On December 21, 1998, Governor Ridge signed into law Act 141 of 1998 (the "Act") which fundamentally changes the way in which distributable "income" is determined for charitable purposes by nonprofit corporations and charitable trusts in Pennsylvania.

Newly revised Sections 5548(C) of the Pennsylvania Associations Code (applicable to nonprofit corporations) and newly created Section 8113 of the Pennsylvania Probate, Estates and Fiduciaries Code (applicable to charitable trusts) permit charitable endowments, trusts and similar funds to eliminate distinctions between accounting income and capital gains and instead to redefine "income" for distribution purposes as a fixed percentage, not less than 2% nor more than 7%, of the market value of the charitable fund.

It is clearly observable that in today’s economic climate, investment "income," that is to say interest, dividends, rents and royalties, has not kept pace with the exploding value of many financial assets. Indeed, at the present time, income yields on not only equities, but also fixed income securities are at near historic lows. The unfortunate result of this performance dichotomy is that while the total return (that is, income plus appreciation) realized by investing in equities has recently been extremely high, minimal income is produced. Many charitable funds, especially those which are permitted to distribute only income, have consequently been forced to limit investments in assets which have a high growth potential but produce little income and instead invest in assets, such as bonds, which typically produce more income but only moderate appreciation.

Prior to the enactment of the Act only limited relief to the limitations imposed by "income only" restrictions was available to Pennsylvania nonprofit corporations and no relief at all was available to Pennsylvania charitable trusts. Under prior Pennsylvania law, directors of nonprofit corporations, but not Trustees, could elect to treat some net realized capital gains generated by investments as

"income," but only to the extent that such net realized capital gains did not exceed 9% of the market value of the remaining principal of the charitable fund.

This reliance on net realized gains, however, often forced charities to sometimes prematurely sell assets so that realized gains would be available for distribution. Moreover, like the limitation imposed by investment yield, the reliance on net realized gains firmly linked the fund’s ability to make distributions to its investment program. At its worst this system also discouraged Directors from selling declining investments in that any realized loss would reduce net realized gains and consequently, could reduce amounts available for distribution.

The new Act does away with the infirmities of the prior system by divorcing the accounting concepts of accounting income and appreciation from the definition of distributable income. It abolishes the old rules and instead, if an appropriate election is made by the Directors or the Trustees, allows "income" to be defined as a fixed percentage of the entire market value of the trust or corporation. This may be familiar to some readers as the "unitrust" concept adopted in many charitable remainder and charitable lead trusts. As a quid pro quo for adopting a unitrust format, however, the Act also requires fiduciaries to also adopt a written investment policy embracing a total return investment strategy.

Specifically, the Act provides that:

• The Directors or Trustees may adopt a written investment program seeking to enhance the total return of their investments, which return may be derived from capital appreciation, earnings or distributions with respect to capital, or both, and which must be made a part of the records of the Corporation or Trust.

• If a total return investment policy is adopted, "income" is defined by the Act to mean a fixed percentage of the "value of the assets" held by the nonprofit corporation or trust, not less than 2% nor more than 7% thereof, which the Directors or Trustees shall annually select after determination that such percentage is consistent with the long term preservation of the real value of the assets.

• The "value of the assets" for purposes of the Act, is the average fair market value of the assets over a three year period (or the average value of the assets over any shorter period in the case of assets held less than three years).

• An election to be governed by the Act may be revoked only if the Directors or Trustees determine, in writing, that it is made as part of a long term investment policy also seeking the long term preservation of the real value of the charitable assets.

• An election to be governed by the Act may not be made if the Trust or other governing instrument specifically directs otherwise.

While it is clear that the new rules may be beneficial for many nonprofit corporations and trusts, even those nonprofit corporations who were content with the old system may feel compelled to make the election to be bound by the rules.

The Act has completely repealed former Section 5548(C) of the Associations Code which had authorized the former practice of adding realized capital gains to income and, as a consequence, unless a new election is made to follow a total return investment policy, "income" for charitable purposes will consist only of fiduciary accounting income, that is, interest, dividends, rents and royalties.

Most Charitable Directors and Trustees will consider the changes brought by the to represent an exciting and needed transformation in the way "income only" endowments, scholarships and other restricted charitable funds are administered and invested. By bifurcating the investment and distribution responsibilities of the Directors and Trustees, it is hoped that the effectiveness of both functions may be enhanced. It is imperative, however, that all nonprofit corporations and charitable trusts act promptly to evaluate whether or not their organization can or should elect to be governed by the income and total return investment provisions contained in the Act. It is important to note, however, that the new law applies only to funds restricted as endowment or income only by the donor of the funds. No restrictions apply to the use of unrestricted contributions.

The revisions to Section 5548(C) of the Associations Code completely eliminate the authority of Directors of Pennsylvania nonprofit corporations to allocate any net realized capital gains to income. Thus, unless an election is made to adopt the total return and unitrust provisions described below, only accounting income may be considered income for charitable purposes.