Should you create a donor-advised fund or a private foundation?
A question that individuals looking to build a charitable asset pool often ask us is whether they should establish a private foundation or a donor advised fund. As with many great questions in life, it depends.
Private foundations (PF) and donor advised funds (DAF) are similar. As with direct donations, they can both offer a tax deduction to offset a significant tax year following the sale of, for example, a business, investment assets or real estate.
And they can both offer benefits that direct donations don’t, including:
- Tax-free growth of charitable assets and accumulation for strategic deployment.
- Involvement of other family members, including younger generations, in donation decisions.
- A legacy of charitable giving long after death.
PF and DAF – Some basics
A PF is a non-profit entity created by the donor structured as a trust or a corporation. Trustees or the board (depending on the structure) oversee the administration of the foundation, manage investments and make decisions about charitable grants.
A DAF is an account at a public charity, usually a community foundation or the charitable arm of a large financial institution such as Schwab or Fidelity. You can think of a DAF as a prepackaged PF or a “PF-lite”, where the DAF sponsor handles most of the administration. The donor retains the ability to direct the investment of funds to their account and recommend any charitable grants they wish the sponsor to grant.
Governance can be structured in the same way with family members as directors or directors of the PF or designated account holders of the CFO.
Main differences between CFOs and PFs
Although they are similar in many ways, FPs and DAFs have significant differences that impact the best option.
A PF must file an income tax return with the IRS, which is open for public inspection. With a few clicks, anyone can see the trustees or directors, asset values, and charities the PF has donated to. A CFO, on the other hand, is private.
FPs must distribute at least 5% of assets each year to charities. There is currently no minimum annual distribution requirement for CFOs.
The trustees or administrators of an FP control its investments. Subject to their fiduciary obligations and tax code restrictions on investing in private companies or making concentrated high-risk investments, trustees can invest as they see fit.
Investment options for CFOs vary widely depending on the sponsor’s policies and platform. Some DAF sponsors require the donor to use the investments on their platform, such as with a 401 (k) plan. Other CFOs allow the donor to retain the services of its own investment advisor to manage the assets. Given the wide variation in investment flexibility between CFOs, a donor looking to establish one should shop around and find what works best for them.
The tax deductibility of charitable contributions is limited to a percentage of the adjusted gross income (AGI) of the donor. Amounts exceeding the AGI limit can be carried forward and deducted for up to five years. For contributions to public charities, including DAFs, the AGI limit is 60% for cash contributions and 30% for valued assets. The AGI limits for PF are 30% for cash and 20% for appreciated assets.
Contributions of non-negotiable assets
Contributions of valued assets that the donor has held for more than a year benefit from a tax deduction at fair market value (FMV). This allows them to avoid capital gains embedded in the assets offered.
But there is one important exception to the fair market value deduction rule for pension funds; Contributions of non-negotiable assets such as shares in a limited holding company, works of art or real estate only receive a deduction equal to the base cost of the assets contributed. So if you want to gift them, you have to use a DAF.
Installing a DAF doesn’t cost much, if anything. Current expenses are primarily the asset under management (AUM) fee charged by the DAF sponsor, which varies by sponsor and account size.
The cost of establishing a PF can reach tens of thousands of dollars due to the need to create a non-profit entity and apply for tax exempt status from the IRS. The day-to-day expenses of a PF include the administration and filing of annual income tax returns. For simple FPs these costs are minor, but for larger and more complex foundations they can be substantial.
With rare exceptions, CFOs and PFs are exempt from income tax. FPs are subject to an excise tax of 1.39% on their net investment income. The PF excise tax is a small percentage but is added to the expenses of a PF compared to a DAF.
Control of charitable grants
The trustees or administrators of a PF have full control over charitable grants.
CFOs are different. Technically, DAF donors recommend charitable grants to the DAF sponsor who controls the delivery of the distributions. In practice, however, the donor is in control. As long as the intended recipient is a 501 (c) (3) charity and meets other basic requirements common to PFs and CFOs, the sponsor will approve the request.
Possibility of making charitable donations
Neither the FPs nor the CFOs can honor promises made by individuals. Thus, pledges must be made by the PF or DAF, and not by the donor or any other person.
There is no obstacle to the FPs making commitments. CFOs, however, cannot make binding promises. But they can usually make non-binding commitments, which usually satisfy the recipient charity.
So which one should you use?
Choosing the right vehicle for you will depend on your particular situation and how you weigh the importance of the above factors. That being said, here are some rules of thumb regarding what type of entity to establish:
- Cut. Due to the high initial and ongoing costs, a PF only makes financial sense if you plan to fund it with at least a few million dollars. For example, a start-up cost of $ 10,000 corresponds to 10% of a PF funded with $ 100,000, but only 1% of a PF funded with $ 1 million.
- Need staff. An effective charitable giving can be a lot of work. Sometimes paid staff are needed to help define strategy, review grant applications, perform due diligence on charities, and monitor the effectiveness of charities. While a community foundation can provide some of these services to its DAF donors, a PF is needed when a dedicated staff is required.
- Investment flexibility. Some DAF sponsors allow considerable investment flexibility and allow the donor’s investment advisor to manage the DAF. But FPs offer more flexibility. Donors who want their charity to invest in private real estate and private equity are likely to benefit from using a PF.