Organizing endowments is tricky

Endowments aren’t usually the first thing that come to advisors’ minds when they think about strategies for their clients. But the fact of matter is, the clients you want – the affluent most likely have some philanthropic goals, and helping achieve them will only enhance your practice.

Structuring and managing an endowment was the central point of education at the recent Institute of Advanced Financial Planning (IAFP) Summit in London, Ontario. The Institute, which accredits the R.F.P. designation, built a hypothetical case study around building and managing an endowment for a lucrative estate.

If there was one lesson to be gleaned, it is that endowments are difficult, and require a level of planning expertise that’s far above the competency level of most junior advisors. But the payoff for those who become conversant in the ins and outs of charitable giving, is that they’ll have greater appeal with a very lucrative clientele.

“We know charitable giving is going to be big business in Canada. We always talk about an impending trillion-dollar intergenerational transfer of wealth [and] nobody really knows what the number is going to be, but it’s going to be huge. I’ve seen some commentators suggest one-third of that money could go to charity, which I think is too high. But even if 10% goes to charity it’s going to be a huge boon for the charitable sector,” says Brad Offman, vice president of strategic philanthropy, tax and estate planning for Mackenzie Financial.

Offman says the average size of donations to his firm’s charitable giving funds is around $100,000. The clients involved in giving have substantial assets, so there are ways for advisors to derive fees from managing either an endowment or a third-party donor-advised fund.

John Hope, a London-based R.F.P. with Manulife Securities and co-author of the case study, says creating an endowment really requires application of the best financial planning skills, including comprehensive tax and investment planning. On the client side, advisors who involve themselves with philanthropy planning get a much fuller understanding of the clients’ aspirations, usually resulting in a much more personal and dynamic financial plan.

“The endowment is ultimately a client, and as a couple of speakers alluded, your endowment can be viewed as the best long-term investor you could ever think of. You can have this $10 million that is never supposed to go away,” Hope says. “Building and maintaining that wealth [is a good challenge for the skills of] anyone who thinks of himself or herself as having expertise in managing people’s money.”

A place called Happy Valley

The case study concerns a fictional isolated community called Happy Valley. Most of the Valley’s economy is tied to one company, BAMMCO, which runs the community’s central factory and uses surrounding resources to create a valuable consumable item, Alkadify.

BAMMCO is entirely controlled by the Broomaide family, whose patriarch Jed has recently passed away.

Jed left ownership of BAMMCO equally to his three children. They’ve divided their responsibilities by mutual agreement and there are no disputes among them as to how things should be run. George, the youngest, is in charge of the factory; the export of the raw resources to the foreign manufacturers; and is the current Reeve of Happy Valley. Rachael is in charge of the large BAMMCO land holdings that are dedicated to resource extraction and exploration to continue making Alkadify, as well as to providing housing for most of BAMMCO’s workers.

Jed Jr., the oldest, is focusing his efforts on increasing local manufacturing capacity in the Valley as well as improving the quality of life for Happy Valley residents. Jed Jr. is primarily responsible for the growth and future success of the Valley and BAMMCO.

Jed Sr. left $5 million worth of non-voting, BAMMCO preferred shares with a prescribed yield of 3% to his wife, Abigail. He also left her in control of a further $10 million endowment to be used for the betterment of all the residents of Happy Valley.

Abbey has retained the services of an R.F.P. for administration of this legacy, but she has two concerns. First, she wants to use the money to enhance and improve the lives of every resident in Happy Valley. And, second, she wants these benefits to be lasting.

Abby’s specific goals for the money are as follows. She wants to invest the $10 million endowment to generate a targeted rate of return. She wants to develop a spending policy for the income from the endowment to address certain societal and environmental concerns of the community, and she wants Jed Jr., Rachael and George to continue to support the endowment’s goals using either retained earnings, present cash flow, or both, while serving their best interests and the best interests of BAMMCO.

Basics of an endowment

Before delving into management of the endowment’s money, it’s necessary to have a basic understanding of how one works.

According to Terrence Carter, an estate lawyer, keynote summit speaker, and managing partner of Carters Professional Corporation, a poorly structured endowment will likely undermine the legacy of the donor.

The first order of business is to determine that an endowment fund, rather than one-time charitable donation, best meets the goals of the client.

Why would you suggest an endowment over just a straight gift to charity? First of all, the long-term nature of an endowment will allow the charity to do certain things you can’t do with money that just comes in the door, says Carter. He adds, “It gives it stability. It’s going to have money during the good times and the bad times as we saw last year. It also allows the donor to get some recognition for their name. You give a million dollars and it’s being held for a period of time; it’s easy to get naming rights [and] that’s an attractive feature for your donors.”

If endowed gifts are given to a parallel foundation, then the endowment can be protected from creditors of the operating charity. An endowment can be a near-iron-clad pool of money, for which Carter says it’s exceptionally difficult to change the mandate without getting court-approved changes.

