By Kip Meadows
Most churches are set up well to handle the day-to-day business aspects of their operations. Otherwise, the doors could not open and welcome the congregants.
It is the rare individual congregation, however, who’s well-equipped to handle long-term funds, either endowment gifts or retirement accounts, for personnel or other longer-term capital accounts.
Even if an individual congregation has enough assets to consider managing an investment strategy at the parish level, some gifts might have a specific use attached, such as an endowment for the preservation of the church organ. Some gifts might have specific instructions for disbursement of capital gains or income, such as reinvest capital gains and distribute income to the altar flowers fund. Some gifts might even be in the form of a charitable remainder trust with income distribution and reporting requirements during the donor’s lifetime.
There are many examples where the gift or fund is required to be kept segregated from other funds. The examples of specific gifts above need to be tracked for accounting and year-end reporting purposes. Long-time church financial officers or church treasurers can tell stories of families that want to know how the gift their loved one left to the church has been handled and disbursed. The donor with the good heart and convictions to make a bequest deserves to have his or her wishes carried out.
Legal and regulatory issues require segregation of retirement plan assets from other investment funds. While neither a church nor a retirement plan is subject to tax, both are required to file tax form reports and specific reporting on cost basis, realized and unrealized return, and income are needed.
There are multiple reasons to keep individual gifts or investment pools for different purposes, but managing each individual gift, or each pool or subaccount separately from an investment management perspective is highly inefficient. Smaller accounts are more difficult to diversify, transaction costs are higher as a percentage of assets, and even with diversification using exchange traded funds (ETFs) or other economical strategies, it is difficult to avoid odd lots and fractional shares.
Consolidating accounts for investment purposes also presents challenges, for the reasons outlined above. If accounts are going to be consolidated for investment purposes, there needs to be an accounting system in place to track each subaccount separately.
Unitized accounting: what it means and why it’s the best solution for churches
By using unitized accounting, the accounting methodology used by mutual funds in the U.S., multiple accounts and subaccounts can be combined. Reporting each account and subaccount as a shareholder in the larger pooled investment fund, a church financial team is able to accurately track the original investment, accrued income and dividends, and realized and unrealized gains.
Investment pools that look and act like a mutual fund typically require either an offering memorandum or registration of the investment pool with the SEC. The issue is particularly acute when combining qualified retirement plan assets, and non-retirement plan assets, because private Reg-D funds available to institutional shareholders like a large church organization cannot take advantage of that exemption for retirement plan assets.
There is an exemption, however, for church and fraternal organizations with a legitimate common bond. Private letter rulings issued in the 1950s make clear that a church or fraternal organization has an exemption from registration for an investment pool limited to the use of that church or fraternal organization.
The church’s goal is to be as efficient as possible in structuring the investment management program for both pools. With both pools, the church administrative team wants to focus on asset allocation appropriate for each pool, and subaccounts within the pool.
The subaccount issue can be of particular importance. Not all gifts to a church are on the same terms, in fact there is typically very little that is standard about gifts to charitable and religious organizations. Gifts may be made to the local church, or to the diocese or regional subdivision of the national church, or to the national church. Some gifts are split, for example a donor might make a donation to a church and designate 70% of the fund for the general fund of that parish, and the other 30% to provide ongoing endowment funds for the parish music program.
From a reporting standpoint, a local church treasurer may want to look at the endowments for which his parish is the beneficiary. A regional subdivision of the church, whether it be a diocese or the northwestern section of a state, depending on how the church is organized, may want to look at all the funds in that subdivision or region. The national church finance team might want to view the southeastern U.S., or all endowments in the mid-Atlantic region, or retirement assets by state.
In a nutshell, the ability to sort the underlying data in any number of ways is important. By coding each shareholder/participant with the appropriate “tags,” or sorting by zip code, or by name, that data can be used in an infinite number of subaccount levels, although there is clearly a point of diminishing return. Drilling down three or four levels is typically all that is necessary.
Charitable remainder trusts (“CRT”) also generate some particular issues. A donor may set up a CRT to provide lifetime income for the donor and spouse, with the principal going to the church or sub-entity of the church at the death of the second spouse. During the donor’s lifetime, reporting is required to the IRS to show the income and capital gains generated by the gift.
Combining thousands of subaccounts with differing reporting requirements, and assets that are both qualified retirement assets and non-qualified endowment assets (qualified or non-qualified referring to whether the assets are retirement plan assets and subject to those special accounting treatments) creates a monstrous accounting and reporting issue if each account is handled separately.
Combining the assets together into a single pool, and creating subaccounts and subaccounts of subaccounts for tracking the principal, income and gains, and ending balance of each, is the typical goal.
As Will Rogers said, “I’m not so much interested in the return on my money as the return of my money.” A treasurer at the parish level wants to be assured that participating in a pool doesn’t mean forgoing any accuracy in the original principal amount, and the income and capital gains attributable to that investment balance. Mutual fund-style, unitized accounting is singularly without parallel in its ability to provide that accuracy. The value of the portfolio, interest and dividend income, and realized and unrealized capital gains and losses are accrued on a per share basis. By carrying these items on a share level, shareholder/participants can purchase or redeem shares on a daily basis, and their portion of the total fund will always be tracked accurately.
Investment pools using partnership or trust accounting are typically only valued at the end of each period, with the fund allocated as a percentage of ownership. Accrued income and accrued realized capital gains are much more difficult to allocate accurately, which can have an impact, especially on the tax reporting for a charitable remainder trust.
The benefit of this method of handling investment pools is not limited to churches. Any foundation or endowment, social brother or sisterhood like Masonic Foundations, cooperative utility agencies, administrative groups of hospitals, college and university endowments can all benefit from unitization of their investment program to gain efficiencies and accuracy.