Private foundations versus donor advised funds

In short

A friend of mine once said that giving away money is easy until the day he had to decide how. If you hold a large estate and want to give some of it away, two common tools are a private foundation and a donor advised fund. A private foundation is a charity you create and control yourself. A donor advised fund is an account at a sponsoring charity, where you recommend grants but the sponsor holds the legal control. A foundation gives a family control and a name on the door. A fund brings lower cost and less paperwork. Each one offers a charitable deduction, but the size of that deduction depends on the tool and on what you give. A tax lawyer can run a person's own figures and show how each tool would treat them.

The whole of it

What it is

I once watched a retired grain dealer spend a whole winter deciding between these two, and he told me afterward that the choice was less about money than about how he wanted to feel at the kitchen table. That is a fair way to start. A private foundation is its own legal entity, usually a trust or a nonprofit corporation, set up and funded by one person, one family, or one business. The family picks the board, writes the rules, and chooses the grants. The foundation has its own tax exempt status from the IRS, and it files its own yearly return, Form 990 PF.

A donor advised fund works differently. You give cash, stock, or other assets to a sponsoring charity, which is often called a public charity. That sponsor can be a community foundation or the charitable arm of a financial firm. The sponsor owns the money from that day forward. You get to advise on where grants go, and the sponsor almost always follows your wishes, but the law says the final call belongs to the sponsor. That one fact explains most of the differences between the two.

How it works

If you have ever wanted your name on a building or a scholarship, you know the pull of a foundation. The family sets it up, funds it, and then runs it. The foundation must give away a minimum amount each year, set by federal law under Internal Revenue Code section 4942. Today that minimum is the current figure, which the official source publishes each year of the value of its investment assets. The foundation also pays an excise tax on its net investment income, set by section 4940 at the current figure, which the official source publishes each year. The law bans most deals between the foundation and the people who run it. Those rules are strict. A slip can bring penalty taxes on the donor and the managers.

A donor advised fund asks much less of a donor. The donor opens the account, funds it, and names the advisers. The sponsor handles the legal filings, the audits, and the grant checks. Federal law sets no required yearly payout for the fund as a whole, though a sponsor may set its own rules. Many families like that quiet simplicity. Others feel it hands too much to a third party.

The deduction rules also differ. Gifts to a donor advised fund are treated as gifts to a public charity. That means cash gifts can be deducted up to the current figure, which the official source publishes each year of adjusted gross income, and gifts of long term stock up to the current figure, which the official source publishes each year. Gifts to a private foundation face lower caps. Cash is limited to the current figure, which the official source publishes each year, and long term stock to the current figure, which the official source publishes each year. Publicly traded stock given to a foundation is generally valued at its fair market value on the date of the gift. Stock that is not publicly traded calls for a qualified appraisal. The IRS sets out these valuation rules, so a donor should confirm them before counting on a number.

The numbers, and where to find yours

You have probably noticed that every figure in this field moves with the law. So the limits above come from the Internal Revenue Code and the IRS, and the site fills in the current verified figure for each. Your own numbers come from three places. Your adjusted gross income appears on your Form 1040, and the line number can change from one year's form to the next. The value of any stock or business interest you plan to give comes from a qualified appraisal or a broker statement. The foundation payout rate and the excise tax rate are set by the Internal Revenue Code, in sections 4942 and 4940, and the instructions for Form 990 PF explain how a foundation applies them.

Set up costs differ too. A foundation needs a lawyer to draft the documents and an application to the IRS. A donor advised fund may have no setup fee, though sponsors charge a yearly fee, often set as a share of the balance. A sponsor's fee schedule is public. Read it before opening an account, and check that it matches what the sponsor said in person.

A worked example

Let me tell you about a woman I will call Margaret Hale. She sold her trucking company and has an adjusted gross income of $4,000,000 this year. She wants to give away $1,000,000 in stock that she bought long ago, which has grown well beyond what she paid.

Suppose she gives that stock to a donor advised fund. For the sake of this story, picture the public charity limit on stock gifts at 30 percent of income. Thirty percent of $4,000,000 is $1,200,000. Her gift of $1,000,000 fits inside that, so she may deduct the full $1,000,000 this year. If her top federal rate were 37 percent, the tax saved would be 37 percent of $1,000,000, or $370,000. These percentages are made up for the story. The real ones come from the placeholders above.

Now suppose she gives the same stock to a private foundation. Picture a lower cap of 20 percent of income for stock. Twenty percent of $4,000,000 is $800,000. Her gift is $1,000,000, so only $800,000 could be deducted this year. The other $200,000 carries forward and may be used in later years, up to the same cap. Again, the real percentages are for the IRS and a tax adviser to confirm.

Then comes the payout. Say the foundation holds $10,000,000 and the required payout is 5 percent. Five percent of $10,000,000 is $500,000. The foundation must give away about $500,000 each year to keep its status. Now say the foundation earns $400,000 in investment income and the excise tax is 1.39 percent. The tax is 1.39 percent of $400,000, or $5,560. The foundation pays that cost year after year. A donor advised fund would not owe it, because the sponsor handles those filings.

Where it goes wrong

I have watched good people get tangled in rules they never knew existed. With a foundation, the common trouble is self dealing. A family member may be paid only a reasonable amount for real work, and the foundation cannot lend to or buy from insiders. It also cannot hold too much of one business. That is called the excess business holdings rule, and it can force a sale. The penalty is a tax on the foundation and on the managers who knew about it.

With a donor advised fund, the common trouble is a wrong idea of control. The sponsor owns the money. If a donor asks for a grant that breaks the sponsor's rules, the sponsor can say no. Grants that give the donor a personal benefit, like a ticket to a gala, are not allowed. Another trouble is the gap between giving and granting. A deduction arrives the day the account is funded. The charities a donor cares about may wait years for the money. That is legal. Yet some donors feel uneasy about it. It is a fair question to ask a sponsor.

Both tools also carry a quiet risk. Neither one lets a donor pull the money back. Once it is given, it belongs to charity.

Questions to answer before you leave this page

If you could sit with your own family at the table, what would each person want from this gift, and does anyone want a seat on a board? How much time and staff are you ready to spend each year on filings, grants, and rules? Does your adjusted gross income leave room under the deduction caps for the assets you plan to give? Have you asked a tax lawyer to run your own numbers with the current limits from the IRS? Would you be comfortable if the sponsor of a fund, not you, held the final word on each grant? And when you picture your giving ten years from now, who is standing beside you?