Arguably, he says, the most complex area of planning around an endowment is with regards to the disbursement quota (DQ) that charities must follow to maintain their registered status and issue income tax receipts to clients.

Under the Income Tax Act, a Canadian charitable organization or foundation must spend 80% of the previous year’s receipted donations and transfers, plus at least 3.5% of investment assets in excess of $25,000 each year on its own charitable activities or grants to qualified recipients.

If an endowment is either bequeathed at death – referred to as a testamentary gift – or is structured as an inter vivos 10-year gift under the Income Tax Act, the endowment is defined as “enduring property” and is not subject to the 80% DQ. In other words, it can be managed as independent pool of assets where hopefully the capital will sustain a nice annual yield.

“If a client gives a gift of enduring property, you don’t have to spend 80% of that in the following year. That’s important. If somebody is going to give a gift of a million dollars and they want it to be used for research or whatever, you don’t want them to find out that . . . the charity has to spend [almost all of it] in the following year; unless of course that’s what they want,” Carter says.

Other sources of enduring property include RRSPS and RRIFs, inter-charity five-year gifts to charitable organizations, or transfers of 10-year gifts and bequests or inheritances from another charity.

Advisors need to keep in mind if money is added to a 10-year gift, that new money is reset at 10 years, Carter says. “Every time you give to the charity fund, you’re creating a new 10-year gift. It’s not like one 10-year gift where everybody gives in 10 bucks,” he says. As a result, each additional donation to an endowment should be separately tracked as a 10-year gift, he adds.

Clearly define the intent of the endowment

A donor must clearly identify the charity the money is going to. In addition, he or she must indicate the amount of each donation, when the date of the gift is made, set out the name and address of the donor and set out a serial number of the official receipt issued to the donor for the gift.

After the charity’s board has taken over the endowment in trust, it cannot offer any more input. For at least ten years, the board is bound by the original documents set up on the charity.

If a donor wants to have some input or allow the board more flexibility in how the charity uses the money, Carter says clients should include those instructions when setting up the endowment.

He adds the donor can retain input through a donor-advised provision in the endowment agreement. For example, a deceased donor might have wished the money be used for a specific type of research at a hospital that no longer conducts such research. If there’s no flexibility in the instructions the board will have difficulty varying the terms of the endowment. So, allowing for some leeway in how the money is used can avoid potential conflicts down the road.

Carter says large pools of assets such as endowments have a tendency to attract family members who will fight to get the money back if the board appears to have varied the terms of a charitable trust.

”If the family finds out about a charity [violating] the endowment [agreement] it could be in trouble. The children of donors are always trying to figure out how they can get mom and dad’s money back. They can complain to the public guardian trustee, and all of a sudden the charity finds itself at the end of an application [to reclaim the money],” Carter says.

The other area a donor should clarify is whether a charity can encroach on the capital of the investment. Generally, they are not allowed to do so until the 10 years are out. This means in lean years of returns, like in 2008, the charity may not be able to access funds in the endowment during a period of great need. In addition, they are prohibited from borrowing against the endowment.

Carter says an endowment can carry forward surpluses in the event of a DQ shortfall. A DQ surplus, meanwhile, can be carried forward five years, or back one year. If it’s anticipated there will be a DQ surplus in the following year, the anticipated surplus can be used to offset the current DQ shortfall.

What is the true dollar amount?

“If it’s a more sophisticated charity and they are used to managing money, normally a $50,000 to $100,000 gift is sort of minimal to have a perpetual endowment,” Carter says. “Gifts of publicly traded shares are exempt, gifts of private shares are not. The types of gifts that come in will be a factor because the donor’s tax benefits or liabilities will be an important consideration.”

Advisors may not be aware, though, of anti-tax shelter provisions the CRA has added to the Income Tax Act. The CRA has lost billions to sketchy tax havens, where a tax receipt ends up being much more than the donation usually because of a perceived increase in the market value of the gift.

“The CRA is cracking down on these schemes and has put in some pretty tough rules in the Income Tax Act that affect the good charities,” Carter says. “They have a really dumb provision that says if it’s a gift in kind, other than publicly traded shares, real estate or some sort of cultural property, and if the donor has held the gift for three years or less, then the amount of the receipt is not the fair market value but the adjusted cost base.” This rule doesn’t apply if the donor has died. It’s a tricky situation for living donors, who may get a smaller receipt then they expected because the CRA assesses they have derived benefit from the gift.

“Is the donor going to get a benefit directly or indirectly that has to be subtracted from the fair market value?” Carter asks. “The best example of this is a rubber chicken dinner. You pay $100 bucks for the dinner and the chicken costs $20, but you get a receipt for the difference. You need to apply that [same deduction] on any direct or indirect benefit that you get from the charity. That could include things like your wife working for the charity. If it can be tied in that the benefit you’re giving could fund your wife’s salary, then that benefit will need to be deducted.”

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Mark Noble is a Toronto-based investments writer.

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Mark Noble