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Regulation and Compliance > Federal Regulation > IRS

IRS Ruling Favors Harvard for Charitable Trusts

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WASHINGTON (–A request by Harvard University resulted in an Internal Revenue Service ruling that enables a tax-exempt educational organization to allow certain charitable trusts in which the tax-exempt organization is the trustee to invest with an endowment without generating unrelated business taxable income. The threat of generating such income has long rendered the investment of trust assets in an endowment impractical.

Harvard, in Cambridge, Mass., has the largest university endowment in the United States at US$19 billion and invests roughly one-quarter of that endowment in private equity and hedge funds.

Harvard’s endowment is in the care of many managers. David Scudder, vice president of trusts at Harvard Management Co., Boston, a wholly owned university subsidiary that oversees the endowment, declined to say how many managers are involved. That gets “a little confusing,” he said. But he confirmed reports that the endowment is invested according to a “policy portfolio” used as a model by its managers, which allocates 25% to what he prefers to call “absolute return” funds, as well as private equity.

Although the managers have some discretion in veering from that model, he said one might infer they don’t veer very far, “as we do not believe in market timing.”

Harvard already uses a “unit” concept internally with respect to the endowments of various departments and schools. Each department owns a certain number of units in the endowment and is entitled to a payout in an amount based on the performance of the endowment and the number of units it holds. Harvard sets the value of the endowment units on a monthly basis, and they may be redeemed for value.

In its letter to the IRS in January 2003, Harvard said that it wanted to enable its charitable trusts to invest in the units in a manner similar to its departments or schools. Under the contemplated contracts, the trusts would have no ownership interest in the underlying assets of the endowment or any contract rights with respect to the other trusts. Furthermore, Harvard represented that it would not generate income from the investment management of the trusts. If there is a spread between the greater amount of earnings generated by the endowment and a lesser amount of annual payout under the contracts with the trusts, the difference will be credited to the principal amount of the endowment and reflected in an increase in unit value. Payouts will be made quarterly.

On the basis of those representations, in a ruling made public in December 2003, the IRS said that the “issuance of units from [Harvard] to the Trusts, the making or receipt of payments with respect to the units, and the holding or redemption of the units, will not generate unrelated business taxable income.”

Other educational institutions that want to enter into analogous contracts will have to ask for similar rulings, because the IRS also said that this ruling “is directed only to the organization that requested it” and it may not be used or cited as precedent.

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