While a private foundation may be an appropriate charitable vehicle for some taxpayers, many may be better served by alternate charitable arrangements. This column briefly discusses alternatives to private foundations.Donor-advised funds
Donor-advised funds, also known as charitable gift funds or philanthropic funds, allow a donor to make a charitable contribution to a specific public charity or community foundation that uses the assets to establish a separate fund. The public charity or community foundation typically receives grant requests from those charities seeking distributions from the advised fund, and the donor suggests which grant requests should be honored. The donor retains the right, generally during his or her lifetime, to make recommendations for using the separate fund's income and principal. However, the donor can only make recommendations; he or she cannot make a binding directive. The fund is advised rather than directed by the donor. Also, the fund is limited to supporting the public charity's exempt purpose.
Law change alert: The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has temporarily increased the limitation on cash contributions to charities from 50% to 60% of adjusted gross income (AGI) for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026. AGI limitations for noncash contributions remain the same during those years.
Planning tip: Under the TCJA, the standard deduction has almost doubled. Combined with the capping of the state and local tax deduction, changes in the mortgage interest deduction, and the elimination of miscellaneous itemized deductions, there is a likelihood that fewer taxpayers will be itemizing for tax years 2018-2025. For contributions to exceed the standard deduction, taxpayers may want to "bunch" or increase contributions on alternating years. One possible vehicle for bunching contributions is the donor-advised fund. Taxpayers can claim the charitable tax deduction in the year of funding the donor-advised fund and schedule grants over the next two years or other multiyear periods.
A donor-advised fund is a fund or account:
- That is separately identified by reference to contributions of a donor or donors;
- That is owned and controlled by a sponsoring organization (see paragraph below); and
- For which a donor (or any person appointed or designated by the donor) has, or reasonably expects to have, advisory privileges as to the distribution or investment of amounts held in the fund or account (Sec. 4966(d)(2)(A)).
A sponsoring organization of a donor-advised fund is an organization that:
- Is described in Sec. 170(c) (i.e., an organization to which deductible charitable contributions may be made other than a governmental entity, without regard to the requirement under Sec. 170(c)(2)(A) that the organization be organized in the United States);
- Is not a private foundation; and
- Maintains one or more donor-advised funds (Sec. 4966(d)(1)).
Donor-advised funds are tax-qualified public charities under Secs. 501(c)(3) and 509(a). Contributions are therefore tax-deductible under the standard rules for public charities. Donor-advised funds offer the following tax advantages:
- The contributions to the fund are tax-deductible immediately even though the fund may not disburse them to the taxpayer's recommended charity right away. Thus, a donor may claim a tax deduction when he or she is in a higher marginal tax rate, while actual payouts from the account can be deferred until later, allowing the account to grow in the meantime.
- If appreciated securities are contributed (either stock or mutual fund shares) that the donor has held for more than a year, the full current market value (FMV) can be deducted up to the 30% AGI limitation. Also, capital gains tax on the appreciation can be avoided.
- The contributions reduce the value of the donor's taxable estate.
- Contributions to donor-advised funds are generally treated as contributions to public charities. Thus, contributions usually qualify for the more favorable 60%, 50%, and 30% AGI limits (as compared to the 30% and 20% limits for private foundations).
In addition to the tax benefits described above, donor-advised funds offer a number of nontax benefits:
- The donor has more control over how the contributions are invested and distributed. The recommendations on which charity should ultimately receive the funds are nearly always followed. (The fund legally can reject a donor's recommendation but rarely if ever will, unless, for example, a charity is designated that is not tax-qualified.) This control is particularly attractive for donors who want an immediate tax deduction but may either need more time to research possible recipients or want to change the organizations receiving the gifts each year.
- Expert advice on grant-making and administrative services may be provided to the donor.
- The fund generally costs little to operate and may appeal to a donor who does not wish to fund a private foundation.
- Donors may have the convenience of being able to defer to their donor-advised funds when solicited for charitable contributions. The donor may simply send a standard response, such as the following: "All my donations are made through my donor-advised funds. Send requests to the following (name and address of fund) for further consideration."
- The donor-advised fund can be established quickly at year end when there is insufficient time to establish a private foundation.
Some donor-advised funds also allow donors to name successor advisers, who can continue to recommend how donations are spent long after the original donor is gone. Preferably, the successor adviser can name yet another successor adviser to follow in his or her footsteps. In this way, control over how contributions are spent can continue indefinitely.
A number of major mutual fund companies have established donor-advised funds. Typically, minimum initial contributions are around $10,000 to $50,000, depending on the fund. Later contributions can be made in smaller amounts. The fund handles all the administrative aspects. Until the contribution principal is spent, it earns income and can grow tax-free.
An account is established in the name of the donor that tracks the balance available for grants. The donor often has the ability to choose how the funds are invested. Assuming the invested funds grow, the donor will be able to grant more to the designated charities than initially invested. The opposite is also true — if the invested funds decline, there is less available for the charities. In any event, the donor's income tax deduction is determined at the time contributions are made. The future performance of the account impacts only the amount that will eventually go to charities.
A donor-advised fund will charge an annual fee to handle the account's investments and to cover other administrative and marketing costs, including any commissions paid to brokers. However, if the funds were in a private foundation, they would be subject to a 1% or 2% excise tax on net investment income.
