Comparing Private Foundations and Donor-Advised Funds

Co-written by Aimee McFarland, CPA, and Malia Wollerson, CPA

Private foundations are a popular and effective way for individuals and families to manage charitable giving. While many people may be familiar with traditional nonprofit organizations, such as charities or churches, private foundations offer unique advantages and opportunities for philanthropic efforts. This article will provide an overview of private foundations and how they compare to donor-advised funds.

What is a Private Foundation?

A private foundation is a legal entity that individuals or families establish to support charitable causes. Unlike public charities, which rely on donations from the general public, private foundations are typically funded and controlled by a single source, such as a family or a corporation. This means the donors have greater autonomy over how the funds are used and distributed.

Private foundations can be a good fit for individuals or families with significant wealth and looking for a more structured and long-term approach to their philanthropic efforts. They also offer a way for donors to involve their family members in the giving process, creating a legacy of charitable giving that can be passed down for generations.

Types of Private Foundations

There are several types of private foundations, each with its own unique characteristics and requirements. The two main types are operating foundations and non-operating foundations.

• Operating foundations: As the name suggests, these foundations actively engage in charitable activities rather than solely providing grants to other organizations. They may run their own programs or projects, such as educational initiatives or community development programs.

• Non-operating foundations: These foundations primarily make grants to other organizations that carry out charitable activities. They do not engage in direct charitable activities themselves.

Other types of private foundations include family, corporate and independent foundations. Each type has its own set of regulations and requirements, so it’s important to carefully consider which type of foundation best aligns with your philanthropic goals and vision.

Benefits of a Private Foundation

A private foundation is governed by a board of directors, which may include the original donors and their family members. Unlike a public charity, a private foundation can be governed by a relatively closed group of individuals.

Private foundations come with tax benefits.

Donations to a private foundation are tax deductible but limited by the donor’s adjusted gross income (AGI). Donors can deduct up to 30% of their AGI for cash contributions and up to 20% of their AGI for publicly traded securities. Donors can also deduct the basis of private business contributions up to 20% of their AGI. However, it’s worth noting that the basis of a private business is often significantly less than the fair market value of the business, limiting the value of this particular deduction.

Private foundations provide flexibility in investment. Unlike some other charitable endeavors, private foundations can diversify their portfolios, investing in almost anything from stocks and bonds to real estate, except businesses owned by the family of the donor. This restriction is in place to prevent self-dealing and ensure that the foundation’s investments are used for charitable purposes.

Private Foundation Rules

Private foundations are subject to strict regulations and guidelines set by the IRS. These regulations are in place to ensure that foundations are operating for charitable purposes and not for personal gain. Some of the rules that private foundations must follow include:

• Annual distribution requirement: Private foundations are required to distribute at least 5% of their assets each year to qualified charitable organizations.

• Prohibited transactions: Private foundations cannot engage in certain types of transactions, such as self-dealing or excess business holdings, which could benefit individuals involved with the foundation.

• Annual filing: Private foundations must file Form 990-PF tax filings each year.

• Conflict of interest policies: Private foundations are required to have written conflict of interest policies in place to prevent any potential conflicts of interest.

The Difference Between a Private Foundation and a Donor-Advised Fund

While both private foundations and donor-advised funds are popular charitable giving vehicles, there are some key differences between them. A donor-advised fund is a type of charitable investment account held by a sponsoring organization that allows donors to make contributions and recommend grants to their favorite charities. Private foundations, on the other hand, are stand-alone entities with their own governing board and more control over how funds are distributed.

Some other key differences between private foundations and DAFs include:

• Tax deductions: Donors can deduct a larger percentage of donations to a donor-advised fund than a private foundation. For a private foundation, the deduction is limited to 30% of AGI for cash contributions and 20% of AGI for publicly traded securities. For donoradvised funds, it’s 60% for cash contributions and 30% for publicly traded securities.

• Deductibility of non-publicly traded assets. Non-publicly traded assets donated to private foundations are only deductible at their cost basis, while donations to donor-advised funds may be deductible at fair market value.

• Income taxes. Private foundation income is subject to an excise tax of 1.39 percent. Donor-advised fund income is not taxed.

• Annual payout requirement: Private foundations are required to distribute at least 5% of their assets each year to qualified charitable organizations, while there is no annual payout requirement for donor-advised funds.

• Administrative expenses: Private foundations typically have higher administrative expenses due to their independent structure, while donor-advised funds can benefit from the administrative support of the sponsoring organization that manages the account.

• Investment control: Private foundations have more control over how their assets are invested, while donor-advised funds typically have limited investment options as the sponsoring organization is responsible for managing in vestments.

• Public disclosure: Private foundations are required to disclose certain information about their operations and finances to the public, while donor-advised funds do not have this requirement.

Comparing both options strategically

When you’re looking to leave a philanthropic legacy, choosing a charitable vehicle that aligns with your goals, resources and desired involvement is vital. Both donor-advised funds and private foundations are powerful tools but cater to different needs and ambitions.

If you seek greater control and flexibility in charitable giving and where funds are invested, a private foundation may be the right fit. However, the control and flexibility come at a cost.

Setting up a private foundation is not easy and will require legal fees, annual tax filings and mandated distributions. This often requires a more substantial financial commitment and a greater time commitment than a donor-advised fund.

Donor-advised funds are the epitome of simplicity and accessibility. They can be established with minimal fuss, often without legal costs, making them especially suitable for individuals who prefer a more hands-off approach. This simplicity extends to tax benefits. With donor-advised funds, donors can enjoy significant deductions on their contributions, especially for owners of non-publicly traded assets such as private stock. Further, donor-advised funds don’t have any annual distribution requirements or taxes to pay. While you can often start a donor-advised fund with less than $25,000, they are generally structured for a shorter-term use than private foundations, catering well to one to two generations of philanthropy.

However, this simplicity comes with its imitations. Investment choices in donor-advised funds are limited, and their grant-making is limited to public 501(c)(3)s. Also, while the fund grows tax-free, it will likely be subject to AUM fees, which can erode the fund’s value over time.

This article is meant to provide a brief overview of private foundations and how they compare to donor-advised funds. It is not a substitute for speaking with one of our expert advisors about your unique situation. Please contact Heard, McElroy & Vestal to discuss the optimal vehicle for your charitable giving by calling (800) 241-0151 or emailing hmv@hmvcpa.com.

Co-written by Aimee McFarland, CPA, audit partner, and Malia Wollerson, CPA, tax director, at Heard, McElroy & Vestal, LLC