What is a Donor-Advised Fund and How Does It Work?
A Donor-Advised Fund (“DAF”) is a separately managed charitable account (referred to as a “Fund”) that is owned and operated by a Sec. 501(c)(3) organization. A DAF allows a donor to make a charitable contribution of cash, appreciated securities, real estate, and other tangible assets into your Fund at the San Diego Seniors Community Foundation (“SDSCF”) over time. You can lock-in a tax deduction in the year given, and then recommend grants from the fund to non-profit organizations of the donor’s choosing.
A gift to a donor-advised fund is a donation to a public charity because a donor-advised fund is, by definition, “owned and controlled” by a public charity. For federal income tax purposes, this is good news, thanks to the highly favorable deductibility rules that apply to an individual’s lifetime gifts to public charities.
Setting up a DAF is Easy
Setting up a DAF is quick and easy, and is a simple, inexpensive, and effective way for you to support your favorite senior-related charitable causes in an efficient manner. There are no start-up costs, and the donor receives an immediate gift acknowledgment letter that can be used to support a tax deduction. You can add to your donor-advised fund whenever you want.
Donors that set up a DAF are given “advisory rights” on grantmaking from their Fund. This enables you to direct your giving through one expertly-managed and cost-effective vehicle. You choose which non-profit agencies to support, how much to distribute, and when. When the DAF is established, the donors name the fund (which can include family member names) and then appoint grantmaking “advisors” who can include themselves as well as family members and friends. This offers the opportunity to engage family members in effective philanthropy and create a legacy of giving.
Since the DAF is an asset of SDSCF, the responsibility for professional management of the investment assets and corporate operations lies with the SDSCF staff. This means that donors can simply make contributions to the DAF, and then over time recommend grant distributions from the DAF’s remaining assets. For example, if you typically donate $3,000 a month to charity ($36,000 a year), you could essentially prepay for, say, five years’ worth of donation by putting $180,000 in a DAF now.
For more information on Donor Advised Funds, see our blog titled “Why Would I Want A Donor-Advised Fund?”
What is A Private Foundation
A private foundation is a Sec. 501(c)(3) non-profit organization that is not a public charity. It can be established by a family, individual, or corporation with gifts of cash, stocks and bonds, real estate, and certain other tangible assets.
Private foundations are often established as a family legacy – bearing the family’s name – and overseen by one or more generations of family members who learn to appreciate the joy and benefits of philanthropic investments.
Since a private foundation is a separate corporation, the board is responsible for overseeing all financial and operational activities of the nonprofit corporation including investment management, maintaining corporate formalities, risk management, public transparency, annual reporting, and compliance with IRS regulations and accounting standards. Given the extent of operational oversight required, establishing a Private Foundation typically makes sense only when an initial sizable gift is contemplated and where the donor wants to maintain direct control over the donated assets.
Operating and Non-Operating
There are two types of private foundations: Operating and Non-Operating. For purposes of this article, we will consider non-Operating foundations that are established primarily as grantmaking institutions.
Such institutions place foundation assets in well-diversified investment portfolios, typically managed by outside professional investment advisors, with a goal of achieving at least a long-term total return of 5% per annum (preferably higher). Each year a non-operating private foundation must distribute 5% of the prior year’s average net investment assets (referred to as the Minimum Distribution Requirement, or “MDR”) in the form of grants to public charities or eligible administrative expenses. Failure to meet the MDR results in excise tax penalties.
Private Foundations must qualify with the IRS as a tax-exempt entity and involve significant start-up expenses and ongoing operational and administrative costs. The effort involved in maintaining annual compliance for a private foundation may create a burden for its founders. Accordingly, the board and any hired staff of a private foundation must have the time and business acumen to professionally manage a nonprofit corporation. Additionally, establishing a private foundation can take a year or more, which may not correlate with the donor’s required timing for a tax deduction, nor the preferred timeline for initial grant distributions.
Pros and Cons
Both a Private Foundation and a Donor-Advised Fund give donors the ability to support their favorite charities and encourage a legacy and tradition that involves family members in strategic philanthropy. Each option is also eligible for a tax deduction, depending on the donor’s personal tax situation, but the deduction limits differ for a private foundation vs a DAF. See the table below for specifics.
Private Foundations must comply with law and corporate formalities, including financial accounting and tax reporting standards and compliance, keeping official meeting notes, providing compensation benchmarking backup to IRS to justify salaries paid to family members, carrying various types of insurance for board members, asking trustees to sign conflict-of-interest statements, etc. In contrast to the management and operational aspects of a private foundation and the associated costs, a DAF is managed by a public charity and involves only a fraction of the cost. All legal, financial, operational, and tax and regulatory requirements for a DAF are handled by SDSCF.
While a private foundation must meet its annual Minimum Distribution Requirement, there is no annual grant distribution requirement for DAFs. Additionally, individual DAFs do not need to file an annual tax return because SDSCF files a consolidated return.
