This article explores two strategies for family philanthropy, the Private Foundation (PF) and the Donor Advised Fund (DAF) and how these effective and meaningful tools for family philanthropy can help your clients increase the likelihood for the successful transfer of their family wealth. Most material on this subject addresses these two strategies as an “either or” proposition, i.e. either a PF or a DAF. We will explore how these two options can work alongside of, complement each other, giving the client “the best of both worlds.”
Americans are currently experiencing the greatest transfer of wealth in history. Statistics paint the picture: An estimated $59 trillion will pass from an aging generation to younger generations by 2061, including $21 trillion destined for charities. At its peak between 2030 and 2045, 10 percent of the total wealth in this country is expected to change hands every 5 years.
This massive transfer of wealth between generations presents significant challenges for the parents or grandparents who now own this wealth, the heirs and charities who will be beneficiaries of transferred wealth, and the professional advisors who will guide their clients through this transfer and, ideally, remain as trusted advisors to the heirs after the wealth eventually transfers.
Role of Philanthropy
In their book, Philanthropy, Heirs & Values, authors Roy Williams and Vic Preisser make a strong argument for family philanthropy and its role in preparing heirs for their inheritance. These studies showed how families used their philanthropy as a tool to educate the next generation about successful wealth-handling and to ensure their values are preserved for generations to come.
Studies show that using philanthropic tools to educate heirs and prepare them for the consequences of inherited wealth substantially increases the odds for successful transfer of family wealth. Earning the loyalty of the heirs during the remaining lifetime of the parents or grandparents increases the financial advisor’s chances of retaining management of the financial and philanthropic assets that will eventually be transferred to the heirs.
When it comes to establishing an appropriate vehicle for family philanthropy, the two most often chosen are Private Foundations (PF) and DAF (DAF). Both have their distinct advantages, as well as some drawbacks. What is most intriguing is how well the two options can work together to give the client the best choice.
Triggered by the enormous wealth accumulated in the early 20th century and continuing into the 21st century, the PF has long been considered the gold standard of family philanthropy for families of significant wealth. The hallmark of the PF is the control it offers donors in the selection of board members and the charitable organizations that benefit from its support, as well as the ability to continue family involvement over successive generations.
In the DAF, the donor makes a contribution to an IRS-recognized public charity (the “sponsor”) and retains the privilege to “advise” the sponsor on the administration of the DAF. The key word here is “advise”. By giving up “absolute” control, the donor enjoys “virtually” all the benefits of a private foundation without the complexity, costs, lower tax benefits, lack of privacy and stringent IRS rules of a private foundation.
Tracing their origin to community foundations, it was only 30 years ago that DAFs began to emerge from obscurity and now are the most popular, fastest growing vehicle for family philanthropy in America, currently outnumbering PFs by eight to one.
The Symbiotic Relationship of a PF and a DAF
Too often, donors view PFs and DAFs as alternatives, when in fact, they can use them both as complementary vehicles to accomplish different purposes. There are advantages to a PF and a DAF working together. For example, to facilitate charitable gifts of highly appreciated illiquid assets, advisors are increasingly using DAFs as a complement to PFs. In addition, there are certain things a donor can do in private foundation that cannot be done, or done as well, in a DAF. The reverse is true as well. So, by using PFs and DAFs together, the donor has the best of both worlds and can select the giving vehicle that works best for a given situation. Donors who want to maintain an existing PF, or contemplate establishing a PF should consider incorporating a DAF as part of the family’s overall philanthropic structure. Together, the relationship is symbiotic. Together, they provide a balance that can only be achieved by the two working together.
Considerations for Foundation Philanthropy
High net worth families often make substantial charitable gifts each year in the form of checkbook charity or by gifting appreciated stock. However, if illiquid assets make up the bulk of their net worth, these complex assets can create a number of issues.
Donors may be concerned that their favorite small charity can’t accommodate the gift or sale of these assets efficiently. Sometimes illiquid assets have a limited market or require sophisticated liquidation techniques involving special tax, legal and financial considerations. Beyond that, families may not be satisfied with simply turning their money over to one charity to use as the charity sees fit. They’re concerned about the possibility that their grants may be used for other charitable projects than they intended or that the residual assets will be managed poorly.
