Tab 11: Investment and Spending Policy

Required Documents

• Investment Policy
• Spending Policy

 

Other Suggested Documents

• Gift/Fund Acceptance Policy

What should be in the investment policy?

Your investment policy should contain the measures or benchmarks used by your foundation or investment managers to evaluate investment performance. Additionally, asset allocation guidelines are very important to your investment policy. The asset allocation guidelines should contain asset parameters for each class of assets, including stocks, bonds, and cash. Diversification guidelines should reference the parameters regarding the percentage of the investment portfolio that can be invested in a particular company. For example, "the holding of an individual security shall not exceed 5 percent of the total fund assets without explicit committee approval," or, "the holdings in an individual security shall not exceed 3 percent of the total amount of outstanding stock." Additionally, your investment policy should contain indexes for measuring investment performance.

What is a spending policy?

A spending policy is a guideline for calculating payout amounts.

What are excess business holdings and how do they affect a community foundation?

The excess business holdings of a foundation are the amount of stock or other interest in a business enterprise that exceeds the permitted holdings. A private foundation is generally permitted to hold up to 20 percent of the voting stock of a corporation, reduced by the percentage of voting stock actually or constructively owned by disqualified persons.

The Pension Protection Act makes the private foundation excess business holdings rule applicable to donor advised funds as if they were private foundations. (1) That is, the holdings of a donor advised fund, together with the holdings of persons who are disqualified persons with respect to that fund, in a business enterprise may not exceed:

• 20 percent (2) of the voting stock (3) of an incorporated business; or
• 20 percent of the profits interest of a partnership or a joint venture or the beneficial interest of a trust or similar entity.
• Ownership of unincorporated businesses that are not substantially related to the fund's purposes is prohibited.

Donor advised funds receiving gifts of interests in a business enterprise after the date of enactment (August 2006) will have five years to divest holdings that are above the permitted amount, with the possibility of an additional five years if approved by the Secretary of the Treasury. Funds that currently hold such assets will have a much longer period to divest under the same complicated transition relief given to private foundations in 1969. Definition of "business enterprise": A "business enterprise" is the active conduct of a trade or business, including any activity which is regularly carried on for the production of income from the sale of goods or the performance of services. Specifically excluded from the definition are:

• holdings that take the form of bonds or other debt instruments unless they are a disguised form of equity
• income from dividends, interest, royalties, or the sale of capital assets
• income from leases, unless the income would be taxed as unrelated business income
• "functionally-related" businesses and program-related investments
• businesses that derive at least 95 percent of their income from passive sources (dividends, interest, rent, royalties, capital gains, etc.). This will have the effect of excluding gifts of interests in most family-limited partnerships and other types of holding company arrangements.

Definition of a "disqualified person": Donors and persons appointed or designated by donors are disqualified persons if they have or reasonably expect to have advisory privileges with respect to the donor advised fund by virtue of their status as donors. Members of donors' and advisors' families are also disqualified, but the section does not define "family" and does not cross reference either section 4958 or 4946 for the definition. Finally, the term includes 35 percent controlled entities as defined in section 4958(f)(3).

Impact: The new rule will mainly affect contributions of closely held businesses and, in most cases, will require the donor advised fund to dispose of the contributed interest within five years of the date of the gift, because the disqualified persons will generally own more than 20 percent of the business. (5) The rule will not apply to assets held by the sponsoring charity, as long as they are not held by the donor advised fund, apparently permitting a sponsoring charity to keep a contributed asset as part of its overall investment portfolio. It will also not apply to gifts to funds, such as field of interest or designated funds, that are not donor advised.

Because they are not "business enterprises," the rule will not apply to most gifts of real property. The most important exception will be undeveloped land, which may become a business enterprise if the charity that owns it takes extensive steps to subdivide it and prepare it for sale. This is a particularly dangerous situation because this could require immediate divestiture. Interests in investment partnerships and LLCs, including family partnerships, hedge funds, REITs, and so forth, are excluded from the definition of business enterprise as long as 95 percent or more of the entity's income is from passive sources. Examples of other property gifts that are excluded because they are not business enterprises include oil and gas interests (non-working), life insurance, tangible personal property (as long as it is not inventory), and remainder interests in personal residences and farms.

