As we approach year-end, it is a good time to start thinking about charitable giving. Private foundations and donor-advised funds (DAFs) are two popular options to consider. Here are the pros, cons and tax impacts of each method.
Defining Private Foundations
A private foundation is a not-for-profit organization defined as a legal entity in which the donor or a family member—if appointed as board member—retains complete control over investment and grant decisions. Often, these foundations are designed to provide a long-term platform for supporting charitable values of the donor, such as awarding grants, investing in community programs, or facilitating scholarships and fellowships. In a private foundation, donors can hold almost any kind of assets such as Investment portfolios, tangible assets such as art, real estate and even certain intangible personal property, but there are limitations to these foundations holding investments in family businesses. Private foundations that are non-operating are required by the IRS to distribute a 5% of the net value of their annual investment assets in the form of grants or other eligible administrative expenses.
The Criteria for Donor-Advised Funds (DAFs)
On the other hand, a donor-advised fund (DAF) is a giving account within a sponsor organization, generally where the donors investment assets are held, where donors can recommend how funds are invested and granted, but the final approval is up to the sponsor organization. A DAF does not have the same lifespan as a private foundation. While a DAF may only last a generation or two, a private foundation can be designed to operate in perpetuity, and may have more sentimental ties to the family legacy that help keep it going. Unlike private foundations, the IRS does not have an annual payout requirement for DAFs. A DAF does not have to file tax returns either which simplifies the administrative responsibilities and offers more privacy to donors.
Pros of Private Foundations
Private foundations give donors more control than DAFs and enable families to pass on a legacy of philanthropy. There are no gift or estate taxes.
Cons of Private Foundations
A private foundation can take several weeks or months to set up since the process is more complex and requires filing state incorporation paperwork. The other reason private foundations take more time to set up is that they require submitting an IRS Application for Recognition of Exemption Under Section 501(c)(3).
The legal services required to manage the start-up process for private foundations can be substantial and administration costs are higher than DAFs at an average cost of 7%. A donor’s contribution to a private foundation is also limited to only 30% of their adjusted gross income. The donor’s benefit is further limited on gifts of stock or real property to 20% of their adjusted gross income. Additionally, private foundations must annually pay an excise tax on 1.39% of their net investment income.
Despite its namesake, private foundations do not protect the privacy of their board members, donors, and staff whose names are included in their tax returns that are part of public records. These tax returns also include other detailed information regarding the grants, investment fees and staff compensation.
Pros of DAFs
The main advantages of using a DAF over a private foundation are the instant tax benefits and the privacy it affords to its donors, advisors and grantees. Other advantages include no requirement for grant distribution and no excise tax on investment income. With a DAF, there is a tax deduction limit for gifts of cash up to 60% of adjusted gross income which is double the amount allowed for private foundations. DAFs also have an immediate start-up time and can often be completed in less than a day. Given the simplicity of setting up a DAF, it is not surprising that it also has no start-up costs associated with it. Even its operating costs are generally low at .85% or less. While the final decisions are made by the sponsor organization, it is rare that they do not follow the donor’s direction. As such, donors have more time to focus on charitable objectives.
Cons of DAFs
The main drawback of a DAF is relying on the sponsor organization to make most major decisions. A DAF is incapable of making gifts to split interest trusts and it cannot make contributions to a private non-operating foundation. Since grants made to charities may be subject to a minimum donation amount, the donors interested in donating smaller amounts should investigate this with the sponsoring organization and may consider some of these donations directly to those charities instead.
When to Use Donor-Advised Funds or Private Foundations
DAFs are useful for making a charitable contribution as a tax deduction in a given tax year without having to immediately decide where the money will go because the fund will distribute the value of your gift over time. This allows people to make a gift now to obtain the desired tax benefits for that year without having to hastily decide what charity will ultimately benefit from the donation. DAFs are a good option for those seeking a consolidated giving strategy with a lower donation threshold that maximizes available tax advantages. A DAF is ideal for those who prefer to share the burden of managing their charitable assets with the help of a sponsor organization.
Private foundations are ideal for promoting family involvement and is a vehicle through which families can control their charitable legacy for generations. This benefit is for people willing and able to spend more to pay third parties to assist in the management and administration responsibilities that come with the complexities of managing private foundations.
Control is the main factor that separates private funds from DAFs and will be the first quality to consider when deciding which is the right platform for making charitable donations.
Continue the Conversation
If you would like to learn more about donor-advised funds and private foundations, please reach out. Our Private Client Services team can help you choose the best charitable giving option and prepare for long-term financial health.