Choosing Between a Private Foundation and a Donor Advised Fund for Your Charitable Giving
Hi, thank you for tuning into today’s Emerald GEM, which stands for Get Educated in Minutes. I’m Kerry Reeves, Director of Wealth Strategies for Wilmington Trust Emerald Family Office & Advisory® and your host for today’s podcast. In today’s GEM, I’m going to discuss the difference between a donor advised fund and a private foundation and how to determine if either strategy would be optimal for your charitable giving.
Let’s get started.
I’ll start by telling you (1) what a private foundation is and (2) what a donor advised fund is.
A private foundation is a nonprofit corporation or charitable trust that qualifies for tax-exempt status under the internal revenue code. A private foundation is organized and operated exclusively for religious, charitable, scientific, or educational purposes. Making a contribution to a private foundation may qualify you for a charitable deduction. Typically, a private foundation receives its funding from one family or one business. For the right client, a private foundation may be the best way to leave a philanthropic legacy.
An example of how a private foundation might work is that I could establish “Kerry’s Private Foundation.” Each year, I, or perhaps other members of my family, could make charitable contributions to the foundation and use those contributions as income tax deductions. Each year the private foundation would make grants for one or more charitable causes, as the trustees or the board of directors may determine. In addition, upon my death, my estate plan may leave some or all of my assets to the foundation. This would qualify my estate for an estate tax deduction and the private foundation would continue leaving a legacy that may last for generations.
There are, of course, advantages and potential disadvantages to using a private foundation as your charitable vehicle.
Let’s start with some of the advantages:
- A private foundation is exempt from federal income tax.
- Contributions to a private foundation will provide the donor with a charitable deduction—currently that deduction is limited to 30% of adjusted gross income —but remember, unused charitable deductions can be carried forward for up to five years.1
- You can continue to maintain a level of control over the foundation. For instance, you could serve as a trustee or on the board of directors and determine what types of charitable grants should be made from the foundation each year. In addition, you may have the ability to determine certain investment strategies.
- A private foundation may encourage intergenerational involvement.
- You can create an endowment that will fund future giving.
- And not only may contributions allow for income tax deductions, but they may provide for estate and gift tax deductions a well.
Now, of course, there are some potential disadvantages (or at least considerations) to establishing a private foundation:
- Initial filings and expenses. You will likely need to hire an attorney to draft the foundation’s operating documents (those documents will depend on whether your foundation is in corporate or trust form) and your attorney or accountant will need to file a 1023 application with the IRS to obtain tax-exempt status. In addition, each state that the foundation operates in will have its own initial registration requirements. There are ongoing reporting requirements which include the filing of a form 990, a private foundation tax return, and each state that the foundation operates in will have its own ongoing filing requirements. So, this is all to say there will be time and cost associated with maintaining a private foundation.
- There is a reduced adjusted gross income limitation for deductibility compared to a public charity. For instance, as mentioned, the tax deduction for contributions to a private foundation is limited to 30% of adjusted gross income, whereas, for a public charity, that limitation is 60% for certain contributions.2
- Contributions to a private foundation are generally limited to a basis deduction, unless contributing cash or publicly traded securities.
- Finally, a private foundation has restrictions and excise taxes3, which include:
a. An excise tax of currently 1.39% on net investment income4
b. Minimum annual distribution requirements—which is generally 5% of the net fair-market-value of the foundation’s assets on a rolling basis
c. Prohibition on self-dealing
d. Prohibition on excess business holdings (with limited exceptions)
e. Limitation on high-risk investments; and
f. A private foundation must avoid certain taxable expenditures
Every tax-exempt charitable organization is classified as either a private foundation or a public charity. While a tax-exempt organization, a private foundation does not meet any test which, under the internal revenue code, would qualify it as a public charity.
A “public charity” generally receives at least one-third of its funding from the general public and is typically run by a larger board that is representative of the communities it serves. Some of the most well-known nonprofit organizations are public charities, such as the American Red Cross, the United Way, the Salvation Army, and similar organizations. There are certain benefits to being a public charity. The additional restrictions and excise taxes that I mentioned applying to private foundations generally do not apply to public charities. In addition, contributions made to a public charity enjoy a higher adjusted gross income deduction limitation—currently 60%.2
So why am I talking about public charities when this GEM is focused on private foundations and donor advised funds? Well, a donor advised fund, which is commonly referred to as a “DAF,” is a type of public charity. So, when someone says they have a DAF, what that means is they have an account at a DAF. The account is created at an existing grantmaking charitable organization. For instance, many large financial institutions have established donor advised funds for their clients to contribute to as part of their charitable giving strategy.
