Donor advised funds and private foundations: How to decide what is right for you

When it comes to fulfilling lasting charitable goals while maximizing immediate income tax benefits, two of the most popular options are establishing a donor advised fund and creating a private foundation.

So, how do you decide which approach is right for you? Understanding the differences between the two is essential.

Comparison: Donor advised fund and private foundation

Donor advised fund

A donor advised fund is easy to create and manage. To begin, an account is opened with a sponsor organization and an immediate charitable income tax deduction may be taken in the year in which assets are gifted to the fund. As the advisor to the fund, you recommend to the sponsor organization distributions to be made from the fund to other charitable organizations. This can be as easy as completing an online form, sending an email, or making a request online.

Key benefits

• Minimal initial funding requirements
• No annual distribution requirements
• Charitable contribution tax deduction up to 60% of adjusted gross income (AGI) for cash or 30% for appreciated assets
• Donations may be made anonymously
• Sponsor organization is responsible for ongoing legal and tax compliance and grantee due diligence

Potential drawbacks

• Sponsor organization has control over assets and must approve distribution requests
• Certain forms of grantmaking may be limited, depending on the sponsor organization (e.g., “program-related investments” and international grantmaking)
• The sponsor organization sets the investment options, which may range from a limited group of target allocations for smaller accounts to a customized asset allocation for large accounts that meet a certain minimum balance.
• Administrative fees are set by sponsor organization

A donor advised fund is a particularly attractive option to consider in a year when you have realized a large amount of capital gains or have significant additional income. A donor advised fund may be a good choice for those who want a charitable vehicle that can easily be terminated, transferred to other funds or updated to include additional advisors.

Private foundation

A private foundation is a distinct nonprofit legal entity you create and control. It is subject to special legal and tax compliance requirements, which also become your responsibility. Like a donor advised fund, a private foundation allows you to make a tax-deductible charitable contribution today, then grow and distribute those assets over time to other charities, however, it comes with a few added nuances.

Key benefits

• Full control over investment and grantmaking
• Flexibility to consider more specialized grantmaking, such as IRS-approved scholarship program administered by the foundation, “program-related investments,” grants to other private foundations, grants to individuals, and international philanthropy
• Ability to develop philanthropy staff and engage in direct charitable work

Potential drawbacks

• Higher set-up cost and time commitment
• There is no minimum initial funding requirement, however, even a donor with $1,000,000 may find the setup and legal costs of a private foundation too burdensome
• 5% annual distribution requirement
• 1.39% excise tax on net investment income
• Annual federal and state tax filing requirements, as well as legal compliance. Depending on the terms of its grants, private foundations may need to conduct annual reviews to ensure grants are being used for the intended purposes.
• Private foundations are subject to Attorney General oversight and information on tax filings are public, including grant and expense activity
• Tax deduction equal to 30% of AGI for cash or 20% for appreciated assets (less than with a donor advised fund)

Many families choose a private foundation so they can maintain investment control and establish a visible and enduring philanthropic legacy. For example, a family wishing to turn their philanthropy into a multi-generational effort may include children and grandchildren in grantmaking decisions or the management of the foundation.

Donor advised fund and private foundation: Working in tandem

If you have long-term charitable goals, there are significant ways a donor advised fund and a private foundation can work together. Given the tax deduction limits are more generous with a donor advised fund, you can accompany a gift to a private foundation with a gift to a donor advised fund to maximize your charitable tax deductions and your charitable impact.

A distribution from a private foundation to a donor advised fund will count towards the private foundation’s 5% annual distribution requirement. Then, best practice is to follow-up the distribution to the donor advised fund with a subsequent distribution from the donor advised fund to specific charities, so the distributions are benefitting charities and thus, impacting communities. However, flexibility on grant timing can aid in grant cycles and overall maximum support for nonprofit programs. A preliminary gift to a donor advised fund may also provide anonymity or facilitate international grantmaking in certain circumstances.

Furthermore, private foundation dollars can establish donor advised funds and collectively oversee the funds with the help of other family members. This creates an avenue to introduce rising generations to the charitable giving process, with direct responsibility to a pool of charitable assets. Families with a private foundation and multiple family branches may find having separate donor advised funds allows additional family members the opportunity to engage in independent giving and further develop their own charitable and financial values. Both donor advised funds and private foundations can have focus areas and mission statements to help guide charitable giving as well.

When neither a donor advised fund nor a private foundation is the right choice

For some individuals or families, it may turn out neither a donor advised fund, nor a private foundation is necessary. Often this is the case for individuals or families who have specific charitable goals and prefer to fund their gifts directly and on their own schedule, without the overhead of an intermediary.

For example, if you are most concerned about an immediate, one-time impact, while also minimizing ongoing costs, you are likely better served by donating directly to your intended charitable organization. You also may decide you are most comfortable structuring long-term gifts through an endowment fund of a specific charity. Likewise, you could look to our trust counsel to determine if there is another vehicle like a charitable remainder trust or charitable lead trust that works best for your goals.

Here is an overview comparing the benefits and tax considerations for both options: