When it comes to charitable giving, there are two commonly considered options: private foundations and donor-advised funds. Both offer tax incentives, encourage charitable gifts and allow you to support the organizations that you care about. However, these two foundation types are different in many ways that impact charitable function, donor control, administrative cost and general complexity. Understanding these differences may help you choose the right structure for your charitable legacy.
What Is a Private Foundation?
In its simplest form, a private foundation is a 501(c)(3) tax-exempt organization established by an individual, family or corporation in either corporate or trust format to receive and manage charitable donations and to make grants to public charities and/or to carry out charitable activities. Unlike public charities, private foundations typically receive their funding from a single or related source—a family endowment or corporate contributions—and make charitable grants to other 501(c)(3) public charities. They operate independently, establish their own charitable missions, grantmaking strategies and make their own investment decisions. All of which means that it can be a very personalized approach to philanthropy. However, the increased control comes at a cost.
Pros of Private Foundations:
- Control: Founders maintain authority over grantmaking, investment decisions, and governance. They can create specific funding priorities, ensuring their vision is carried out over time.
- Legacy Building: Families can establish long-term philanthropic traditions, involving multiple generations in decision-making. This can instill values of generosity and service in younger family members.
- Broader Giving Options: Private foundations can support a wider range of causes, including direct scholarships, program initiatives, and even international giving. Unlike DAFs, some private foundation formats can also engage in direct charitable activities, such as running their own programs or funding research projects.
- Perpetuity: Many foundations are designed to exist indefinitely, creating an enduring impact for generations.
Cons of Private Foundations:
- IRS Red Tape: Because private foundations are controlled by a tightly-held, family or related board of directors or trustees, the IRS places very restrictive regulations on how a private foundation is allowed to operate. Restrictions are in place to maintain activity only related to its tax exempt purpose, tight regulations on self dealing and private inurement, employment, as well as mandatory charitable distributions and excise taxes on net investment income. In short, the IRS does its best to restrict and keep private foundations from operating outside of the intended charitable lines.
- Administrative Burden: Foundations require annual tax filings, regular board meetings, and compliance with strict IRS regulations. Managing these responsibilities often requires hiring staff or third party consultants to help maintain compliance.
- Operating Costs: The expenses associated with legal fees to set up and operate, staff salaries, third party administrators and record-keeping can be substantial. Even small foundations must dedicate significant resources to compliance and governance.
- Limited Tax Deductions: Donations to private foundations can be limited to cost basis, except for donations of cash and publicly traded stock. The limit at which they can be deducted annually is less than gifts to DAFs or public charities. Deductions annually are limited to 30% of AGI for gifts of cash and 20% for gifts of appreciated property (cost basis only).
- Mandatory Payout Requirements: Private foundations must distribute at least 5% of their assets annually to maintain tax-exempt status. This requirement ensures funds are used for charitable purposes but can be a challenge in years of economic downturn.
- Public Scrutiny: Since private foundations must file Form 990-PF, their financial activities, including salaries and grants, and donors are all publicly accessible.
What Is a Donor Advised Fund?
A donor advised fund (DAF) is a charitable giving account that allows ongoing donor involvement. A DAF must be sponsored by a qualified 501(c)(3) public charity that operates a DAF program. Over time, donors can donate assets into the DAF and recommend to the DAF sponsor where annual gifts are sent to qualified charities. DAFs are simple, easy to use, require no tax filing on the donor’s part and allow families to engage in charitable giving in a very friendly format.
Pros of Donor Advised Funds:
- Easy: DAFs simple to set up and administration is provided by the sponsoring organization that handles compliance, investment management, grant distributions and tax filing. DAFs are perfect for donors who want to give charitably, receive tax benefits all without managing an organization.
- Immediate Tax Benefits: Donors receive an immediate income tax deduction when they contribute assets to a DAF. These income tax deductions are at the highest allowable level, the same as if they were given directly to a public charity. Income tax deductions for assets are based on fair market value. Great for tax planning in high-income years. Deductions annually are limited to 60% of AGI for gifts of cash and 30% for gifts of appreciated property at fair market value.
- Cost effective: Compared to private foundations, DAFs have lower start-up costs and no legal fees. No board meetings, tax filings or operational expenses to manage by the donor.
- Investment Growth: Funds in a DAF can be invested, and donations can grow tax-free over time before being granted to public charities.
Cons of Donor Advised Funds:
- Limited Control: While donors can recommend grants, the final decision is with the sponsoring organization. A donor must understand any limitation published by the sponsoring organization.
- Restricted Giving: For the most part, DAFs can only give grants to IRS-approved 501(c)(3) public charities. No direct scholarships can be awarded and no international can be made directly unless done through approved 501(c)(3) intermediaries.
- Investment Limitations: Donors may have fewer options for managing their funds than private foundations. They must understand the investment policies of the DAF sponsoring organization. Some organizations may limit donor involvement regarding investments to pooled allocations. Other sponsoring organizations allow for segregated investment accounts and even allow donors to use their trusted investment advisors.
- No direct operational activities: Unlike some forms of private foundations, DAFs are not allowed to directly run charitable programs or hire staff to carry out projects. However, in partnership with other 501(c)(3) public charities, donors can still put boots on the ground and get involved with those organizations that their DAF financially supports.
Legal and Tax Considerations Defined
Although both of these types of giving vehicles offer income tax deductions, they are treated differently in the eyes of the IRS. Here are some of the key differences:
- Private foundations allow deductions of up to 30% of adjusted gross income (AGI) for gifts of cash and 20% for gifts of appreciated assets.
- DAFs allow the maximum deduction limits of up to 60% of AGI for gifts of cash and 30% for gifts of appreciated assets.
- Private foundations are limited to cost basis only deductions on gifts of anything other than cash or publicly traded stock.
- DAFs allow fair-market value deductions on gifts of appreciated assets such as private business ownership and real estate.
- Private foundations are subject to an excise tax on net investment income, whereas DAFs are not.
- DAFs allow donors to remain anonymous when making grants, while private foundations must disclose grant recipients in public filings.
- Private foundations are required to file a Form 990-PF annually where DAFs do not file individual tax returns and are included in the sponsoring organizations Form 990.
Making the Best Decision for Your Charitable Giving
Deciding between a private foundation and a DAF can be a difficult decision. Some individuals can’t fully decide and end up setting up one of each for different charitable giving, operational and tax purposes. Key things to remember are:
- If you seek full control, long-term family involvement, and broad giving options, a private foundation may be the right choice. It provides autonomy and flexibility but comes with increased responsibility, compliance and cost.
- If you prefer ease of use, immediate tax benefits at the highest level, and low administrative burden, a donor advised fund offers a streamlined, effective solution. It allows for hands-off giving while still supporting meaningful causes.
- If you have appreciated assets to donate other than cash or publicly traded stock, such as private business interests or real estate, a private foundation may not be the best option as your income tax deductions may be limited to cost basis deductions only.
Start Your Philanthropic Journey Today
Whether you choose the autonomy of a private foundation or the ease of a DAF, the end goal is the same… to make a lasting impact on those organizations that your charitable funds will support. Carefully planned giving, combined with the tax benefits and the creation of a lasting family legacy of giving can be powerful and impactful as you carry out your financial and charitable plans.
Not sure which one is best for your charitable goals and financial strategy? Talk to your financial advisor or philanthropy specialist to get clarity. Our team is available today to help you make the right move forward. Contact us to learn more.
