Published in the New Hampshire Bar Association - Bar News
Clients interested in sustained charitable giving often choose to contribute to a donor-advised fund (DAF) or establish a private foundation, but unlike these options, a private operating foundation permits the donor to be actively engaged in charitable activities.
For each of these three common options for ongoing charitable giving, there are important tax considerations.
Donor Advised Fund
A donor advised fund is one in which a donor makes a contribution to a sponsoring organization, such as a community foundation, designating the donated funds for a charitable purpose. The donor's contributions are separately identified by reference to the donor, and the donor has advisory rights to make nonbinding recommendations as to how the funds should be distributed through grants. However, the donation must be "completed gift," which means the funds are owned and controlled by the sponsoring organization, and the ultimate decision regarding grants is made by the sponsoring organization. IRC § 4966(d)(2)(A).
DAFs appeal to donors because there are no start-up costs, and administration is provided by the sponsoring organization (usually for a small fee). The DAF is not required to distribute funds each year, which permits some donors to make a sizable donation in one year to optimize tax planning, even before identifying recipients.
Donations to the DAF are tax-deductible to the same extent as donations made to a public charity (up to 50 percent of adjusted gross income (AGI) for cash contributions, 30 percent of AGI for gifts of securities or real property), with the ability to carry forward an unused deduction for five years. Furthermore, a DAF may make grants to a variety of charitable entities, and the grant may be made anonymously.
There are some limits on who may receive funds from a DAF. A DAF will incur a 20 percent tax penalty if it distributes funds to an individual, or for a non-charitable purpose, or to a non-charitable recipient, unless the sponsoring organization exercises expenditure responsibility. IRC § 4966(a), (c).
A distribution to another DAF, a private operating foundation, or a private non-operating foundation that distributes all of its contributions each year will not be taxable. IRC Reg. § 1.170A-9(g), (h). DAFs have special rules prohibiting grants that provide an excess benefit to a disqualified person (IRC § 4958(a)) or more than an incidental benefit to a donor or related person (IRC § 4967). If either occurs, then the IRS collects a substantial penalty.
Private Non-Operating Foundation
A private non-operating foundation is usually created and funded by a small group of donors (e.g., a family foundation), and the foundation's charitable activities consist mainly of making grants to public charities. IRC § 170(b)(1)(A)(vii).
Private foundations must make annual qualifying distributions equal to 5 percent of its net investment assets, and if a private non-operating foundation does not distribute the minimum amount required, it will be taxed annually at 30 percent on any undistributed income (with an additional 100 percent penalty if not distributed within the taxable period). IRC § 4942.
Donations to a private non-operating foundation are only deducible up to 30 percent of the donor's AGI for cash gifts, 20 percent for gifts of securities or real property.
Private Operating Foundation
In contrast, a private operating foundation is one that typically engages in independent charitable activities, but does not meet the public support test to qualify as a public charity. A private operating foundation must spend at least 85 percent of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities (known as the income test), and must also satisfy one of three alternative tests: an assets test, endowment test or support test. IRC § 4943(j)(3)(A).
Importantly, a private operating foundation will not be subject to the same distribution requirements imposed on a non-operating foundation. IRC § 4942(a)(1).
Donations to a private operating foundation are deductible to the donor to the same extent as those made to a public charity. A private operating foundation may accept a donation from a DAF or a private non-operating foundation.
Private foundations (both operating and non-operating) are subject to a number of technical rules under the Internal Revenue Code. Private foundations are generally exempt from income tax under section 501(a), but must pay an annual excise tax of 2 percent on net investment income. This may be reduced to 1 percent by increasing annual distributions for charitable purposes. IRC § 4940.
If a private foundation engages in a transaction with a disqualified person, considered "self-dealing," it will be subject to an additional penalty tax (initially 10 percent of the amount involved, but if not corrected within a specified period, there is an additional tax of 200 percent, plus a foundation manager may also be taxed). IRC § 4941.
There are also stringent rules regarding excess business holdings (e.g., stock in a family business), which if violated will trigger an initial 10 percent tax on the value of any excess business holdings, rising to 200 percent if not divested within a specified period of time. IRC § 4943. If a foundation makes investments that jeopardize its ability to accomplish its exempt purposes, the IRS collects a 10 percent tax on the investment and, if not corrected, the investment will be subject to an additional 25 percent tax. IRC § 4944.
Significantly, the IRS also imposes a penalty on a private foundation if it makes a prohibited (and therefore taxable) expenditure, which includes lobbying, attempting to influence the outcome of a public election, making grants to individuals for travel, study or similar purposes (unless the grant was awarded on an objective and nondiscriminatory basis); and grants to non-charitable organizations, unless the grantor foundation exercises expenditure responsibility to insure the grant is spent solely for the purposes for which it was made. IRC § 4945.
In conclusion, a donor relinquishes some control when using a DAF, but avoids many of the requirements imposed by the IRS on private foundations. If a donor wishes to establish a family legacy for awarding grants mainly to public charities, then either a private non-operating foundation or a DAF is an option. If an additional goal is to be actively involved in charitable activities, then a private operating foundation should be considered.Click here for full article in Bar News.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.