The pros, cons and tax impacts of private foundations vs. donor-advised funds
As we approach year-end, it’s 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 consequences of each method:
What is a private foundation?
A private foundation is a not-for-profit legal entity in which the donor or a family member retains complete control over investment and grant decisions. Often, foundations are designed to provide a long-term platform to support the charitable values of the donor by awarding grants, investing in community programs, or facilitating scholarships and fellowships.
In a private foundation, donors can hold almost any kind of asset, including investment portfolios, tangible assets such as art and real estate, and even certain intangible personal property. There are limitations to foundations holding investments in family businesses.
Nonoperating private foundations are required by the IRS to distribute 5% of the net value of their annual investment assets in the form of grants or other eligible administrative expenses.
The 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.
The cons of private foundations
- A private foundation can take weeks or months to set up since the process is more complex and requires filing state incorporation paperwork. Private foundations are also required to submit an IRS Application for Recognition of Exemption under Section 501(c)(3).
- The legal services to manage the start-up process can be substantial.
- Administration costs are also higher for private foundations than for DAFs (7%, on average).
- A donor’s contribution to a private foundation is limited to 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.
- 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 or staff. Names that are included on their tax returns become part of public records. These tax returns also include detailed information regarding the grants, investment fees and staff compensation.
What is a donor-advised fund (DAF)?
A DAF is a giving account within a sponsor organization, which is generally where the donor’s investment assets are held. Donors can recommend how funds are invested and granted, but 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 it may have sentimental ties to a family legacy to 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 administrative responsibilities and offers more privacy to donors.
The pros of DAFs
Instant tax benefits and privacy for donors, advisors and grantees are the primary advantages of DAFs over private foundations. In addition:
- There’s no requirement for grant distribution and no excise tax on investment income.
- There is a tax deduction limit for gifts of cash — up to 60% of adjusted gross income. That’s double the amount allowed for private foundations.
- DAFs can often be set up in less than a day, without any startup costs.
- Operating costs are generally low (0.85% or less).
- Final decisions are made by the sponsor organization, but it’s rare not to follow the donor’s direction. As such, donors have more time to focus on charitable objectives.
The cons of DAFs
- The main drawback of DAFs is that they rely on sponsor organizations to make most major decisions.
- A DAF is incapable of making gifts to split-interest trusts, and it cannot make contributions to a private nonoperating foundation.
- Grants made to charities may be subject to a minimum donation amount. Donors who are interested in donating smaller amounts should investigate this with their sponsoring organization and may consider making donations directly to charities instead.
When to donate to a DAF vs. a private foundation
Control is the main factor that separates private funds from DAFs, and it should be the first quality you consider when picking the right platform for your charitable donation.
DAFs are useful if you want to make a charitable contribution to qualify for a tax deduction in a given tax year, without having to immediately decide where the money will go. The fund will distribute the value of your gift over time, so you can get the desired tax benefit without hastily picking a charity.
DAFs are a good option for individuals who want a consolidated giving strategy with a lower donation threshold that maximizes available tax advantages. And they’re ideal for people who want help managing their charitable assets.
Private foundations are an ideal way to promote family involvement in charitable giving. Foundations can become a vehicle to control a family’s charitable legacy for generations. However, you must be willing and able to pay third parties to help with management and administration responsibilities that come with the complexities of managing a private foundation.
How Wipfli can help
Not sure which charitable giving option is best for you? Our private client services team can review the pros, cons and tax consequences for your personal situation and help you choose the best gifting option. Contact us today to learn more.
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