When building a philanthropic legacy, a donor should not only consider the “who” but also the “how” and “why” of his or her charitable giving. How detailed is the donor’s charitable vision – are there specific charities or even specific projects that the donor would like to support, or are the donor’s charitable goals still evolving? How much control would the donor like to maintain over the administration of the gift – would the donor like to be involved day-to-day, or is a more turn-key solution desired? Is the donor seeking to make philanthropy the “family business”? Depending on the donor’s preferences, different vehicles – or a combination of vehicles – may be used to accomplish his or her charitable goals. In this article, we discuss the benefits and burdens of creating a donor advised fund or private foundation, as well as when a donor advised fund or private foundation would be the appropriate choice for a donor’s philanthropic goals. In a future issue of Pieces of the Puzzle, we will cover gifting arrangements with public charities, such as the creation of an endowed fund, a named gift, and gifts to supporting organizations.
1. Donor advised Fund
A donor advised fund (or “DAF”) is an account housed at a public charity1 (often dedicated to the administration of such funds), over which the donor has advisory privileges over charitable distributions and fund investments. The charity administering the DAF is responsible for the management and administration of the fund, and must have ultimate authority over the distribution and investment of the funds – though it will generally follow the donor’s guidance except where legally prohibited (such as grants directly to individuals). Keep in mind, however, that some charities administering DAFs have internal policies regarding permissible recipients. For example, due to the reporting requirements associated with donations to foreign charities, some donor advised funds do not permit distributions to international recipients.
By making a donation to a DAF, the donor enjoys the tax benefits of making a current gift – while affording the donor additional time to clarify his or her charitable vision, and develop recommendations for future distributions. For example, if a donor does not yet have clear philanthropic goals, but would like to minimize his or her taxable income for a given year (for example, in a year a major asset is sold), he or she may give to a DAF in that tax year and then recommend the DAF distribute the funds over time, as the donor’s charitable goals develop.
Donor advised funds allow the donor to enjoy some of the benefits of a private foundation, such as influence over the timing of distributions, selection of recipients and management of the funds, without the administrative burdens, though without the same degree of control. The donor may consult with his or her family on how to direct the funds, and may even appoint additional or successor donor advisors, to guide the fund with the donor during his or her life or after the donor’s death. However, a DAF will not provide as many opportunities as a private foundation to actively involve family members and build a multi-generational family legacy.
Regardless of when the DAF funds are distributed out to the ultimate charitable recipients, the donor is entitled to a charitable tax deduction in the year the donation is made and at the preferential deduction limits which apply to public charities. Donors may deduct the full, fair market value of long-term capital assets given to a public charity – up to 30% of his or her adjusted gross income. Donations of short-term capital assets are only deductible to the extent of a donor’s basis in the asset (in general, the amount paid for the asset) – however, along with cash, short-term capital assets are deductible to up to 50% of the donor’s adjusted gross income. The balance of the deduction for the gift may be carried forward up to five years.
Start-Up Costs and Administrative Burdens
Establishing a DAF is a “turn-key” solution for donors seeking influence over charitable distributions, but willing to give up the complete control that a private foundation would afford in exchange for fewer administrative burdens. Establishing a donor advised fund is a relatively quick process, with a small amount of paperwork and a minimal initial funding amount (typically starting at $5,000). The charity hosting the DAF is responsible for conducting due diligence on potential recipients to ensure they are taxexempt organizations. Further, the charity housing the DAF is also responsible for compliance with state and federal rules applicable to public charities, including the filing of annual tax returns, and because the entity housing the donor advised fund is already tax exempt, there is no need to apply for tax-exempt status.
The charity hosting the DAF will also charge an annual administrative fee for the management of the fund. Most fee arrangements are based on the amount of the assets under management, with annual fees generally ranging from 0.25% to 2% of the fund’s assets. The fee percentage generally decreases as the fund’s value increases. The creation of a donor advised fund is ideal for: Donors without clearly defined charitable goals at the time of donation or donors seeking flexibility for future grants; Donors who want the option to involve family in charitable decision making; or Donors seeking maximum tax benefits and low start-up, administrative and oversight costs.
2. Private Foundation
Most private foundations are grant-making organizations, which distribute funds to charitable recipients (such as public charities or, in some cases, individuals), rather than directly conduct charitable activities.2 Donors set up private foundations – rather than giving to a DAF or an existing public charity – for a number of reasons, which include:
- A desire to meet a need that is not being met by existing organizations;
- A need to maintain a high level of control over the donated funds; or
- Desire to unite their family around a common goal. Since the directors of a private foundation have fiduciary duties to the foundation, they must meet and correspond regularly on foundation business. Family members may also be employed by a private foundation in some cases, though any compensation must be objectively reasonable and will be closely scrutinized by the IRS — so it is vital that the family member be qualified for the role and committed to the foundation. It is important to consider the interests and strengths of family members before beginning a foundation designed to create a family tradition of philanthropy.
Additionally, in contrast to a DAF, private foundations may make grants to individuals (such as scholarships or fellowships), so long as such grants are made in accordance with IRS regulations. However, additional restrictions on private foundation grants apply, such as limits on grants to foreign organizations.
Tax Benefits and Burdens
Tax benefits are more limited for gifts to grant-making private foundations than gifts to public charities or private operating foundations. Deductions for gifts of appreciated property other than publicly-traded stocks are limited to the donor’s basis in the property (which may be substantially less than its fair market value). Donors may only deduct 30% of cash and short-term capital asset donations to a private foundation and 20% of a long-term capital asset in a given year (contrasted to a limit of 50% and 30% when the same assets are gifted to a public charity or private operating foundation).
Private foundations are also subject to a small excise tax of 1% or 2% on the foundation’s net investment income. Furthermore, a private foundation is required to make a minimum annual charitable distribution of 5% of the net fair market value of its assets.3 Foundations must invest their assets prudently and are limited in their ownership of active businesses. Foundations are also restricted in what transactions they can enter into with certain individuals (such as the donor and those related to the donor).
Tax Benefits and Burdens
Establishing a private foundation may require significant start up and administrative costs, including legal and filing fees. In addition to incurring costs, the donor must make various decisions regarding how he or she would like to structure the foundation, including its mission, leadership structure, and whether to form the foundation as a corporation or a trust (with the latter being a more appropriate choice to hinder changes to the foundation after the donor’s death). Once the foundation has been legally established, the foundation must apply for federal, and in some cases state, tax-exempt status. IRS review of the foundation’s application for exempt status may take many months, but tax-exempt status will generally be retroactive to the date of formation.
On an ongoing basis, the foundation will also be responsible for annual tax and compliance filings, such as the filing of the federal Form 990-PF, which discloses the foundation’s income, assets and charitable distributions. The foundation will be responsible for the costs associated with employing an accountant to prepare the annual tax returns, as well as the cost of hiring an investment advisor to manage the foundation’s assets. Finally, the foundation is responsible for the vetting of grantees, including the review of grant applications, confirming exempt status of grant recipients and monitoring the use of distributed funds. This due diligence may be done by the donor, by staff of the foundation or by outside consultants hired to assist the foundation with grant administration. The creation of a private foundation is ideal for:
- Donors who wish to focus on a particular issue or fill a gap in the activities of other charitable organizations;
- Donors who wish to create a family legacy by having a named foundation which involves family members;
- Donors seeking a high level of control over the investment, administration and distribution of funds; or Donors wishing to make grants to individuals.