending rules in UPMIFA specifically apply to "endowment funds" held by institutions. For purposes of UPMIFA, an "endowment fund" is an institutional fund that is not wholly expendable on a current basis because of a donor restriction in the gift instrument governing the endowment fund. The endowment restriction may be either permanent or for a limited duration. The new spending rules do not apply to all institutional funds. Only donor-restricted endowment funds are subject to UPMIFA's endowment fund spending rules. Such provisions do not apply to funds that are restricted only by a board of directors or to funds only informally referred to as "endowments."
Historic Dollar Value Rule Eliminated
UPMIFA eliminates UMIFA's historic dollar value rule and thereby permits more flexibility regarding the expenditure and accumulation of endowment funds. Many endowment agreements provide that only the "income" from the gift could be spent, while the "principal" should be retained. Prior to UMIFA, which was enacted in Illinois in 1973, terms such as "income" and "principal" generally were interpreted in accordance with trust law, which provided that capital appreciation was principal and therefore would not be available for expenditure. Accordingly, if an endowment agreement provided that the fund should pay all "income" but retain the "principal," the endowment could spend only dividends, interest, rent, royalties, and the like and not touch any appreciation. An organization managing an endowment with this language was forced to make a difficult decision: Invest the endowment fund for total return, including long-term growth, and live with a smaller spending rate, or invest the endowment fund for current income, but sacrifice growth, so that the fund could not keep up with inflation over time.
The adoption of UMIFA solved this problem by allowing charities to appropriate appreciation for spending in certain circumstances. First, the specific terms of a donor's spending direction in a gift instrument would always govern. Therefore, any provision that, for example, directed an endowment to distribute five percent of the fair market value of its assets annually would govern the distributions from that fund. However, UMIFA provided that mere use of the terms "income" or "principal" was not sufficient to indicate a donor's intent not to spend appreciation. If an endowment fund used the term "income," then the endowment fund could spend what was historically known as "income" for trust accounting purposes - dividends, interest, rents, royalties, and the like. Additionally, UMIFA allowed an institution to interpret the term "income" to include appreciation, allowing those amounts to be spent as well. This power to spend appreciation was not, however, unlimited. An endowment fund could spend appreciation only to the extent that the value of the fund exceeded its "historic dollar value," which generally was equal to the original value of any gifts to the fund.
While this new rule was an improvement over trust law, UMIFA's spending guidelines continued to create problems. UMIFA still required an organization to track separately the difference between income and principal. It also raised issues on how and when an institution should measure appreciation and historic dollar value in order to determine how much (if any) spending might be appropriate from a given fund.
UPMIFA addresses these issues by permitting an institution to use a more flexible spending standard. As with UMIFA, the intentions of the donor as specifically expressed in a gift instrument will always govern the spending from an endowment fund. UPMIFA also continues to provide that the mere use of the terms "income" or "principal" will not be interpreted to mean that the donor intended to limit the spending from the fund in any particular manner. Unless specifically directed to the contrary, under UPMIFA an institution may expend so much of an endowment fund as an ordinarily prudent person in a like position would spend for the uses, benefits, purposes, and duration for which the endowment fund was established. Under this new rule of prudence, a distinction no longer exists between income and principal, nor is there a need to track historic dollar value. This allows an institution to spend any amount from an endowment fund (whether it was historically categorized as income or principal or whether the fund is above historic dollar value), provided that the spending decision is prudent under the circumstances.
As part of this flexible spending standard, UPMIFA identifies the factors an institution should consider in making decisions about whether an expenditure from an endowment fund is prudent:
the duration and preservation of the endowment fund;
the purposes of the institution and the endowment fund;
general economic conditions;
the effects of inflation or deflation;
the expected total return from investments;
other resources of the institution; and
the investment policy of the institution.
The governing board of an institution should weigh all of these factors when setting an expenditure policy for its endowment funds. These new spending rules give an institution great flexibility by permitting it to spend as much as it deems prudent, even at a time when a weak economy may result in decreased returns or losses to an institution's endowment. Endowment funds that are in existence as of UPMIFA's effective date must apply the new management and expenditure standards to all actions taken on or after June 30, 2009.
In some versions of UPMIFA, the legislation contains a provision that expenditure rates in excess of seven percent of the endowment fund are presumed not to be prudent. Illinois did not adopt this optional provision of UPMIFA. Institutions that have endowment funds that may be governed by the laws of states other than Illinois should confirm whether this optional provision or any other variation from the uniform act was adopted in that state.
As mentioned, a donor may overcome UPMIFA's flexible spending rules by including specific restrictions in the terms of the written gift agreement. A donor cannot simply rely on use of terms such as "income" or "principal" as evidence of an intent to limit spending; the donor must be very precise in documenting any limitations, which may include a specific reference to limiting the applicability of UPMIFA.