The tax advantages of donor-advised funds are subject to some degree of risk because there are no clear-cut tax guidelines, as there are for public charities. As a practical matter, it is unlikely that a donor-advised fund affiliated with a major investment house would not be able to successfully defend itself against any IRS challenges. Furthermore, if the IRS revokes the donation fund's tax-exempt status or imposes other restrictions, the effect would generally be prospective. Of course, that is not guaranteed.
Example 1. Contributing to a donor-advised fund saves taxes in high-income years: M sold her pizza franchise at a substantial profit during December of the current year. She would like to set aside $1 million of the proceeds to provide continued support to various charities. She would also like to shelter part of the gain with the resulting charitable contribution deduction. M is unwilling to establish a private foundation due to the numerous administrative requirements.
At first glance, M's objectives appear difficult to meet without establishing a private foundation. If she uses the $1 million to make a current-year contribution, she will be entitled to a contribution deduction for the full amount. Unfortunately, she will not have any of the designated funds left to provide future support to the charities. Conversely, if M retains a portion of the proceeds to provide charitable support in future years, she will be unable to use the entire $1 million to shelter the current-year gain.
A donor-advised fund provides M with a viable alternative to using a private foundation to meet her objectives. M would contribute the $1 million of proceeds to a donor-advised fund. The contributed funds would be invested in accordance with an investment strategy she recommends (i.e., current income, growth, etc.). The fund's income and principle would be available to provide future support for qualified charitable organizations, which can be determined based on M's recommendations. M will also be entitled to a charitable contribution deduction (subject to AGI limitations) for the full amount contributed, since the fund qualifies as a public charity. As a result, M's objectives of generating a current-year deduction (to shelter the gain) and providing future support to charities have been met.
Another alternative would have been for M to have made a $1 million gift of her company's stock to a donor-advised fund or private foundation before selling the company. The idea is to shift the resulting gain to a tax-exempt entity while still realizing a charitable contribution. Caution should be exercised because, as demonstrated in Ferguson, 108 T.C. 244 (1997), the closer the contribution is to the eventual sale, the greater the risk that the IRS might collapse the two transactions into one. However, in both Palmer, 62 T.C. 684 (1974), and Rauenhorst, 119 T.C. 157 (2002), the Tax Court ruled in favor of the taxpayers since the charities were not bound to sell the underlying securities.
When evaluating a donor-advised fund, the charity or community foundation's reputation should be evaluated, as well as whether there are minimum contributions, required balances, and grant restrictions. Annual fees and other related costs charged by the fund, investment options available, and past investment performance should also be evaluated.
The private foundation penalty tax on excessive business holdings under Sec. 4943 also applies to donor-advised funds. Furthermore, sponsoring organizations are subject to a penalty tax when a taxable distribution, as defined at Sec. 4966(c)(1), is made from a donor-advised fund (Secs. 4966(a)(1) and (2)).
Donors, their advisers, or related persons may be subject to an excise tax for advising a sponsoring organization to distribute funds from a donor-advised fund that results in the person (who requested the distribution) receiving more than an incidental benefit from the distribution. The tax is 125% of the benefit amount (Sec. 4967).Other alternatives
A supporting organization qualifies as a public charity and thus avoids the excise tax regime to which a private foundation is subject (Sec. 509(a)(3)). However, a supporting organization must meet certain organizational formalities and activity requirements. For example, the supporting organization must be controlled by the public charity or charities it supports. It must also be operated exclusively to benefit the supported charity, including performing the supported charity's functions or carrying out its purposes. This alternative meets many of the same tax and nontax goals as a private foundation; however, the donor's choice of recipient charities and control over distributions may be limited.
A supporting organization may appeal to a donor who desires the benefits of a private foundation but who wants a larger charitable income tax deduction than is permitted for gifts to a foundation (because support organizations qualify for the more favorable AGI limits of a public charity). Although the donor to a supporting organization will have less control than with a private foundation, the larger charitable income tax deduction may be more important than the amount of control. Both a supporting organization and a private foundation will provide a donor with more control over distributions than a donor-advised fund.
If a supporting organization makes a grant, loan, compensation payment, or other similar payment to a substantial contributor (or a person related to the substantial contributor) of the organization, the substantial contributor is treated as a disqualified person for purposes of the excess benefit transaction rules under Sec. 4958. The entire amount of the payment is treated as an excess benefit.
A conduit foundation, also called a passthrough foundation, must distribute all of its income (including contributions) by the 15th day of the third month after year end (Sec. 170(b)(1)(F)(ii)). However, contributions received by bequest may be held as an endowment and, accordingly, this alternative is useful in estate planning for funding a family's charitable giving program. A conduit foundation must comply with most private foundation rules; however, contributions to the foundation are subject to the more favorable AGI percentage limitations imposed on contributions to public charities.
A pooled common fund is a separate foundation, typically established by a public charity or a community trust. Different taxpayers establish funds within the larger foundation, and they are entitled to direct how the income and principal are distributed. However, the income must be distributed within 2½ months after the tax year end. Additionally, the principal cannot be maintained for longer than one year after the death of the donor or the surviving spouse if that person had the right to designate the charitable recipients (Sec. 170(b)(1)(F)(iii)).
Contributions to the fund are subject to the more favorable AGI limitations imposed on public charities; however, the fund is subject to other private foundation rules.
A charitable gift annuity (CGA) is a contract between an individual and a tax-exempt organization, often a school or church, whereby a gift to charity is made in exchange for a guaranteed income stream for the life of the individual or for the joint lives of the individual and a named beneficiary. An individual who purchases a CGA typically wants to provide a fixed income stream for the annuity period and make a gift to the charitable organization.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 19th edition (March 2018), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).