Clients create charitable organizations for many reasons. The two reasons we hear most often are (i) charitable giving, and (ii) family legacy planning. Family legacy planning can mean different things to different people but generally, clients are looking for a vehicle to encourage future family unity and philanthropic engagement. A variety of options exist to accomplish these goals for clients and there is no singular answer as to which is the best option. Factors such as expected funding, desired control, and intended grants should be considered in the analysis. However, for most clients, either a donor advised fund (“DAF”) or a private foundation (“PF”) is generally the appropriate vehicle.
Donor Advised Funds
DAFs are not independent charitable organizations; rather, DAFs are funds within a sponsoring organization, which is a public charity (“PC”). To form a DAF, a donor contributes property that is maintained as a distinct fund custodied at the sponsoring organization, bearing a name selected by the donor (i.e., “Smith Family Fund”). Additional property may be contributed to the fund over time.
Private Foundations
PFs are charitable organizations that generally receive assets directly or indirectly from one source. PFs may be operating or non-operating. Operating PFs primarily provide services to benefit the public, rather than make grants. Non-operating PFs are the traditional PFs that most people think of when hearing the term “foundation” and generally only make grants to PCs.
Differences to Consider
Tax-Exemption
Generally, tax-exempt organizations are exempt from income taxes (ignoring UBIT), while donors may receive income tax, gift tax, and/or estate tax deductions on charitable contributions. The income tax deduction limitations are higher for DAFs (and PCs) than for PFs, while some other 501(c)’s are ineligible for donor income tax deductions. If a client is primarily concerned with maximizing income tax deductions, a DAF may be a better option. No limitations apply to estate and gift tax deductions for DAFs and PFs.
Grants
A key distinction between DAFs and PFs is the control over the recipient of grants. All grants made by a DAF are in the absolute discretion of the sponsoring organization, compared to a PF, which is controlled by its board or trustees. A DAF has one or more advisors to provide grant recommendations to the sponsoring organization, which are often followed because the advisor is often the client or the client’s family. However, the sponsoring organization is not obligated to take suggestions from the advisors. In contrast, the decision makers of a PF have control over grantmaking, subject to specific PF regulations, such as the 5% distribution requirement (discussed below).
Leadership Succession
When creating a DAF, the donor may designate a succession of advisors. Depending on the sponsoring organization, the succession may be as detailed as the donor desires, essentially mimicking a PF structure. PFs may be structured as trusts or corporations. The trust form usually is the best option for clients that are concerned with a leadership succession, as the trustee succession can be extremely detailed, avoids corporate formalities, and can easily be amended over time. For example, clients can include specific appointment provisions for different family branches to ensure that each branch has a trustee position. In addition, clients can require specific eligibility and participation requirements to become a trustee.
Name Recognition and Anonymity
To some clients, family legacy planning may mean name recognition. Some people think of naming a building when they hear “name recognition.” Others think of well-known organizations, such as the Rockefeller Foundation, which are known for having substantial assets and making sizeable grants. However, some organizations may prefer their asset size or grant recipients to remain unknown. For many PFs, this is not possible. PFs are required to file a tax return (Form 990-PF), which is often published online by the IRS and GuideStar. As a result, information about the PF, such as officer identity, substantial contributors, grants, and asset information is publicly available. To some organizations, a priority is anonymity. In contrast, DAFs do not file a distinct tax return and, consequently, are not found in the IRS tax-exempt entity search or on GuideStar. The DAF’s sponsoring organization files a tax return but can keep personal information related to each DAF private.
Regulations
There are limitations to which organizations and for what purposes DAFs can make grants, such as precluding non-operating PFs and buying tables at events. However, the sponsoring organization’s ultimate control over grantmaking should prevent such noncompliant grants from occurring.
The IRS imposes significantly more regulations on PFs than on DAFs. Failure to be aware of such requirements could result in financial penalties and/or loss of tax exemption. The need to adhere to the complex regulations can result in heightened costs associated with the ongoing maintenance of PFs. Below are three relevant regulations, but there are many more.
- Self-Dealing: Self-dealing occurs when a PF participates in a transaction with a disqualified person (“DQP”). There are six types of such transactions and particular attention should be given to the payment of compensation. For example, many clients intend to hire their children to work for the PF. However, this is highly scrutinized because children are DQPs.
- Distribution Requirement: A PF generally must distribute 5% of its total assets annually (with a few exceptions, but always including investment assets). This requirement should be considered when funding a PF. For example, $20 million requires that $1 million is distributed to charity annually (ignoring asset growth). As PF assets grow, the due diligence required to make responsible grants increases dramatically. However, a client could simultaneously create a DAF and, in the event the PF quickly needs to distribute assets, the DAF would be an eligible grant recipient.
- Excess Business Holdings: A PF and DQPs should not collectively own more than 20% of a partnership or corporation voting stock. Several ownership scenarios are excluded from the definition. For example, when a PF receives the business interest by bequest or gift, the penalty is delayed for five years to provide time to dispose of the interest. This is a very complicated issue that needs to be evaluated by a client’s advisors.
Not every charitable vehicle is appropriate for every client. Whether your client currently has a charitable vehicle or is thinking about creating one, we can help evaluate and implement the best structure for your client. Please do not hesitate to contact us.
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