Private foundations must list their board members and all grant awards on their annual IRS return, whereas donors that establish a DAF with SDSCF have the option of anonymity. Alternatively, they can name their DAF, offering opportunity to establish a Fund with their family name, or honor a loved-one with a legacy memorial.
The board of a Private Foundation may approve any grant to an eligible 501c3 nonprofit organization. In contrast, grant recommendations from a DAF require approval of the SDSCF board. While this may at first appear to be a disadvantage, in actual practice a donor’s grant recommendation is rarely denied because SDSCF’s mission is to provide support for, and build the capacity of, multiple 501c3 nonprofits. Before the grant distribution is made to a recommended nonprofit organization, SDSCF conducts a due diligence process, fully vetting the entity to verify it is in good standing with the IRS and State agency and examining the purpose of the grant to ensure it is compliant with law and IRS regulations. Reasons why a grant recommendation may be declined typically involve a legal or tax-related matter. A private foundation would need to conduct these same due diligence procedures internally and bear that cost.
DAF’s do not pay taxes, whereas private foundations are subject to a 1-2 percent excise tax on net investment income.
The comparison chart below is designed to enable the reader to gain a quick visual comparison between a Private Foundation and a DAF. The chart’s content captures the majority of important comparisons but is not intended to be exhaustive.
|Donor-Advised Fund at SDSCF||Private Foundation|
|Required to establish||Simple Fund Agreement form||Create new legal entity and establish tax exemption|
|Ease of setup **||Can be established in one day||May take months to establish and qualify for tax exemption|
|Setup costs||None||Legal fees and other start-up costs can be substantial|
|Cash gifts||Deductible up to 60% of AGI *||Deductible up to 30% of AGI|
|Appreciated Marketable Securities***||Deductible at fair value, up to 30% of AGI||Deductible at fair value, up to 20% of AGI|
|Closely held stock and most other appreciated property||Deductible at fair value, up to 30% of AGI||Deductible at cost basis, up to 20% of AGI|
|Valuation of donated real estate||Fair Market Value||Limited to the lesser of fair market value, or cost basis|
|Required annual distributions||None – Flexible distributions||5% of average net investment assets, regardless of earnings|
|Excise tax on net investment income||None||1% – 2%|
|Annual tax reporting||None for individual DAF fund holder||Annual Federal and State Returns|
|Legal and accounting fees||Typically none||Typically incurred annually|
|Confidentiality||Full anonymity if desired||Form 990PF listing board members and grants is available to the public|
|IRS Form 990 and State tax filing||No||Yes|
|Grant administration||Handled by SDSCF staff||Oversight by PV staff/board|
|Grant-making consultation, and research/evaluation of potential grantees||Yes – typically no additional fee||Requires staff or consultant|
|Planned giving opportunities to add to fund||Yes||Legal fees apply|
|Administrative burden||Handled by SDSCF team||Managed by private foundation’s board, or paid staff/consultants|
|Investment oversight||SDSCF’s team, using outside professional investment advisors||Private Foundation’s board or staff, using outside professional investment advisors|
|Investment options||Limited, depending on SDSCF’s investment portfolio options||Flexible|
|Control and ownership||Owned by SDSCF, donor has grantmaking advisory rights||Full control by founders and board|
|Named legacy opportunity||Yes – donor establishes name of DAF fund||Yes – Founders establish name of Private Foundation|
|Ability to name successors||Yes||Yes|
|Lifespan of Fund/Foundation||No required limit – however most DAF’s convert to endowment funds after original donors or the succeeding generation dies; donor’s preferred charitable purpose continues||Foundations can exist in perpetuity|
|Liability and Insurance||Advisors to fund are covered by SDSCF’s insurance policies||Must purchase general liability package and D&O Insurance|
|Self-dealing rules||Federal law prohibits any grant, loan, compensation or other similar payment to donors, advisors, members of their family and related entities||Strict regulations prohibit most transactions between a private foundation and its donors (including related persons or corporations)|
* 60% of AGI for 2018-2025, limit suspended under CARES act – currently 100% of AGI with the appropriate election
** A donor that is experiencing a transaction resulting in a sizable tax situation, such as the sale of a business or appreciated real estate, can quickly set up a DAF and make an immediate contribution eligible for a tax deduction.
*** Donors often contribute appreciated stock into a DAF, enabling the donor to avoid any capital gains tax on the long-term growth in the value of the stock, and gaining the advantage of granting out portions of the proceeds over time.
The majority of donors prefer a Donor-Advised Fund over a private foundation, because the DAF is quick and easy to setup, provides flexibility in grantmaking, and avoids the burdens of administrative oversight, investment management, and fiduciary liability.
Occasionally, the principals of private foundations have chosen to wind up and dissolve their private foundation, roll the assets into a DAF at a Community Foundation such as SDSCF, and become the donor-advisors committee for the new DAF. This relieves them of the day-to-day operational burden and investment management of a separate non-profit corporation, with their sole remaining duty that of reviewing and approving grants from the DAF.
For information about setting up a Donor-Advised Fund, contact Rich Israel at email@example.com.