Donors often want to support more than just one charity — and sometimes more than one community. Also, they may not want to contribute the entire asset to any one charity, but rather just a portion.
In addition, families may want continuing involvement that will permit future generations of the family to participate in an ongoing philanthropic plan. Philanthropy is a useful tool in helping educate heirs on the responsibility of inheritance. Expert studies show that using philanthropic tools to educate heirs and prepare them for the consequences of inherited wealth substantially increases the odds for successful transfer of family wealth.
To resolve these issues, families are seeking solutions that permit their ongoing involvement in how the assets are managed, liquidated and reinvested. They want flexibility with accountability. They want flexibility in their grant making. They want a way to support multiple charities — now and into the future. And of course, they want to maximize the tax advantages of their philanthropic program. Both the PF and the DAF can help the family deal with these important considerations.
Establishing a Companion DAF
Advisors can help clients who have an existing PF establish a “companion DAF”, that is, a DAF set up right alongside the PF. The process for setting up the companion DAF is simple and quick. Typically, DAFs can be established in week depending on the complexity of the asset. (Speed and ease of set up become important when your client has year-end time constraints.)
DAFs need a sponsor, but not all DAF sponsors operate alike. Some are more restrictive and less “donor friendly” than others. Sponsors include (a) community foundations, (b) charitable entities of for-profit financial institutions, (c) single-issue national charitable and religious organizations and (d) national independent sponsors that aren’t affiliated with for-profit financial institutions or other charities.
The board of the PF can become the advisor to the companion DAF, and the DAF can carry the original name of the PF. If anonymity is preferred, another name can be used. For donors who want full recognition of their family grantmaking, some DAF sponsors will create a letterhead – to compliment the look and feel of the PF.
DAFs are considered public charities for tax purposes. Because the donor’s liquid or illiquid asset is often highly appreciated, the designation of the DAF as a public charity carries with it significant tax advantages over PFs. The good news is that the DAF can work alongside the PF leaving more assets available for their combined charitable grantmaking.
Much of the wealth in this country is in the form of highly appreciated illiquid assets: family businesses (C-Corp and S-Corp shares, LLC and LP interests) and real estate. For many financial advisors, illiquid assets can represent a significant portion of a typical client-family’s net worth – but since it’s illiquid, the financial advisors cannot manage it.
If the client is contributing appreciated illiquid assets to the companion DAF, the tax deduction is valued at fair market value (FMV). If those illiquid assets are contributed to the PF, the deduction is limited to the donor’s basis. Therefore, given what is usually a large difference in value between the donor’s basis (cost) and FMV, a gift of illiquid assets to a DAF results in a substantially larger deduction – and thus, more money is available for grantmaking.
Advisors can help clients set up a companion DAF to the PF and contribute all or a portion of the illiquid asset. For example, the donor may contribute a portion of his closely held shares or an undivided partial interest in real estate. Donors may prefer the DAF for its higher annual adjusted income deduction of 60 percent of adjusted gross income (AGI) for gifts of cash – 30 percent for gifts of other asset types) relative to PF limits of 30 percent and 20 percent.1 (Both vehicles allow a five-year carryover of unused deductions.) Gifts to a DAF — as companion to the PF — offer other advantages as well.
Assets in a DAF aren’t subject to the excise tax on net investment income, and DAFs aren’t required to make a minimum annual distribution. In the aggregate, grant payouts as a percent of assets of DAFs are typically in the range of 20% per year. Administrative fees for the DAF are typically less than operating costs of the companion PF.
From a tax perspective, gifting illiquid assets to a DAF offers no advantage over a direct gift to any public charity. However, the DAF and the PF allow the donor to retain much greater flexibility than a direct gift: for example, ongoing family involvement and investment flexibility. It also gives the family an opportunity to support many charities or easily change the recipient charity should the goals of the donor cease to coincide with the mission of a particular charity.
