Considering a Private Foundation or Donor Advised Fund? You May Want Both.

July 27, 2017
Senior Wealth Planner Kerri Mast discusses a common dilemma among philanthropically inclined individuals.

Individuals interested in philanthropy often grapple with the question of whether to use a private foundation or donor advised fund (DAF). In the past, the answer may have turned on size. Those making large gifts funded private foundations, while smaller gifts funded DAFs. Though size may remain a consideration – individuals can establish a DAF with $5,000 but would not set up a private foundation at that level – it is no longer a deciding factor for large charitable vehicles. So how does one decide?

There are advantages to each.

Private foundations allow individuals to retain control, pay charitable expenses (including salaries) and are often considered to be the most prestigious charitable vehicle, as they are used by many of the United States’ wealthiest families.1 DAFs, which have gained huge popularity in recent years, offer simplicity in administration, higher income tax deduction limitations and no required payout rates.

But both have downsides, too.

Private foundations have to file a separate tax return, which includes the value of the foundation and the size and recipient of each grant. All of this is public information. In addition, their net investment income is subject to a 2% excise tax, while public charities do not pay tax on investment income. Private foundations are also required to distribute at least 5% each year in support of their charitable purpose. In addition, the rules governing private foundations can be complex, creating traps for the unwary.

With DAFs, individuals relinquish control – at least legal control – and, while they can advise as to grants and investment allocation, that advice is not binding. In addition, DAFs do not allow individuals to pay expenses, such as salary or travel expenses. Further, certain DAF providers may restrict grantmaking or investment options. For example, a faith-based DAF provider may prohibit grants whose purposes are deemed antithetical to that faith, or a locally based DAF provider might restrict grants to a certain geographic area. Individuals may also have limited investment options. For example, many DAFs offer narrow investment choices from pools of their mutual funds. (However, it should be noted that certain DAF providers do allow donors to select their own investment manager.)

After weighing the advantages and downsides and choosing one, what if a person feels he or she has made the wrong choice? If individuals start with a private foundation and have buyer’s regret, they can transfer the assets into a DAF. But it does not work the other way around. Assets cannot be moved from a DAF into a private foundation.

For some, using both may be the best solution.

In lieu of selecting one vehicle or the other, some people elect to use both a private foundation and DAF. There are a number of reasons this may be appropriate, including managing the minimum payout requirement, managing excise tax exposure, avoiding mission drift and shifting certain administrative responsibilities.

Managing the Minimum Payout Requirement. As mentioned, private foundations are required to distribute annually 5% of their value in support of their charitable purpose. There may be years when a private foundation is not prepared to make a distribution. This could be due to a shift in grantmaking strategy, a large infusion of assets or an event that pulls the family’s attention away from the foundation for a period of time. A foundation’s distribution to a DAF counts toward its 5% distribution requirement. This allows the foundation to make its required distribution now but withhold a decision regarding the ultimate recipients.

Managing Excise Tax Exposure. Also noted earlier, private foundations are subject to an excise tax on net investment income. Generally, the rate of tax is 2%. However, the rate can be reduced to 1% in any year the distributions reach certain thresholds – essentially, if the foundation distributes more as a percentage of assets than it did over the prior five years. There may be years when the private foundation would have meaningful tax savings by meeting the 1% threshold. For example, if the foundation holds stock in a private company, sale of that stock could result in a lot of investment income. If the foundation is not prepared in that year to make a distribution sufficient to meet the 1% threshold, it could distribute that amount to a DAF. By doing this, the foundation could meet the requirements to get the lower tax rate but withhold a decision regarding the ultimate recipients.

Avoiding Mission Drift. Private foundation boards often establish mission statements and grantmaking guidelines. These can be helpful for creating a focused grantmaking program. Even when a foundation has a focused grantmaking program, board members often have individual philanthropic interests outside of the focus area. For example, consider a foundation that supports affordable housing initiatives. The board members, while committed to affordable housing, may also wish to support their respective alma maters, their houses of worship or other local interests. It usually is permissible for a foundation to make distributions in support of these initiatives. However, in an effort to avoid drifting from the stated mission, and from publishing off-mission grants on the publicly available tax return, many foundations use a DAF to make grants that are outside of their stated mission.

Shifting Administrative Responsibilities. As noted, DAFs can provide administrative simplicity. This can be useful in a variety of situations. Consider, for example, a grant to an international organization. If a private foundation makes a grant to an international organization, it is required to exercise a certain level of due diligence called expenditure responsibility. Expenditure responsibility requires enhanced record-keeping over a period of time. Private foundations can develop a process for exercising expenditure responsibility. Alternatively, as certain DAFs are structured to provide expenditure responsibility, the private foundation can make international grants through a DAF, thus relieving the foundation of this administrative burden.

When choosing a philanthropic vehicle, people likely will consider both a private foundation and a DAF. There are advantages to each, as well as a few limitations. Philanthropically inclined individuals may find it useful to use both and tailor the use to their particular circumstance.

1 Three hundred of the top 400 wealthiest families in the United States use private foundations. Source: Silk, Roger D., and James W. Lintott, Managing Foundations and Charitable Trusts. 1st ed. Bloomberg Press, 2011.

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