Donor-advised funds are a fast-growing and increasingly popular means of charitable giving thanks to their potential for tax free growth, low administrative burden, flexibility in investment, and ability to donate anonymously. Given the advantages, should donors convert an existing private foundation into a donor-advised fund?
What Is a Private Foundation?
A private foundation is an independent charitable corporation or trust established as a tax-exempt entity under Section 501(c)(3) of the Internal Revenue Code used to make charitable distributions, usually throughout a taxable year. Private foundations are funded entirely through contributions from an individual, family, or corporate donor(s) and can be set up to operate in perpetuity, providing a platform for long-term giving.
Private foundations can be established as either operating foundations or non-operating foundations.
- Operating foundations are directly involved in operating a charitable project or enterprise such as a museum, zoo, or library in a continuing and sustaining manner. Rather than making grants to other organizations, their mission is to spend their investment income on their own charitable projects and initiatives.
- Non-operating foundations don’t usually run their own programs, but instead give back to communities by making grants to public charities, individuals, and other organizations. To qualify and continue as a tax-exempt entity, non-operating foundations are required to make an annual distribution of funds equal to roughly 5% of the prior year’s average net investment assets.
Benefits of a Private Foundation
- Reduced Tax Costs – Private foundations provide donors with a charitable income tax deduction and possible transfer tax deductions for all contributions made to the foundation. Note that the private foundation itself is still required to pay a nominal excise tax of 1.39% on its net investment income.
- Full Control for the Donor – A private foundation provides its donor(s) with final say on all areas of operation, including how assets are invested and distributed, which charities and organizations are supported, and who is involved in the foundation’s governance.
- Lasting Charitable Impact and Legacy – Private foundations are excellent charitable tools for those donors who are interested in establishing a legacy of giving because the donor has complete control over governance, heirs, and loved ones can be included as part of the distribution process. As long as it is funded, the private foundation can continue to give beyond a single lifetime.
What Is a Donor-Advised Fund?
A donor-advised fund is a charitable giving option where donors make irrevocable gifts directly to a sponsoring charity (public charity) that maintains their donor-advised fund account. The donor will receive an immediate charitable deduction for their donations and the money is deposited into an account that can grow in value, allowing funds to be continually granted out to charities.
In exchange for their irrevocable gift to the sponsoring charity, donors receive advisory privileges to recommend which grants to be distributed to qualified charities and can also advise on how their gifts are invested. The donor(s) essentially give up complete control of the fund in exchange for not having to manage the administrative burden. While the sponsoring charity does not have to follow the direction of the donor, their goals and purposes are usually in alignment.
Benefits of a Donor-Advised Fund
- Reduced Tax Costs and Tax Free Growth – Donor-advised funds assist donors in achieving their tax reduction goals by avoiding capital gains taxes and receiving an income tax reduction from their contributions of cash and/or appreciable assets. Donors can also choose to grow their donor-advised fund contributions over time, allowing them to build up more funds to make more donations. The sponsoring charity will also provide the donor with different investment strategies to choose from, based on how they would like to invest their funds and secure tax-free growth for the account.
- Flexible Donations and Investment Opportunities – Rather than make a one-time donation to a single organization, a donor can recommend multiple donations be made to any number of eligible 501(c)(3) organizations (public charities). The donor can recommend that their financial advisor manage the assets of the donor-advised fund in a wide range of investment options. Donors are also allowed to contribute a wide range of assets, including cash or cash equivalents, publicly traded securities or mutual fund shares, real estate, restricted stock, and more to the fund.
- Low Cost and Low Maintenance – Donor-advised funds do not have any initial set-up costs or management fees, and any initial contributions to the fund tend to be lower than required by other charitable vehicles. The sponsoring charity handles all the administrative duties, reducing the responsibilities of the donors and allowing them to concentrate on grantmaking. This does mean that donors do not have complete control over how funds are invested or granted, and may only make recommendations to the sponsoring organization.
Donor-Advised Fund vs. Private Foundation
In weighing which charitable option is the best for a donor, there are a few important question to ask:
- How much control does the donor want to have over their grantmaking?
- How much work does the donor want to undertake? Do they want to hire staff to assist with the administration?
- Which tax deductions will benefit the donor the most?
In general, if a donor desires complete control over all aspects of how funds are distributed, a private foundation is the preferred option. However, if the donor is comfortable with advising (or even prefers to advise) the sponsoring charity, then they may appreciate the advantages of a donor-advised fund. There are a few other important considerations when comparing the two options:
- As private foundations are not required to be governed by a diversified board of directors, donors are able to exercise greater control over the grant-making activities of the foundation compared to other charitable initiatives. In contrast, donor-advised funds are restricted to donating to 501(c)(3) organizations (public charities) and may not donate to individuals.
