Are Endowments Tax Exempt? What You Need to Know

Endowments play a crucial role in funding nonprofit organizations, universities, and charitable foundations. These funds are invested to generate income that supports an institution’s long-term financial stability. Many endowments receive favorable tax treatment, but this status is not automatic.

Criteria for Tax-Exempt Status

To qualify for tax-exempt status, an endowment must be associated with an organization that meets IRS requirements under Section 501(c) of the Internal Revenue Code. The most common designation, 501(c)(3), applies to organizations operated for religious, charitable, scientific, or educational purposes. To maintain this status, earnings cannot benefit private individuals or shareholders, and the entity cannot engage in substantial lobbying or political activities.

The IRS also assesses whether the endowment is structured and managed in alignment with its tax-exempt purpose. This includes restrictions on how funds are invested and distributed. For example, an endowment supporting a nonprofit hospital must direct its income toward healthcare services rather than speculative investments. Organizations must also file Form 990 annually, detailing financial activities, governance, and compliance with tax-exempt regulations.

Types of Endowments

Endowments vary in structure and purpose, influencing how they operate within tax-exempt regulations.

Charitable

Charitable endowments support nonprofit organizations that provide public benefits, such as social services, healthcare, and the arts. These funds, typically held by 501(c)(3) organizations, must be used in ways that align with their mission. Contributions to these endowments are often tax-deductible under Section 170 of the Internal Revenue Code.

Strict oversight is necessary to ensure proper fund management. Many organizations follow the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which establishes guidelines for investment decisions and spending policies. UPMIFA permits nonprofits to spend a portion of an endowment’s earnings while preserving its principal for long-term sustainability. Mismanagement can result in penalties or loss of tax-exempt status.

Educational

Educational endowments support universities, colleges, and private schools, funding scholarships, faculty salaries, research, and campus improvements. Many institutions rely on endowment income to offset tuition costs and maintain financial stability.

Under the Tax Cuts and Jobs Act of 2017, private colleges and universities with assets exceeding $500,000 per full-time student are subject to a 1.4% excise tax on net investment income. This primarily affects institutions with large endowments. Despite this tax, most educational endowments remain tax-exempt as long as they serve academic purposes. Schools must also comply with donor restrictions to ensure designated funds are used appropriately.

Foundation

Foundation endowments support philanthropic activities. Private foundations, such as family or corporate foundations, are typically funded by a single source and must distribute at least 5% of their assets annually to maintain tax-exempt status under Section 4942 of the Internal Revenue Code. Public foundations, which receive broad public support, often serve as grant-making entities for charitable causes.

Private foundations face additional tax regulations, including a 1.39% excise tax on net investment income, restrictions on self-dealing, and limitations on certain investments. Noncompliance can result in excise taxes or loss of tax-exempt status. Public foundations generally have fewer restrictions but must demonstrate ongoing public support to retain their classification.

Unrelated Business Income

Endowments benefit from tax-exempt status, but not all income is tax-free. Revenue from activities unrelated to an organization’s primary mission may be subject to Unrelated Business Income Tax (UBIT) under Section 511 of the Internal Revenue Code. The IRS defines unrelated business income (UBI) as revenue from a trade or business that is regularly conducted and not substantially related to the organization’s exempt purpose.

Investment income, such as dividends, interest, and capital gains, is typically not considered UBI unless derived from debt-financed property. If an endowment acquires an investment using borrowed funds, a portion of the income may be classified as Unrelated Debt-Financed Income (UDFI) and subject to UBIT. For example, if a university endowment purchases rental property with a mortgage, part of the rental income could be taxable.

Some endowments engage in business ventures beyond traditional investments. Licensing intellectual property, operating commercial enterprises, or selling goods and services unrelated to their exempt purpose can trigger UBIT liabilities. For example, if a charitable foundation owns a parking garage open to the public at market rates, the income may be taxable. Similarly, if a nonprofit hospital leases lab space to private medical companies without integrating it into its tax-exempt healthcare services, it could face UBIT obligations. Organizations must assess whether these activities align with their mission or should be structured differently to minimize tax exposure.

Revocation of Exemption

Tax-exempt status is not permanent. Organizations managing endowments must comply with IRS regulations to maintain their designation. One common reason for losing this status is failure to meet annual reporting requirements. Organizations must file Form 990, 990-EZ, or 990-PF, depending on their structure and financial activity. If an entity fails to file for three consecutive years, the IRS automatically revokes its exemption under the Pension Protection Act of 2006. Reinstatement requires a formal application, payment of user fees, and corrective measures.

Improper financial management can also jeopardize exemption. Endowment funds cannot be used for private benefit or excessive compensation. Transactions that provide undue enrichment to insiders, such as board members or major donors, can trigger intermediate sanctions under Section 4958. The IRS may impose excise taxes on individuals involved and, in severe cases, revoke the entity’s exemption. Similarly, if an organization engages in excessive speculative investments that deviate from its mission, it risks scrutiny.