The PF donor has a great deal of flexibility in where the assets are custodied and how they are managed. Not all DAF programs are alike in this regard. Many offer only a limited menu of proprietary pooled investment options or mutual funds. Others offer the flexibility of separately managed investment accounts – typically only on what are usually much higher account sizes. A few sponsors allow the donor to recommend the financial advisor and the familiar investment platform and offer the flexibility of open architecture investment.
There is no privacy with a PF. Everything about a PF is public. Anyone can use the internet to access a PF’s 990PF tax return and determine asset holdings, names of directors and key employees (and their compensation), administrative fees paid, grantee organizations and grant payments and much more. This information opens the door to solicitations from prospecting consultants and grant seekers. Many donors are concerned about being inundated with grant requests. This availability of information can be an issue for many donors or family members who treasure their privacy.
Privacy is a distinguishing feature of the companion DAF. Your client can choose to support their favorite charities with full recognition or with anonymity on a grant-by-grant basis. The client can even use the DAF to support causes not favored by other family members or charitable causes outside the scope of the PF. Through the life cycle of the PF, donors may establish separate DAFs for family members with other philanthropic or geographic interests apart from those of a PF. PFs typically make grant disbursements quarterly or semiannually. Most DAFs are more flexible; some process grants daily.
Tax-Filing and Annual Distributions
In addition to requiring PFs to file the annual IRS 990PF tax return, some states require PFs to file an audited financial statement, which adds complexity and cost. In contrast, the companion DAF doesn’t require a separate tax return or state filings. The sponsoring organization files a consolidated return on behalf of all of its DAFs. This is key to the DAFs feature of maintaining the privacy of the donor.
PFs, by law, are required to make an annual 5 percent minimum distribution. DAFs don’t have this IRS restriction – there’s no minimum distribution requirement (although sponsors typically report aggregate distributions between 15 percent and 20 percent or more).
The 5 percent minimum distribution can become a double-hit burden when the corpus of a PF sustains portfolio losses in a down market environment and the PF satisfies its 5% payout requirement. Grants made from the PF to the companion DAF can be used to satisfy the minimum requirement. (Note: The transfer of assets from a PF to the companion DAF is a one-way street. Generally, the DAF can’t make distributions to a PF.)
Because of the complexity of the compliance and reporting rules that a PF must meet, the administrative costs and taxes that are incurred establishing and maintaining the PF typically exceed those of the companion DAF. As a result, the DAF has more dollars available for grantmaking.
Moving Funds from a PF to a DAF
It’s interesting to note that IRS records show that nearly two-thirds of the private non-operating PFs in the country fall below the $1 million threshold. In recent years, many donor advised fund sponsors are reporting increased funds being transferred from PFs.
Market volatility and uncertainty may give your clients pause for thought. A significant downturn can reduce assets at many PFs to such a level that maintaining a PF is no longer efficient or prudent.
Other reasons for moving funds from a PF to a DAF include:
- The PF’s original purpose no longer has the urgency it once did.
- The original founder may be slowing down, and the children or grandchildren may not share the founder’s passion.
- Busy schedules and geographic dispersion make it increasingly difficult to provide the required administrative attention.
- The founder’s desire that children and grandchildren focus on the family’s philanthropy, not on the PF’s administration.
In terminations, professional expert legal advice is recommended to comply with state requirements, which vary by state. For a partial transfer, all it takes is a grant to the established companion DAF.
As trusted advisors to clients, you are challenged to align your clients’ charitable goals with the appropriate solution to carry out those goals. This may involve a combination of charitable vehicles.
We believe there is a compelling case for considering DAFs as part of your clients’ charitable giving program. Although every donor’s situation is unique, DAFs can provide an attractive, tax-advantaged, and cost-effective complement to the PF, while making it easier for your clients to achieve their goals for charitable giving.
Note 1: Under the CARES Act, donors can deduct 100% of AGI for cash gifts given directly to public charities in 2020. Gifts to DAFs, supporting organizations and private foundation do not qualify for the 100% AGI limit.
In addition to DAFs, iGiftFund offers a variety of gift fund options that are donor funds but not DAFs and thus qualify for the higher AGI limit for 2020. Learn more about iGiftFund’s unique solutions and how we can work with you.
Call me at 800.810.0366 or email me at philtobin@iGitFund.org today.