Attorneys

• Mark Stadler

Related Practices

• Non-Profit Organizations

Limited Application
Pennsylvania nonprofit corporations are permitted to hold property in trust for their charitable purposes. Where such a trust is created, the corporation's directors serve as the trustees of the trust property. With respect to nonprofit corporations, Act 141 applies to trusts where only the income may be distributed. For example, such a trust would exist where Mr. Smith gives $1 million in trust to a nonprofit corporation under a trust document which states that only the income from the $1 million trust principal may be expended for the corporation's charitable purposes. Typically, under such a scenario, the principal would remain intact in perpetuity or be distributed to a third party remainderman at some stated time in the future.

Prior Law
In the example provided above, conflicts could arise concerning both the manner in which the trust's funds are invested and the manner in which distributed income is calculated. Should income be maximized or should growth of principal be maximized? Even though the best total return might be produced by investing in non income producing assets, the corporation's board might conceivably ignore such investments due to its desire to produce distributable income for the corporation's charitable purposes.

Under prior law, the nonprofit corporation's directors could partially address these issues by allocating net realized capital gains to income for distribution purposes so long as the total income to be distributed did not exceed 9 percent of the principal remaining. For example, if the Smith Trust described above realized capital gains of $50,000 plus dividends and interest of $60,000 in a given year, $30,000 of capital gains could be allocated to income so that $90,000 ($ 1,000,000 x .09) could be distributed as income with the balance of the capital gains ($20,000) then being added to principal.

While helpful, this provision provided relief only when capital gains were actually realized. Also, it created incentives for the board to sell assets and realize gains even where the better strategy might have been to hold the assets longer.

Changes Implemented by Act 141
Act 141 amended the prior law as follows:

• Unless the trust document specifically precludes such an election, a nonprofit corporation can elect to adopt and follow a "total return" investment policy, i.e., a policy to seek the best total return on the principal whether from capital appreciation, earnings or both.
• If this election is made, income from the trust will be defined as a percentage of the trust principal, with the nonprofit's board being permitted to annually set that percentage at between 2 and 7 percent. For purposes of this provision, the value of the trust principal is the fair market value of the trust assets averaged over a period of three or more preceding years.

In the Smith Trust example, let us make four assumptions. First, the average value of the trust assets is $1 million; second, the board has made the relevant election; third, the board has selected 6 percent as the income percentage for the year; and fourth, the trust has $100,000 in capital gains for the year, but no interest or dividends. Under this example, the trust's income for the year would be deemed to be $60,000 ($1,000,000 x 0.06). Absent such an election, only the actual income of the trust would be available for distribution. Under the Uniform Principal and Income Act, the $100,000 in capital gains would be added to principal, leaving the trust with no distributable income for the year in question. While the remaindermen under the trust might welcome this outcome, the failure to distribute income would be arguably inconsistent with the desires of the trust's grantor to establish a regular flow of income for charitable purposes.

Act 141 hopes to avoid dilemmas such as this by permitting the nonprofit's board to maximize return on the principal (whether through capital appreciation or earnings) while at the same time assuring an annual "income" distribution of 2 to 7 percent of the average fair market value of the principal.

Pennsylvania's efforts to modernize charitable trust rules (as demonstrated by Act 141) have continued with the recent passage of the Prudent Investor Rule under which a nonprofit board's investment and fund management decisions are to be reviewed with respect to the trust portfolio as a whole and the overall investment strategy of the organization. Prior law required each investment to be judged individually under a "prudent man" standard.

Other Applications
The 2 to 7 percent range of Act 141 is intended to apply only to property held in trust by a nonprofit and with respect to which only the income can be expended currently. However, this range may also serve as a reference point for the courts and state regulators in determining the amount of a nonprofit endowment which may be expended in one year. It is worthwhile to note that the "Comment" to Act 141 states that "the upper limit of this range (i.e. 7%) is actually more than would be considered prudent in long term management of a trust." However, this upper range was adopted to provide sufficient flexibility for the trustees to adjust to the charity's specific needs from time to time.
In light of these standards, the 2 to 7 percent range adopted in Act 141 should serve as a useful benchmark for the annual spending of a charity's endowment where the endowment funds are not formally held in trust. A charity expending endowment funds inconsistent with this range may be subject to challenge by its members, its contributors and/or the Attorney General.

For more information, please contact mstadler@cohenlaw.com.