Donor-advised funds (DAFs) are an increasingly popular structure for individuals, families and even businesses to fund their charitable efforts. A DAF can be simply described as a bank or investment account that holds property for the benefit of charity. When and how the funds are distributed from the DAF account to charity is up to the DAF administrator, who receives recommendations on what charitable organizations receive the DAF’s funds and when by the donor or another person(s) designated by the donor. So long as the donor or designee recommend distributions to qualified charities and the dos and don’ts outlined in this article are heeded, the donor’s or designee’s recommendations are rarely ignored.
DAFs are popular because, relative to other options for significant philanthropists such as private foundations or supporting organizations, they offer simplicity in administration, higher income tax deduction limits and no required payouts. Today’s DAFs can be funded with almost anything, from cryptocurrency to commercial real estate to common stock, and can flex to almost any donor’s wishes – well, almost. All philanthropic structures have their limits, including DAFs, and before a donor commits to using one, it is important to understand what a DAF can and cannot do. Here’s a download on some of the major dos and don’ts:
- Do consider your tax deduction. Know and heed the limits on tax deductibility, but remember that any tax deductions in excess of the limits can be carried forward. While most donors give to charity because of philanthropic motivations, rather than tax savings, the tax savings provided by giving to charity effectively allow donors to give more to the causes that matter to them. Gifts to a DAF provide higher tax deductibility limits than do gifts to a private foundation (a cousin to the DAF). A donor can deduct up to 60% of her adjusted gross income if donating cash to a DAF and up to 30% of her adjusted gross income if donating appreciated securities. Compare these limits with the 30% limit for cash and 20% limit for appreciated securities allowed for gifts to a private foundation. The donor can carry forward her excess charitable deductions for three years. For those donors seeking to make large gifts to charity relative to their taxable income, a DAF can provide a bigger tax deduction, making it the more attractive philanthropic structure in some situations. Also remember that donors do get their tax deductions when funds or assets are contributed to the DAF and don’t get any tax deduction when the funds are later distributed from the DAF to a charity.
- Do consider a DAF for gifts of illiquid assets like real estate and stock in a privately held business, but don’t overlook the excess business holdings and unrelated business income tax. Donating appreciated, low-basis assets to charity typically provides about 30% more funds for charity than selling those appreciated assets, paying tax on the gains and then donating the cash proceeds to charity. Charitably inclined individuals often have unique and illiquid assets with large, unrealized gains, such as real estate or an interest in a privately held business. While donating these sorts of illiquid assets to a private foundation will only provide the donor with a tax deduction equal to her income tax basis in the assets, donating them to a DAF will provide a tax deduction equal to the fair market value of the property. Most DAF administrators will gladly accept such illiquid assets but will require that the assets are sold shortly after they are donated to the DAF. If the DAF retains an interest in a privately held business, real estate or other income-producing property, be mindful that two expensive excise taxes may apply to the DAF: the unrelated business income tax and the excess business holdings tax. The excess business holdings tax applies if the DAF donor (and certain related persons) and the DAF’s percentage ownership in a business enterprise exceeds a certain threshold, which varies depending on the situation. For example, if the donor and the DAF he funded own more than 40% of the stock in a privately held business, the excess business holdings tax is likely to be imposed on the DAF. The unrelated business income tax applies if the DAF has profits from an operating business that are not related to its tax-exempt purpose. For example, if the DAF holds commercial real estate that pays rental income into the DAF, the unrelated business income tax will likely apply. These two taxes might unexpectedly hit a DAF for longer than desired if an existing plan to sell the business or the real estate donated to the DAF falls through after the donation is made.
- Do implement governance structures like a family board for larger DAFs, but don’t pay compensation or travel expenses from the DAF. Fortune 500 companies have a seasoned and active board of directors that help the organization to succeed. Similarly, large philanthropic organizations that engage a family group, including large DAFs, should have a board, steering committee or similar governance structure in place to help ensure the DAF is making the most charitable impact. However, unlike public company boards or even private foundation boards, DAFs cannot pay these board or committee members and cannot reimburse for most meeting or travel expenses.
- Do ensure undistributed DAF assets are invested, growing the donation tax-free. Investment returns (such as income, dividends and capital gains) inside a DAF are not taxed, allowing the funds to grow and compound more aggressively compared with a taxable account or even a private foundation account, which pays a 1% or 2% tax on investment income. However, too many donors, especially donors of smaller DAFs, neglect to ensure the funds held in the DAF are invested. Donors of larger DAFs should contact their Brown Brothers Harriman (BBH) relationship manager so that we may formally manage the account. Donors of smaller DAFs should also ensure that an appropriate investment asset allocation is selected, even if BBH or another investment advisor does not manage the account. Otherwise, the benefit of tax-free compounding is lost.
- Do name an organization to receive or individual to direct the balance in the DAF after the donor’s death. A DAF is like a retirement plan or life insurance policy in that it typically does not pass pursuant to the donor’s will or trust documents upon death. Instead, the donor should designate an organization to receive or another person or persons to direct the distribution of the DAF funds upon the donor’s passing. Too often, the account paperwork whereby the donor makes this designation is not completed, which is a big “don’t.” If neither an organization nor person is designated and the donor or person in charge of making the distribution recommendations from the DAF dies, the DAF funds may revert to the DAF administrator’s general fund or a similar outcome that is unlikely to be consistent with the donor’s intentions.
- Don’t use a DAF to purchase event or raffle tickets, parking spaces, silent auction items or other perks. DAF funds cannot be used, either directly or indirectly, to benefit the donor. A DAF cannot be used to purchase tickets for a charitable gala or other event or for a donation that confers a benefit back or perk to the donor, even if the donation amount exceeds the cost of the event or perk. For example, if tickets to a charitable gala cost $500 and the cost of the meal provided at the gala is $100 (making $400 of the ticket tax deductible), none of the $500 ticket price should be funded from a DAF. Gifts from a DAF that provide a small, incidental benefit like a coffee mug, Christmas ornament, museum pass or similar items are OK and can be accepted by the donor without a problem.
- Don’t use your DAF to pay a legally enforceable pledge against the donor. As described earlier, a DAF cannot be used to provide benefits to the donor. If the DAF pays an enforceable charitable pledge made in the donor’s name, the DAF has essentially paid a debt on behalf of the donor and therefore conferred an impermissible benefit back to the donor. Thus, DAFs must not be used to pay off binding charitable commitments of the donor or any other individual. If DAF funds are to be used to fund a charitable gift and the donor wants to let the charity know in some official way prior to the gift, the donor should consider a nonbinding pledge or other nonbinding statement of intent.
One final wisdom: Do consider a DAF! Despite the many don’ts discussed, DAFs are a fantastic structure to fund family philanthropy.