Prudence Standard Updated
UPMIFA also enacts more specific standards governing the investment of institutional funds than those effective under UMIFA. UMIFA required only that institutions exercise ordinary business care. Under UPMIFA, each person responsible for managing and investing an institutional fund now must consider the charitable purposes of the institution and the purposes of the fund and act in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances. Prudence also is required when incurring investment costs, and all costs must be appropriate and reasonable in relation to the assets and investment decisions.
UPMIFA establishes a list of factors those responsible should consider, if relevant, when making investment decisions. These factors include:
the general economic conditions;
the possible effects of inflation or deflation;
the tax consequences of an investment strategy;
the role of each investment within the portfolio as a whole;
the expected total return from income and appreciation of the investments;
the institution's other resources and needs; and
an asset's special relationship or value to the institution's charitable purpose.
As part of the prudence standard, an institution also is required to diversify the investments of an institutional fund unless the institution reasonably determines that there are special circumstances indicating that it is better not to diversify. These revised standards better accommodate current investment approaches (such as modern portfolio theory) and align more closely with the investment standards for trusts enumerated in the Uniform Prudent Investor Act.
UPMIFA also sets forth specific standards for delegating the management and investment of an institutional fund. Under UPMIFA, an institution must act in good faith and with the care that an ordinarily prudent person in a like position would exercise when selecting an agent, when establishing the terms and scope of the delegation, and when periodically reviewing the agent's actions. It also sets forth the consequences of such a delegation to the institution and the agent. These changes clarify the standards for delegation to an agent, as UMIFA merely permitted the general delegation of investment duties subject to an ordinary business care and prudence standard, taking into account certain enumerated economic factors.
Modification of Restrictions Updated
UPMIFA also updates the method for modifying donor restrictions on the expenditure and use of an institutional fund. As under UMIFA, an institution may request that a donor modify or release a restriction. If that option is unavailable, however, UPMIFA enables a court to release or modify a donor restriction in broader circumstances than those permitted by UMIFA. A court now, for example, can release or modify a donor restriction when it is impracticable, wasteful, or impairs management or investment, or is due to unanticipated changed circumstances where a modification will further the purposes of the fund. Changes must be consistent with the donor's probable intention. A court also, upon application, can modify the charitable purposes contained in a gift instrument if the original purposes become unlawful, impracticable, impossible to achieve, or wasteful. The modification must be consistent with the charitable purposes expressed in the gift instrument.
Finally, UPMIFA allows for release or modification of restrictions by the Illinois Attorney General, without court involvement, where either (1) a restriction is unlawful, impracticable, impossible to achieve, or wasteful or (2) the institutional fund subject to the restriction has a total value of less than $50,000 and has existed for more than 20 years and the funds are used in a manner consistent with the charitable purposes expressed in the gift instrument.
Quarles & Brady Comments
Illinois charitable organizations should determine whether they have institutional funds subject to UPMIFA. If an organization has such funds, the organization may wish to take the following steps:
- It should review its investment policies and the terms of any delegation of investment authority to determine whether they comply with UPMIFA's prudent investment standards.
- It should determine which of its institutional funds constitute endowment funds under UPMIFA. The terms of any such endowment fund should be reviewed to determine whether there are any specific donor restrictions regarding expenditures.
- Endowment funds that do not contain specific expenditure limitations are subject to the new spending rules contained in UPMIFA. In setting a new endowment expenditure policy that complies with the new prudence standard, an institution should consider all of the factors set forth in UPMIFA.
- Organizations that have standard endowment agreements for use with potential donors should review the agreements to make sure that they appropriately reference or incorporate the organization's new expenditure policy and allow for future changes.
- UPMIFA makes clear that the governing documents of an endowment fund include an organization's charitable solicitation materials. Therefore, institutions should review their fundraising materials to make sure that they accurately represent the organization's spending policy and allow for future changes.
Donors to charitable institutions should determine whether it is appropriate or desirable to impose specific restrictions on any future gifts in order to eliminate or limit the application of UPMIFA's flexible endowment spending rules.
We note that most private foundations do not hold "endowment" funds for purposes of UPMIFA's spending rules. In most cases, the private foundation's spending obligations are not limited by the private foundation's governing documents or any separate gift instrument. There are, however, some circumstances where the provisions of UPMIFA might apply to a private foundation's spending policy. This is more likely to be the case if the foundation is older and is in trust, rather than corporate, form. If a private foundation (or any other organization) is concerned about how UPMIFA impacts its current spending policy, or the applicability of UPMIFA generally, it should contact its attorney.
This update is intended as a general summary of legal matters and not as specific advice to any particular client. If you have any questions concerning the subject matter of this update, please contact Elaine Waterhouse Wilson at 312-715-5141 / firstname.lastname@example.org, Krupa Shah at 312-715-5027 / email@example.com, or your Quarles & Brady attorney.