Existing holdings: The rules that will apply to donor advised funds holding business interests on the date of enactment of PPA are quite complex. In phase one, donor advised funds that, together with their disqualified persons, hold more than a combined 50 percent interest in a business will be required to reduce their combined holdings to 50 percent and, in most cases, the foundation's share of the holdings to 25 percent, in accordance with the following schedule:

• 20 years if the donor advised funds and disqualified persons collectively own 95 percent or more of the voting or profits interests of a business enterprise
• 15 years if the combined total is more than 75 percent but less than 95 percent
• 10 years if the combined total is more than 50 percent but less than 75 percent.

Phase two is the 15-year period that begins at the end of phase one. During this period, the combined holdings are limited to 50 percent, but if the disqualified persons' share is 2 percent or more, the foundation may own no more than 25 percent of the total. At the end of phase two, the combined holdings may not exceed 35 percent and the foundation's share may not be more than 25 percent if the disqualified persons' share is 2 percent or more. (6)

Note that this is a general description of the application of the excess business holdings rules to donor advised funds but should not be relied upon as legal advice and cannot be relied upon for the purposes of avoiding any penalties that may be imposed by the Internal Revenue Code.

¹ The language is clear that it is only the donor-advised fund - not the sponsoring charity - that is to be treated as a private foundation. Accordingly, it appears that this section does not apply to assets held by the sponsoring charity's investment pools, or assets held by funds that are not donor-advised.

² Thirty-five percent if it can be shown that persons who are not disqualified persons have effective control of the business.

³ Additionally, the donor-advised fund will be barred from holding non-voting stock of an incorporated business unless the disqualified persons collectively own less than 20 percent of the voting stock.

⁴ Excess holdings acquired by purchase must be disposed of immediately. If purchases by disqualified persons cause the donor-advised fund to have excess holdings, the donor-advised fund will have 90 days to dispose of the excess.

⁵ Under the de minimis rule, the donor-advised fund could continue to hold an interest that did not exceed two percent of the voting stock and two percent of the value.

⁶ Additional rules apply to cover situations such as mergers, redemptions, and acquisitions.

Our policy says that we will not accept gifts that violate the excess business holdings rules. Why is this insufficient?

It is not enough to say that you will not accept gifts that violate the excess business holdings rules. Your policy should define what gifts are acceptable so that there is a guideline for determining which gifts might be subject to excess business holdings rules and, in the case of a gift that was received and that violates the excess business holdings rules, the process and timeline for disposing of the asset.

Asset allocation
The distribution of a pool of assets among various asset classes including, but not limited to, domestic and foreign equities, mutual funds, or bonds, cash, real estate, venture capital, etc.

Donor advised funds
A fund may be classified as donor advised if it has at least three characteristics: (1) a donor or person appointed or designated by the donor has, or reasonably expects to have, advisory privileges with respect to the fund's distributions or investments, (2) the fund is separately identified by reference to contributions of the donor(s), and (3) the fund is owned and controlled by a sponsoring organization, such as a community foundation. A fund possessing these characteristics may be exempt from the donor advised fund classification if it grants to one single public charity or government unit or if the fund meets certain requirements applicable to scholarship funds.

Excess business holdings
The amount of stock or other interest in a business enterprise held in a donor advised fund that exceeds the permitted holdings. The excess business holdings rules were created for private foundations but were extended to apply to donor advised funds by the Pension Protection Act of 2006.

Financial diversification
Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio.

Gift acceptance policy
This type of policy outlines the issues regarding the acceptance or rejection of proposed gifts.

Spending policy
A board approved policy that determines what percentage of a group of assets, such as an endowment, should be spent to cover both operating costs and grants of an institution. Typical spending rules combine calculations based on previous years' spending, the current year's income and investment return rates and the policy of the foundation covering grant commitments.