Marie-Claire Hart is an advanced planning attorney at Northwestern Mutual.
When you have significant wealth, your financial life is more complex. And that certainly carries into your charitable giving. For someone of your means, simply writing checks to the organizations you care about may not be the most impactful way to give. There are a number of options you may consider. Two of the most popular are forming a private foundation or using donor-advised funds.
While both mechanisms afford greater control over the timing of your charitable tax deduction and distribution of money to charities, each vehicle has its pros and cons as a charitable planning tool. The option that’s best for your charitable giving plan depends on your unique situation. Here, we explain what private foundations and donor advised funds are, how they work, compare the two and offer some perspective as to which might be best suited for your charitable giving endeavors.
What is a private foundation?
A private foundation is a charitable organization with donor funding that comes exclusively from you, your family or some other small group of donors. Most private foundations do not provide charitable services directly but instead grant money to charities that do.
How does a private foundation work?
First, you must form your foundation. You can do that either as a corporation or as a trust. Generally, a corporation offers maximum flexibility if you want to make changes to the foundation in the future, while trusts are easier to create.
Regardless of the legal structure you use, once it’s created, you’ll need to appoint a board, hold regular meetings, manage day-to-day operations and provide donor funding. The foundation will also need to apply for tax-exempt status shortly after formation so that your donations are tax-deductible.
Then comes the fun part: distributions to the causes you want to support. Private foundations allow you and your family members to serve on the board of directors and have influence over the organization’s grantmaking. But keep in mind, each year your private foundation will need to distribute at least 5 percent of its net fair market value to qualified charities. Failure to do so may trigger a 30 percent excise tax (that can grow to 100 percent) on the portion of the minimum distribution that is not distributed that year. This rule makes those required annual distributions critical to maximizing the impact of your gifts if you intend to use a private foundation as your preferred giving vehicle.
What are donor-advised funds?
Donor-advised funds are often considered an alternative to private foundations. Think of donor-advised funds as investment accounts created for the sole purpose of donating your money to charity. Donor-advised funds are administered by a sponsoring organization that agrees to consider your wishes for how funds are invested and distributed. All the money you use to fund the account is tax-deductible in the year you give, and you are free to contribute to it once or at multiple times (a decision typically driven by your tax needs).
How do donor-advised funds work?
Setting up your donor-advised fund can be quick and easy. In many cases, it’s not dissimilar to setting up any other brokerage account. Some sponsoring organizations have rules about the minimum investment amount (usually $5,000 to $10,000) and types of assets you can contribute. While you can always contribute cash and marketable securities, many sponsoring organizations also allow you to contribute life insurance policies, closely held stock or real estate.
When it comes to how your donations are invested, a lot depends on the sponsoring organization, because it legally owns and controls the assets you contribute. Some sponsoring organizations allow you to choose investments only from a pre-selected fund menu (similar to how your 401(k) plan might work), while others allow you to develop a customized investment plan with your financial advisor.
Of course, the goal of donor-advised funds is to distribute your money to charity. While legally you will not retain ownership of the funds or control over distributions, sponsoring organizations typically defer to your advice on these matters.
Comparing donor-advised funds and private foundations
9 Key differences
When it comes to choosing between donor-advised funds and private foundations, the devil is in the details. Often, these key differences will play a role in deciding which giving vehicle is right for your situation.
- Start-up time
Donor-advised funds are much simpler to set up, requiring only minimal start-up time. In fact, you can get some donor-advised funds up and running almost immediately. Private foundations require you to set up a legal entity, and that can take weeks or even months.
- Start-up costs
Donor-advised funds are inexpensive or even free to create. Private foundations usually require the involvement of your legal team, which can significantly increase start-up costs.
- Initial contributions
Donor-advised funds have low initial contribution requirements, usually ranging from $5,000 to $10,000. Some don’t have a minimum initial contribution requirement at all. Private foundations generally necessitate a larger initial contribution to justify the start-up expenses and ongoing cost of operation.
- Operating costs
Typically, donor-advised funds have two types of operating costs: a management fee and an investment fee. Collectively, the combined fee can be as little as 1 to 2 percent of your account balance. Because private foundations require you to take on full responsibility for the administrative work, which can include paid staff, ongoing operations can be expensive.
- Distribution requirements
Legally, there is no annual distribution requirement for donor-advised funds. This means your donations can sit for as much or as little time as you’d like, depending on the sponsoring organization’s rules. When you do decide to distribute funds, you are typically required to distribute to public charities and will be subject to the sponsoring organization’s policies. With a private foundation, you must distribute at least 5 percent of its net fair market value annually to qualified organizations. Qualified organizations include public charities, scholarships, individuals needing disaster relief and/or hardship assistance, and international grants. You can also make non-qualified distributions via an IRS-approved process.
With a donor-advised fund, the sponsoring organization legally owns and controls all assets of the fund but generally takes your wishes into account. With a private foundation, the board controls the investment and distribution of assets.
A donor-advised fund is the only vehicle enabling complete donor anonymity, if desired. Sponsoring organizations for donor-advised funds can accept donations privately and do not have to disclose individual fund details, such as a donor’s identity, assets or grants. Private foundations must disclose donations made to the foundation and grants made from the foundation via annual reporting.
- Excise tax on investment income
There is no excise tax on investment income in donor-advised funds. For private foundations, there is a 1.39 percent excise tax on net investment income.
- Tax deduction limits
Generally, donor-advised funds offer higher tax deduction limits as a percentage of your adjusted gross income (AGI) than private foundations. Be sure to consult with your tax professional to understand the full details of how the deductible limits work for each type of giving vehicle for your specific tax situation.
Donor-advised fund or private foundation: Which is right for you?
Because start-up and ongoing administrative costs can be significant, private foundations are typically reserved for individuals and families with significant wealth to give. If your start-up contribution will be closer to $10,000 than $250,000, donor-advised funds are likely the only attainable option.
While the appeal of full control over donations is often the deciding factor for wealthy individuals and families choosing a private foundation over donor-advised funds, the ability to give a one-time gift of $250,000 or more doesn’t mean choosing a private foundation is a no-brainer. Private foundations are still expensive to form and operate, and those costs can quickly chip away at your donations, reducing your impact on the causes you care about. Generally, a private foundation functions most efficiently when the donor has a significant ongoing financial and time commitment to the foundation.
As you weigh the pros and cons of donor-advised funds and private foundations, be sure to discuss your charitable giving plans with your financial advisor and tax professional. By considering your overall financial plan and charitable giving goals, your advisory team can help build a customized strategy that meets your objectives and, ultimately, maximizes your impact on the causes you hold dear.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM) and its subsidiaries, Northwestern Mutual Investment Services, LLC (NMIS) (Investment Brokerage Services), a registered investment adviser, broker-dealer, and member of FINRA and SIPC, and Northwestern Mutual Wealth Management Company® (NMWMC) (Investment Advisory Services), a federal savings bank. NM and its subsidiaries are in Milwaukee, WI. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of Northwestern Mutual Wealth Management Company (NMWMC) are credentialed as NMWMC representatives to provide advisory services.
This publication is not intended as legal or tax advice. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions.