Donor advised funds (DAF), which are often alternatives to establishing a private foundation, have received much attention in recent years. Their rise in prominence has prompted financial institutions and other public charities to offer DAF arrangements. There are several considerations in choosing a DAF or a private foundation to fulfill a donor’s philanthropic needs. Some of the considerations include:
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 assets within the private foundation or DAF. Private foundations are separate legal entities and carry the administrative costs of formation, operation and annual reporting. A private foundation with a larger asset base can better manage the administrative costs, costs of annual legal and tax compliance, and the mandatory annual five percent distributions.
The time involved to maintain annual compliance for a separate entity may create a burden for the founders of the private foundation. Additionally, the establishment of a private foundation can take a year or longer to complete 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. There are little to no start-up costs because the gift is made to an existing Section 501(c)(3) public charity. Since a DAF is housed in an existing entity, this allows an immediate contribution or grant to be made once approved by the DAF.
Family legacy and continuity of the fund is another factor in determining the proper vehicle for philanthropic giving. A private foundation can be maintained in perpetuity, and be an institution that carries on a family name. A private foundation provides opportunities for board selection and succession planning, as well. However, depending on the arrangement with the sponsoring Section 501(c)(3) organization, DAFs may have time limits for the funds. And although it may carry the family name on the fund, a DAF is not legally a separate organization from the sponsoring organization.
Grantmaking and control of assets
Assets contributed to a DAF are no longer legally under the control of the donor. 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 DAF’s may have geographical or other restrictions on where the funds may be granted. The administrative cost to identify community needs to make a greater impact and evaluate qualified organizations is housed within the sponsoring organization of the DAF. A private foundation 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; although 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.
There are rules for both DAFs and private foundations regarding scholarships. A DAF is prohibited from making a contribution to an individual, which prevents DAFs from making grants for travel, study, or similar purposes. However, a sponsoring organization may 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 Internal Revenue Service 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 have 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 substantially 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 on our Nonprofit Standard blog. 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 when a DAF 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.
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 which 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. A 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, includes the listing of contributors and the amount that was given for the year. Since the Form 990-PF is a public document, donors should consider this requirement if privacy is important to them. DAFs are not required to provide the donor listing to the general public, which allows donors to make anonymous gifts.
There are many considerations in determining the proper vehicle for continuous philanthropic planning. Assessing the purpose, along with operating and tax considerations, will help guide donors in the right direction.
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This article was written by Rebekuh Eley, CPA, MST, and originally appeared in BDO USA LLP’s Nonprofit Standard Newsletter – Fall 2016. Copywrite 2016 BDO USA, LLP. All rights reserved. www.bdo.com.
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