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Deciding Whether a Private Foundation or Donor-Advised Fund is Best for You by Adam Cohen, CPA

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Posted on August 09, 2023 by Adam Cohen

Charitable giving is a critical component of financial planning that enables individuals to support organizations and causes close to their hearts. While many people donate cash directly to nonprofit charities, those with substantial wealth often go one step further to create a legacy of philanthropy for future generations via a private foundation or a donor-advised fund (DAF). While both these vehicles provide tax advantages, it is essential to understand when one may be a better option than the other based on an individual or family’s unique circumstances.

Private Foundations

A private foundation is an independent 501(c)(3) tax-exempt entity like a public charity, structured under state laws as a non-profit corporation or charitable trust. As such, it is typically funded by an individual, business or small group of people and governed by a board of directors or trustees responsible for managing, investing and making grants of foundation assets to other charitable organizations or individuals for a charitable purpose. Funders may not receive any financial benefit from the private foundation’s assets. However, they may be hired as employees and paid a “reasonable salary” for the services they carry out on behalf of the foundation. In fact, private foundations may employ other individuals to oversee critical day-to-day activities, such as a CEO, CFO or others responsible for investment management, grant-making and programming.

The board or trustees of a private foundation must also abide by stringent regulations, such as filing annual tax returns and ensuring the entity annually distributes at least 5 percent of its assets on charitable activities, including related administrative and operational expenses and grants made to public charities. Failure to meet this annual minimum distribution requirement (MDR) will result in a penalty of 30 percent of the undistributed amount.

From a tax perspective, a private foundation is subject to tax on its investment income at 1.39 percent and federal unrelated business income at 21 percent plus state income tax. Individuals who donate assets to the foundation receive a charitable tax deduction in the year of their donations equal to 30 percent of adjusted gross income (AGI) for cash contributions or 20 percent of AGI for long-term appreciated assets.

Donor Advised Funds

A DAF is an investment account operated and administered by a sponsoring nonprofit organization for the sole purpose of supporting IRS-qualified charities selected by individual donors. Essentially, donors make irrevocable contributions of cash, stock, bonds, real estate or other alternative assets to a DAF of their choosing and receive an immediate income tax deduction of 30 percent of their adjusted gross income for long-term appreciated assets and 60 percent for cash. Donations of long-held, highly appreciated assets are considered charitable gifts that also enable donors to reduce or eliminate capital gains tax they otherwise would have incurred if they had sold them.

DAF sponsors invest and manage donors’ contributions, which grow tax-free outside of donors’ taxable estates, and make grants to donors’ favorite organizations and causes on the schedules donors set. In this sense, donors maintain the ability to advise how sponsors invest their assets, where they are distributed and when. When donors pass away, they may direct sponsoring organizations to distribute any remaining assets in full to the charities of their choice, or they may decide to keep the funds in place to create a legacy of giving for future generations. For the latter option, donors may divide their funds between their beneficiaries, allowing family members to support the charities that match their unique passions and values.

Which One is Right for You?

When determining whether a private foundation or DAF is better suited to your needs, consider the level of involvement and control you wish to have over your charitable decisions. For example, a private foundation requires you to commit substantial time, resources and upfront costs to manage the foundation’s assets and hold required annual meetings. In contrast, a DAF is a turnkey option that provides a staff of employees to oversee charitable operations and management. Therefore, private foundations offer far greater control over their philanthropic investments than a DAF. Still, that level of oversight and control comes with the costs of lower tax benefits and a lack of anonymity when it comes to your personal finances and giving decisions. Ultimately, the decision should be made under the guidance of your trusted advisors and accountants who understand your short and long-term philanthropic needs and goals.

About the Author: Adam Cohen, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he works with closely held businesses and non-profit charities, hospitals and family foundations to maintain tax efficiency while complying with federal and state regulations. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or info@bpbcpa.com.