So, for example, if I wanted to fund a DAF, I could simply go to a financial institution that has one in existence and set up an account. It might even be named “The Kerry Fund.” Each year I could make charitable contributions to the DAF and receive an income tax deduction. And each year, I would “advise” the DAF sponsor on how I would like charitable grants made from the account. Upon my death, I could leave assets to the DAF, which would qualify my estate for an estate tax deduction, and then the next generation (or a named successor) may have the ability to continue to advise and recommend grants from the DAF.
Again, there are, of course, advantages and potential disadvantages to using a donor advised fund as your charitable vehicle.
Let’s, again, start with the advantages:
- Public charities (like private foundations) are exempt from federal income tax.
- The donor does not need to bear the burden of establishing the entity, applying for tax-exempt status, or ongoing reporting requirements. This is significant time and expense saved.
- A DAF is maintained by a public charity, so the deduction limitations, operational restrictions, and certain excise taxes that apply to private foundations generally do not apply to DAFs.
- Contributions to a DAF may provide the donor with a charitable deduction—currently that deduction is limited to 60% of adjusted gross income. But again, unused charitable deductions can be carried forward for up to five years.2
- Some (but not all) DAFs allow donors to use their own advisors to invest the funds.
- Generally, most DAFs will make the charitable grants which you “advise.”
- If your DAF account is large enough, the DAF sponsor may agree to make grants to organizations that would not otherwise qualify to receive a grant from the DAF, such as a foreign charity. The DAF sponsor may consider performing expenditure responsibilities or obtaining equivalency determinations which are procedures generally required by the IRS for such grants to be permitted.
Now, of course, the potential disadvantages (or at least considerations) to using a DAF:
- By law, donors may only “advise” or “recommend” uses for the contributed funds. Legally, once contributed, the funds are controlled by the DAF sponsor. That said, in most cases, the sponsoring organization will follow the donor’s instructions.
- Generally, the DAF sponsor controls the investment strategies.
- DAFs are subject to a number of restrictions, including rules prohibiting more than “incidental donor benefits” and “excess benefit transactions.”
- Some DAFs have restrictions on the types of grants they will approve.
- Some DAFs have restrictions on how long the funds will be maintained and how many levels of successors you may appoint.
With that said, your charitable objective will play a large role in determining the charitable vehicle that is most optimal for your planning purposes. As you may have deduced, many of the objectives an individual is looking to achieve by establishing a private foundation can be also achieved by using a donor advised fund and potentially in a more efficient manner. Typically, I like to say that if we are looking at smaller dollars, a DAF is more efficient than establishing a private foundation. For large dollars, a private foundation may be most optimal as it provides for a greater level of control and may be in existence for many generations. Finally, private foundations and donor advised funds are not mutually exclusive. An individual or family may incorporate both into their charitable giving strategy.
While the midterm elections are behind us, and as we approach the next election season, I want to add this important note: Neither a private foundation nor a donor advised fund is an appropriate vehicle for making political contributions. A political contribution coming from a private foundation, or a donor advised fund can, in fact, cause very serious tax consequences. Perhaps a topic for a future GEM.
So, today, I have merely scratched the surface on private foundations and donor advised funds. There are many different vehicles for charitable giving that can support your objectives and create a philanthropic legacy. Charitable giving is an important discussion to have with your advisors in order to determine whether your charitable giving is best done individually or through a trust, a private foundation, donor advised fund, or another entity.
1 IRC Section 170
2 IRC Section 170; Under 2017 tax reform, the deduction limit for cash gifts to public charities was increased from 50% to 60%. The 60% limit is scheduled to revert back in 2026.
3 Regulatory excise tax provisions of Chapter 42 of the Internal Revenue Code
4 IRC Section 4940(a)
Definition of Terms
Adjusted gross income (“AGI”): Defined as gross income minus adjustments to income. Gross income includes your wages, dividends, capital gains, business income, retirement distributions as well as other income. Adjustments to income include such items as Educator expenses, Student loan interest, Alimony payments or contributions to a retirement account.
Basis deduction: Deduction limited to a property’s basis, the amount of capital investment in property for tax purposes.
Donor advised fund: A public charity that affords donors the benefit of a charitable deduction at the public charity contribution base limitation. See IRC Section 170.
Excess benefit transaction: A transaction in which an economic benefit is provided by an applicable tax-exempt organization, directly or indirectly, to or for the use of a disqualified person, and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.
Fair market value (“FMV”): The price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.
Incidental donor benefits: A benefit is considered more than incidental if, because of a charitable contribution, the donor receives a benefit that would reduce or eliminate the charitable contribution deduction if the benefit were received as part of the transaction.