Compassion is one of the hallmarks of the medical profession and physicians, once they’ve attained a measure of professional success, often want to give back to the communities they serve. However, writing checks to a handful of charities is not always the best way to make a difference, nor is it the ideal for your fiscal well being. To maximize your philanthropic impact while enjoying significant tax savings and estate planning benefits, you’ll want to explore charitable vehicles such as donor-advised funds (DAFs) and private foundations.
Defining the Terms
Because DAFs and private foundations are two of the most popular choices, they are often compared to each other as competitors—a tactic that could lead you to conclude that they’re very similar instruments. In fact, they have very important differences and applications.
What’s a Donor-Advised Fund?
A DAF is a giving account that is housed and managed within a public charity, such as a community foundation, financial services company, or independent gift fund (e.g., university or church) and their features vary widely. Many financial services firms have their own DAFs and advertise them aggressively because they bring assets under management. Although DAF policies vary, and there is wide discrepancy in the way they are managed, they are typically aimed at smaller asset levels (the amount required to open a DAF might be as little as $5,000). Donors who hold such accounts can make grant recommendations (hence the “advised” in “donor-advised funds”), but technically, control over assets and grants rests with the DAF’s sponsoring organization, which is free to accept or reject any grant recommendation. There’s currently no distribution requirement for DAFs but in some cases, donated funds will be liquidated by the custodian institution if donors fail to recommend grants after a period of years.
What Is a Private Foundation?
A private foundation is a distinct, tax-exempt legal entity with its own charter, mission, guidelines, and bylaws. The individual, family, or business that established the foundation controls it. Usually, a private foundation is set up in perpetuity, and can be kept under the family’s control (along with the assets, which benefit from tax-free growth) for generations. Because it is a distinct legal entity, decisions about grantmaking, investments, and board composition are under the control of the founder and board members. Foundation Source, a company that specializes in the establishment and administration of private foundations, enables its clients to start foundations with a minimum initial funding of $250,000, (the vast majority of all private foundations—over 60 percent—have assets under $1 million). Private foundations are required to annually grant a minimum of 5% of their net average assets from the previous year, although certain expenses such as site visits, conferences, leasing office space, and even compensating family who serve as directors or staff, can count towards that requirement.
Weighing the Differences
Beyond these fundamental differences, there are specific features of DAFs and private foundations that might make one or the other a better choice for your needs. Let’s compare some of the more salient ones.
The tax benefits of investing in a DAF versus a private foundation are limited to one’s Adjusted Gross Income (AGI). For a cash gift to a DAF, the personal deduction is limited to up to 50% of the donor’s adjusted gross income AGI; for a gift of appreciated securities, the deduction is up to 30% of AGI. Typically, donations to a private foundation are tax deductible up to 30% of AGI for cash, and up to 20% for appreciated securities. Few people donate at a level where this makes a difference because contributions that exceed these limits can be carried forward for up to five years for any remaining portion of the deduction. For donors who contemplate contributions that bump up against the AGI limits, it is especially important to speak with a personal tax advisor.
Private foundations are subject to up to 2% tax on investment income; DAFs are not. However, growing assets is not typically the aim of a DAF. It should be noted that although excise taxes on foundation assets are minimal, they are a consideration for some. Consider a foundation earning 5% income on $1 million in assets totaling $50,000. The excise tax on that income would be $1,000 – granted, not a considerable sum, but a factor worth considering.
Although there are exceptions (again, DAFs vary widely in their capabilities and policies), DAFs are typically limited to straightforward granting to U.S.-based, 501 (c)(3) nonprofits. A private foundation may be a better choice for those who want to move beyond the basics. The IRS allows foundations to give directly to individuals in need, run their own scholarship programs, give internationally, make loans for charitable purposes, and even run their own charitable activities.
When it comes to investment control, foundations and DAFs differ as well. DAFs usually offer a choice of investment options based on a selection of mutual funds or investment pools not dissimilar from a 401(k). One’s financial advisor may make recommendations about investment allocations within this pre-defined pool. For larger accounts (typically $250,000 or more), the donor may be able to nominate an independent advisor to manage the investment portfolio, subject to the sponsoring organization’s authorization. Some allow donors to manage a portfolio of stocks, bonds, and mutual funds. But donations of real property and other non-marketable securities (like real estate, jewelry, and artwork) typically have to be sold and may incur additional brokerage fees.
Private foundations can be funded with and continue to hold nearly any type of asset including partnerships, real estate, and jewelry, closely held stock, stock options, art, and other valuables. A foundation exercises total control over its investment strategies, vehicles, policies and managers. It may also engage in mission-related and socially-responsible investing. Financial control rests entirely with the donor, and the donor retains his or her own wealth advisor. Through their private foundation, donors can follow any investment strategy they choose so long as they follow the prudent investor rules, don’t take extreme risks, or engage in risky or jeopardizing investments.
For donors who want more control over grantmaking, investment decisions, and governance, private foundations may be a better choice than DAFs. However, the downside of control is accountability. Grants made by private foundations are listed in annual returns and published in public records; grants made through DAFs are completely anonymous. DAFs are public charities and are therefore subject to less regulation than private foundations. And because DAFs are under the control of sponsoring organizations, the donor doesn’t have to worry about compliance or running afoul of the IRS. Private foundations, by contrast, have to make sure their grantmaking complies with regulations concerning everything from grantee eligibility to self-dealing.
Fortuitously for donors who lack the expertise, time, or energy to devote to foundation administration, companies have emerged that provide the same sort of turn-key services that were once only available with donor-advised funds. Thanks to advanced technology and the outsourcing of services that automate and simplify the way private foundations are operated, donors can set up a foundation in a matter of days and enjoy the control and flexibility that a private foundation can offer without any of the traditional organizational complexities.
Whether your philanthropic and financial planning goals are best served by a DAF, private foundation, or combination of the two, depends on multiple factors. Whereas DAFs offer a lower asset threshold, private foundations offer greater control and flexibility. If you’re unsure about which vehicle to choose, you might want to start with a private foundation. A private foundation may make contributions to a DAF but contributions cannot be made from a DAF to a private foundation. Before making an irrevocable contribution of funds to either charitable vehicle, however, you should consult an independent financial advisor who can offer unbiased advice on the best fit for your individual needs.
R. Paul Wilson, CRPC®
President, Advanced Capital Advisory Group, LLC
Registered representative of, and securities and investment advisory services offered through Hornor, Townsend and Kent, Inc. Member FINRA/SIPC. 8040 Hosbrook Road, Suite 300, Cincinnati, OH 45236. Advanced Capital Advisory Group, LLC is independent of HTK.