Endowments provide ongoing funding from the interest, dividends and capital gains their assets produce. Stipulations usually restrict how beneficiaries manage and use endowments, such as keeping the principal untouched or invested in certain businesses. Typical beneficiaries of endowments are nonprofit organizations, such as colleges, universities, museums and religious orders. The tax treatment of endowment payouts depends on the recipient and how the money will be used, but they typically are not taxable.
When an endowment earns interest, dividends or capital gains from its assets, the taxability of that income depends on the legal entity that controls the endowment. Typically, endowments are legal entities -- such as trusts or corporations -- that are separate from the organization they benefit. Being established for the benefit of a tax-exempt organization can qualify an endowment for tax-exempt status. If the endowment is tax exempt, its earnings aren’t taxed.
Endowments typically have stipulations that require managers to pay out annual earnings up to a certain amount and reinvest any surplus to increase the endowment principal. While the earnings are often tax free to the endowment, the payout might be taxable depending on the recipient. Operational endowments that fund nonprofit organizations make tax-free payments because the recipient is exempt from income tax. If an endowment trust supplemented a for-profit business’s operating budget, on the other hand, the business would recognize the payout as taxable income.
Operating concerns, such as paying an employee’s salary and benefits, can be guaranteed by endowments. Universities and colleges often have endowed professorships or fellowships, positions that are paid for by an endowment and don’t have to come from the department’s operational budget. Typically, these endowments pay out to the department, and the person holding the position is employed by the institution. Employees who hold an endowed position must pay income tax on their income and benefits the same as any other employee, even though the endowment’s payout was tax free to the nonprofit.
The funds provided for by an endowment’s payout might indirectly pass along to an individual, such as an endowed scholarship that pays a student’s tuition or an operational endowment that covers the cost of services a charity provides to an individual. Whether those benefits are taxable depends on the applicable law. Scholarships and fellowships are tax free to the extent they cover qualified education expenses and meet certain guidelines. Charity benefits are tax free to the recipient.
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