- The IRS has no requirements for annual payout amounts for donor-advised funds, but does require an annual 5% payout rate of a private foundation’s net investment assets through grants or administrative expenses in order to avoid paying taxes.
- Donor-advised funds allow for a tax dedication at a higher percentage of AGI, 60% of cash and 30% of assets, in comparison to 30% cash and 20% in assets for private foundations.
- It is easier to make anonymous donations with a donor-advised fund, whereas private foundations will list all of their contributions, grantors, and board members on publicly available tax documents.
- The start up time for donor-advised funds is immediate, while private foundations can take additional time to establish. There’s also no startup costs for donor-advised funds, while establishing a private foundation will incur legal and accounting fees.
|Donor-Advised Fund||Private Foundation|
|Donor control||May advise only||Complete|
|Tax deduction for cash||60% of AGI||30% of AGI|
|Tax deduction for appreciable assets||30% of AGI||20% of AGI|
|Required grant distribution||None||Annual distribution of 5% net investment income|
|Excise tax||None||1.39% on net investment income|
|Anonymous donations||Yes||No, records are publicly available|
|Administrative responsibilities||Minimal, advise on grant making and investing||Full and complete|
|Grant recipients||501(c)(3) organizations (public charities) only||Public charities and individuals|
|Start up time||Minimal||Weeks or months|
|Start up costs||None||Legal and accounting fees|
Converting a Private Foundation to a Donor-Advised Fund
As the donor-advised fund does provide some advantages over a private foundation, converting a private foundation to a donor-advised fund can make sense for a donor if they:
- Would prefer lower overhead costs or higher tax deduction percentages
- No longer wish to handle the investment responsibilities of the fund
- Would rather spend more time on grantmaking than administration duties
- Are interested in making anonymous donations
There are a few key steps required to convert a private foundation into a donor-advised fund, such as obtaining conversion approval from the governing body of the foundation as well as state regulators, transferring assets, and completing appropriate tax forms. If you’d like to discuss the specific benefits of either converting from a private foundation or setting up a new donor-advised fund for your donors, contact our team of experts to learn more.
Can a donor-advised fund give to a private foundation?
In certain circumstances, yes. Because assets held in a donor-advised fund must be granted to a public charity, it cannot make contributions to a private nonoperating foundation. However, a donor-advised fund can make grants to private operating foundations.
How easily can a private foundation convert to a donor-advised fund?
The process is relatively simple. All the net assets will need to be granted out from the private foundation to a donor-advised fund account. Then, final tax returns will need to be filed for the private foundation. To read more details, review our white paper on the process.
Is it possible to convert a donor-advised fund into a private foundation?
No, it is not possible. Because donor-advised funds can only make grants to public charities and private foundations are considered private charities, they are not qualified recipients of any funds or assets from a donor-advised fund.
Can I use the name of my private foundation as the donor-advised fund’s name?
Yes, you may use the name of the private foundation as the name for the donor-advised fund.
What are some other charitable options or philanthropic vehicles for donating?
Beyond the donor-advised fund and private foundation, there are a few other popular means of charitable giving:
- Checkbook giving – Also known as direct giving, donating money or assets to a charity is the most straightforward means of giving. However, because there’s no investment opportunities with direct donations, the donor cannot generate funds for future grants or establish a family legacy of giving. As they are one-time payments, checkbook giving also lacks the flexibility of making grants over time.
- Charitable Remainder Trusts (CRT) – An irrevocable tax-exempt trust that can liquidate an asset to create two types of interests: income interest and remainder interest for a current-year personal income tax deduction. The income interest is paid out to a designated beneficiary (such as the creator of the trust) for a lifetime or at the conclusion of the term. The remainder interest is then passed on to a qualified charitable organization of the donor’s choice as specified in the trust document. Qualified charitable organizations include charities, family foundations and donor-advised funds.
- Charitable Lead Trusts (CLT) – An inverse of the remainder trust, this is an irrevocable trust that creates a lead interest as an income for a charity. The trust’s remainder interest then either comes back to the donor or passes to some other non-charitable beneficiary, typically the donor’s heirs. The charitable interest can be designated for the benefit of one or more charitable beneficiaries, including public charities, donor-advised funds and private foundations.
- There are other giving options with their own specific benefits and functions, such as a charitable gift annuity, pooled income fund, and pooled special needs trust. To learn more about these other options, see our page on understanding charitable gift types.