How to choose: Donor-advised funds vs. private foundation

In 2021, charitable giving passed a milestone: For the first time ever, a greater share of individuals’ charitable donations went into donor-advised funds (DAFs) than into private foundations.

That’s a pretty remarkable shift. As a recent article in The Chronicle of Philanthropy pointed out, in 2011 DAFs attracted about 5% of individuals’ charitable giving; in the following decade, DAFs rocketed to 22% of giving, pushing past private foundations, which held fairly consistently a little above or below 15% over that same period.

Needless to say, a shift of this magnitude has prompted a variety of people – from donors to wealth advisors to institutions to nonprofit leaders – to say, “There’s got to be a reason.”

Actually, there are a few reasons.

The contenders

Before we get into those reasons, though, let’s take a quick look at private foundations and DAFs.

Private foundations are independent charitable entities funded through contributions from an individual, family, or corporate donor to make charitable distributions. Unlike public charities, private foundations are not required to be governed by a diversified board of directors, and they give donors a lot of control over grantmaking activities. Contributions to private foundations are irrevocable and they provide the donor with both an immediate tax benefit and a course for avoiding capital gains taxes on appreciated assets donated directly to the foundation.  Historically the preferred giving vehicle of wealthier individuals and families, they allow donors to exercise a lot of control and enjoy a lot of flexibility, they provide tax benefits, and they make it easy to involve family members in charitable-giving decisions. In 2022, private foundations held some $1.2 trillion in charitable assets.

DAFs also are created for making grants to nonprofit organizations, but they are established for donors by sponsoring charities (such as Renaissance Charitable Foundation). Contributions to DAFs are irrevocable and they provide the donor with both an immediate tax benefit and a course for avoiding capital gains taxes on appreciated assets donated directly to the DAF. Once the DAF is established, the donor can make ongoing contributions, receiving tax benefits in the years in which contributions are made. While the donor no longer owns the assets contributed to the DAF, the donor can recommend which nonprofit organizations should receive grants, a privilege that remains with the donor for life and can be passed on to future generations.

In recent years, DAFs have enjoyed a meteoric rise in popularity. Often described as the nation’s fastest-growing charitable vehicle, DAFs attracted more than $85 billion in contributions in 2022, increasing total assets held in DAFs to just under $230 billion.   

Why DAFs are gaining ground

With those basics established, let’s look a little deeper at DAFs and private foundations, seeing why DAFs seem to be the hotter vehicle. As I said above, I see a few reasons.

Reduced administrative burden

Frankly, establishing a private foundation can take a lot of work, time, and coordination. Complying with requirements about board composition, meetings, decision-making, vetting charities, disbursing grants and more can consume a lot of time, money, and energy. With DAFs, on the other hand, donors have virtually no administrative burden. There is no required board or meetings, and donors have only as much responsibility for vetting charities and making grant suggestions as they want.

Reduced overall expense

Establishing and operating a DAF is much less expensive than a private foundation. The initial creation of a private foundation can be especially costly, involving attorneys and other professionals, and their operation continues to consume wealth. Activities and requirements that create costs include:

• filing for tax-exempt status;
• creating organizational documents;
• ensuring legal compliance;
• maintaining accounting records;
• preparing and filing regulatory reports with the Secretary of State and/or Attorney General of the state where the foundation is doing business;
• paying the excise tax; and
• covering the cost of educating the board and officers on their compliance responsibilities.

With a DAF, on the other hand, a donor has none of those expenses.

No tax preparation

The difference between a private foundation and a DAF is pretty clear when it comes to tax time: If you have established a private foundation, you are responsible for the preparation and filing of IRS Form 990-PF and any related state forms, a process that typically requires the engagement of tax experts. If you have established a DAF, your sole responsibility is to claim eligible deductions for funds contributed to the DAF and tax filings are the responsibility of the charity that sponsors your DAF.

Increased privacy and anonymity

When you create a private foundation, you open your giving up to public scrutiny. A private foundation’s annual tax return must be available for public inspection and is easily accessible on websites such as GuideStar. The foundation must disclose the identity of board members and their compensation (if any), the identity of donors and their contributions, the identity of grant recipients and their grant amounts, and the value of the private foundation, and the composition of the investment portfolio. As a result, anonymous donations are virtually impossible to make … unless that gift is filtered through a DAF, which can make gifts without disclosing the donor and does not require public information filings.

Lower barriers to entry

While private foundations technically can be established with smaller amounts, they typically require hundreds of thousands of dollars to launch, and many begin with millions – and that’s on top of the thousands of dollars it costs to start them. As a result, I believe a private foundation needs to maintain assets over $10 million to justify the expense and time required to operate and stay compliant with requirements. DAFs, on the other hand, have no start-up costs and can be created with as little as a few thousand dollars. As a result, experts like Kathleen Enright, Presidents and CEO of the Council of Foundations, have described DAFs as “an essential tool to democratize philanthropy.”

Making the choice … or changing

Even as we discuss these reasons for the incredible growth in DAFs, we acknowledge that private foundations do have attributes that suit some donors. For example, they do provide some tax benefits, they give donors complete control over what organizations receive grants, and they create a concrete and tangible vehicle for establishing a family legacy. For these and other reasons, some donors will prefer to establish a private foundation. 

However, for most donors, DAFs warrant serious consideration. With their minimal administrative burdens, fewer expenses, zero tax responsibilities, and lower barriers to entry, all combined with increased privacy and the option of anonymity, DAFs give your clients the opportunity to think a lot less about the mechanics of charitable giving and a lot more about simply giving.

While anyone can benefit from creating a DAF, they can be especially useful for clients who:

• experienced a year of unusually high earnings.
• received a windfall of experienced a significant taxable event.
• are interested in converting a Roth IRA.
• could benefit from bunching contributions from multiple years to exceed the standard deduction amount.
• need to rebalance their portfolio.
• want to avoid taxes on appreciated securities or other capital gains.
• want to make charitable donations without the headache of annual tax reporting.

It should be noted that DAFs and private foundations do not need to be an either/or scenario. Some clients might benefit from using both.

On the other hand, some donors have been so attracted by the DAFs that they have chosen to convert private foundations to DAFs. This is a relatively simple process that involves granting the assets from the private foundation to the DAF.  The transaction will result in a one-time tax-filing requirement and there could be some costs associated with dissolving the foundation, but the entire process is typically smooth and can be completed in a relatively short period of time.

As with any wealth management matter, the final decision about whether a DAF, private foundation, or some combination of the two is best will depend on each individual client’s or family’s situation and overall goals and objectives. If, as you help your clients wrestle with these questions, you like input from people who work with DAFs, private foundations and other giving vehicles every day, talk to our experts at Ren.