Donor Advised Funds & Private Foundations: How the IRS Rewards Charitable Giving

Donor Advised Funds & Private Foundations: How the IRS Rewards Charitable Giving

Many of us know the non-monetary rewards of philanthropy. However, there are potential financial benefits for donors, as well—from the IRS, of all places. Possible charitable giving vehicles include private foundations, donor-advised funds, and community foundations.

All of these offer the potential for tax savings in one way or another (provided that we use them wisely over the long-term). The most significant difference between them may be how much control you have over the assets in your account once you donate.

This article addresses these questions:

  • How can you get tax credits for donating to charities?
  • What is a donor-advised fund (DAF)?
  • Where does a private foundation differ from a DAF?
  • In what ways can your company benefit from philanthropy?
  • Can cultural giving become a business strategy?

The Differences Between a DAF and a Private Foundation

A donor-advised fund (DAF) is a charitable giving vehicle that allows you to recommend grants to your favorite charities. Meanwhile, a private foundation is a charity in and of itself. The biggest difference between the two is that while private foundations must distribute 5% of their assets per year, DAFs do not have any minimum distribution requirements. 

However, if you are interested in contributing more than $200,000 per year to your donor-advised fund, it may be advantageous for your wealth manager to help you establish a tax-advantaged private foundation instead: This will allow you to avoid paying capital gains taxes on any gains from selling securities within your philanthropic portfolio.

A DAF can be used as an umbrella under which multiple family members contribute funds simultaneously or at different times during their lifetimes. At the same time, they differ from many other forms of charitable giving accounts (such as annuities or life insurance policies) where each member contributes separately toward his/her own future payout stream.

Contributions into donor-advised funds are pooled together. Everyone gets equal shares in the giving, regardless of when they put money into an account. As a result, someone who puts money into theirs later down the road still benefits from all distributions made prior to their donation(s). Those earlier amounts have already been allocated among other contributors, even though no one has withdrawn anything yet.

The Tax Benefits of a DAF

DAFs have some significant tax benefits, such as:

  • Tax-free income and capital gains. Distributions from your donor-advised fund are not taxed at the federal level or in most states. Depending on how you fund your DAF, any investment accounts earnings may also be tax-free.
  • Flexibility in funding. A wide range of investable assets can be contributed to a donor-advised fund, including cash, publicly-traded securities, and real estate (within certain limitations). You may also use life insurance policies as a funding source for your DAF, so long as the policy has been irrevocably assigned to the trust.

The Tax Benefits of Private Foundations

There are several possible tax-efficient rewards for donating to a private foundation. They include:

  • Income tax deductions. The IRS allows you to deduct charitable contributions from your annual income taxes. For example, if you were to give $1 million to your favorite non-profit organization in a single year, that amount would be deducted from your taxable income, reducing or eliminating any federal or state taxes owed (depending on your circumstances). This applies to both public charities and private foundations.
  • Capital gains deductions. If you donate assets that are highly appreciated to a private foundation, you may be able to avoid paying capital gains taxes, as well. For instance, giving long-term, appreciated shares of stock to it could entitle you to a deduction on your income tax return for 100% of the stock’s fair market value. If you opt to sell that stock at some point, your foundation pays only one or two percent on the overall capital gains.

Your Business Can Utilize a DAF or Private Foundation

A donor-advised fund or private foundation can provide a way for an entrepreneur to give to their favorite charities. Each year, you can designate a percentage of pre-tax profits (or other sources) to be transferred into your philanthropic vehicle of choice. However, those contributions must not be considered taxable income by the IRS. For convenience’s sake, you may want to set up an irrevocable contribution with your accountant and have them draft a letter of instruction stating that all such donations are tax deductible.

Additionally, giving through a DAF or private foundation doesn’t just provide significant tax benefits: It is also beneficial for anyone who wants additional protection from creditors and lawsuits when managing charitable funds. This is because they are protected by federal bankruptcy laws (as long as there is no fraud involved in their establishment or use).

Cultural Giving as Business Strategy

Business owners can use their company’s donor-advised fund to support their charitable goals. For example, Company X could use a DAF to fund the creation of a new product line or help finance an expansion into another market. At the same time, you might also use a donor-advised fund to support your employees: Perhaps your marketing department is looking for ways to improve your customer experience 

Alternately, your accounting department might want more training to perform better audits on behalf of clients. There are many ways in which you can direct funds through your DAF. In addition to being altruistic, these strategies are quite practical: They allow you to put your business at an advantage by growing it through charitable efforts. This, in turn, can make you more attractive as partners and employers in key markets like the healthcare and technology sectors.

Review Your Non-Qualified Assets With a Professional

Normally, when you contribute non-qualified assets to a fund or foundation, you will need to pay income tax on any income generated by them. In some cases, however, you may be able to avoid paying income tax on it by donating those assets to a qualified charity. The IRS provides special rules for charitable contributions of property that are held until death.

These rules can allow you to make an immediate deduction for your contribution and avoid paying tax on the appreciation in value over time. Thankfully, there are many ways to give, but it can be difficult to discern which option is best for you. Just to keep on the safe side, discuss any intended use of your non-qualified assets with your fiduciary financial advisor before making a final decision. 

If you are currently between financial planners, Scott Marsh Financial has ample experience in these areas and more (including investment management, estate planning, and retirement planning for high-net-worth individuals). Contact us today for elite wealth financial planning. 

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More about the author: Scott Marsh

Scott Marsh has been referred to as America’s Financial Advisor and Educator. He is considered one of the foremost thought leaders in the financial services industry and hopes to share his knowledge with others so they can create a legacy of financial prosperity. He is the founder of Scott Marsh...