Top 5 Considerations for Choosing a Donor Advised Fund vs. Private Foundation
Donor advised funds (DAF), which are often explored as alternatives to establishing a private foundation, have garnered a lot of attention in recent years. In fact, Fidelity Charitable recently reported
that DAFs now outnumber foundations 3:1 and are one of the most rapidly growing vehicles for charitable giving nationwide. Their rise in prominence has prompted many financial institutions and other public charities to offer DAF arrangements.
For some donors, the perks are easy to spot: “immediate tax breaks, investing for the growth of charitable assets, and the ability to sustain giving through retirement,” the Nonprofit Times notes. But there are several considerations when deciding if a DAF or a private foundation as the correct giving vehicle to fulfill a donor’s philanthropic needs, including:
Both cost and time should be considered when determining whether to establish a private foundation or a DAF, along with the amount of the gift or the assets the vehicle would manage. Private foundations are separate legal entities, and thus, they carry the administrative costs of formation, operation and annual reporting. A private foundation with a larger asset base can better manage the administrative costs, annual legal and tax compliance costs and mandatory annual five percent distributions, which we’ll discuss in detail below.
The time involved in maintaining annual compliance for a private foundation may create a burden for its founders. Additionally, establishing a private foundation can take a year or longer, which may not be within the donor’s timeframe for distributing the initial contribution. A DAF is typically a segregated fund within an existing public charity, meaning there are little to no start-up costs because the gift is made to an existing Section 501(c)(3) organization. Since a DAF is housed in an existing entity, this allows for an immediate contribution or grant to be made once approved.
Family legacy and continuity of the fund is another factor in determining the proper vehicle for a donor’s philanthropic needs. A private foundation can be maintained in perpetuity, which is an important consideration if a donor is looking for an institution to carry on a family name. A private foundation also provides the founder’s opportunities for board selection and succession planning.
Depending on the arrangement with the sponsoring Section 501(c)(3) organization, DAFs may have time limits. Although the fund may carry a family name, a DAF is not legally separate from the sponsoring organization.
3. Grantmaking and control of assets
Assets contributed to a DAF are no longer legally under the control of the donor. As the name suggests, the donor may advise on the use of those assets in the community, but there is no legal obligation for the DAF to abide by that request—although most do. Some DAFs may have geographical or other restrictions on where the funds may be granted. The administrative cost to identify community needs and evaluate qualified organizations is taken on by the sponsoring organization. A private foundation, however, would need to make this assessment internally and bear that cost.
Private foundations must distribute five percent of the fair market value of their investment assets every year. DAFs do not currently have a mandated distribution requirement by law; as a best practice, however, a plan to distribute assets should be implemented to facilitate funding into the community.
DAFs are limited in their ability to make grants and, generally, grants must go to a public charity. A DAF is prohibited from distributing to a natural person. Grants to organizations that are not public charities must be for a charitable purpose, and the DAF must exercise expenditure responsibility to avoid an excise tax. Private foundations are subject to similar rules requiring expenditure responsibility for grants to organizations that are not public charities.
Both DAFs and private foundations face rules regarding scholarships. A DAF is prohibited from making a contribution to an individual, preventing them from making grants for travel, study or similar purposes. A sponsoring organization may, however, maintain a fund for this purpose, and the donor may be an advisor for this fund. A DAF may grant funds to the sponsoring organization’s scholarship fund. A private foundation is permitted to grant scholarships to individuals, provided the private foundation receives approval from the IRS before distributing scholarship funds. With these differences in mind, a donor wishing to provide scholarships will need to determine how much control they would like over a scholarship fund when choosing between a DAF and a private foundation.
Both DAFs and private foundations must also handle prohibitions against certain transactions with the donor or persons related to the donor. The prohibitions are enforced in the form of an excise tax to the donor or the advisor/manager over the DAF or private foundation. DAFs are prohibited from making any distribution that has a direct or substantial indirect benefit to the donor or related persons. Private foundations are prohibited from entering into any transaction, regardless of the dollar amount, with the founder of the private foundation and related persons. There are certain exceptions to this rule for private foundations, but the prohibitions are stricter within a private foundation than a DAF—we’ve discussed
some of the most common risky transactions for private foundations before. When weighing a private foundation or DAF, the intended transactions with a donor or persons related to the donor should be considered to determine if the transaction is prohibited from all entities, or may be permissible in either a DAF or private foundation.
Certain DAFs may also mandate certain investment options, particularly if it is associated with a financial institution. Private foundations may have more flexibility in their investment options, provided they are investing as a prudent investor and not in excessive business holdings.
4. Tax Implications
A donation to either a private foundation or a DAF is tax deductible. A donation to a DAF is limited to 30-50 percent of a donor’s gross income, whereas a private foundation has a 20-30 percent limitation. The value of a cash or publicly traded stock gift is fair market value for both a DAF and a private foundation. The value of a gift of closely held stock or real estate is fair market value for a DAF and limited to a donor’s cost basis for most private foundations. Thus, donation to a DAF may present a greater immediate tax deduction. Private foundations are also subject to a 1-2 percent excise tax on all investment income. This tax is not applicable to DAFs.
The annual compliance filing for a private foundation, Form 990-PF, is a public document that includes the listing of contributors and the amount that was given for the year. DAFs are not required to provide the donor listing to the general public, which allows donors to make anonymous gifts.
Weighing the options
There are many considerations in determining the proper vehicle for continuous philanthropic planning to suit each individual donor’s needs—and ultimately, maximize impact. Before determining the right structure for a donor’s philanthropic priorities, assessing the purpose, along with operating and tax considerations, will help guide donors in the right direction.
For more information, contact Rebekuh Eley, Nonprofit tax managing director, Central Region Nonprofit & Education Practice Leader, at firstname.lastname@example.org.