By Dr. Jim Dahle, WCI Founder
Many white coat investors have been blessed to have far more than they need to maintain their lifestyle throughout retirement and to provide as much as they wish to leave to their heirs. Their mind then often turns to leaving a legacy behind in some form. This often takes on a charitable flavor. While there is a very good argument to leave all of your money to charity during your lifetime so you can see the good it does, many decide they would rather spread giving out over many years for various reasons. These include:
- It may be more effective to spread the donations out over time
- The pot of money can grow and thus more can be given to charity
- Givers are still undecided about what charities to support
- It can also help meet other goals, like providing income to family members or teaching them to be charitable
While there are tools such as charitable trusts or charitable annuities that can help meet some of these goals, the two primary tools used are Donor Advised Funds (DAFs) and Private Charitable Foundations (PCFs).
What Is a Donor Advised Fund?
A Donor Advised Fund is simply a fund managed by a trustee that allows the donor to advise the trustee about which charities the DAF should support. In practice, the donor dictates where the money goes. It cannot go back to the donor or any other noncharitable cause, but it can be granted to charities now, next year, or decades from now. There is no minimum annual charitable distribution required. The tax break to the donor all comes in the first year of the donation. Funds donated are generally tax-deductible to the donor (although there are limitations and the donor must itemize to get it). Future growth in between the donation and when it's granted to charities is all tax-free. Neither the DAF nor the donor pays taxes on that growth. The DAF doesn't need to file a tax return.
DAFs are available all over the place, including at all your favorite brokerage and mutual fund houses such as Vanguard or Fidelity. Some charities run their own DAF, although they may have restrictions on which charities can receive the money from their DAF. Generally, you will pay a significant Asset Under Management (AUM) fee to the DAF trustee, although it does generally scale down as the assets grow. Despite you paying an AUM fee, you are still the one managing the money in the DAF. You get to select what it invests in, just like your 401(k).
Donations to a DAF are only deductible up to 60% of your Adjusted Gross Income for cash donations. If you donate something other than cash, such as appreciated securities, that deduction is limited to 30% of AGI (although you can carry the deduction forward for the next five years). This includes both publicly traded securities held for at least a year and private businesses. You do get to deduct the entire value of a private business if donated, not just the basis. Neither you nor the DAF pays capital gains taxes on the donation when donating appreciated shares or businesses.
Donations to and grants from a DAF provide anonymity and convenience for tax reporting purposes.
More information here:
What Is a Private Charitable Foundation?
There are two different types of private charitable foundations (PCF), and it is important to understand the distinction. There are operating charitable foundations that actually do charitable work themselves. They run charitable programs like a soup kitchen or a homeless shelter. However, the charitable foundations we will be primarily discussing today are non-operating charitable foundations. A non-operating foundation is a lot like a DAF in that it just grants money to other charities and to individuals.
A PCF is much more like a business than a DAF. It must file a tax return (990-PF) each year. It also has an admittedly very small excise tax that it must pay (1.39% of INCOME, not assets). It can have employees (including you, your children, your grandchildren, and your friends). It also has the ability to give money to entities and individuals who are not actually charities registered with the IRS. Donations to a PCF are much less deductible than donations to a DAF. If donating cash, you can only deduct a donation of up to 30% of AGI. If donating appreciated shares held for at least one year, you can only deduct a donation of up to 20% of AGI. If donating to a private business, you can only deduct the BASIS of the business (which is often close to zero), not its actual value. Neither you nor the PCF will pay capital gains taxes when appreciated shares or businesses are sold by the PCF.
PCFs must also distribute or spend at least 5% of their assets each year. If the investment returns (plus any contributions made) are not at least 5%, the foundation's endowment will shrink.
What Are the Differences Between a DAF and a PCF?
Let's briefly review the differences between a DAF and a PCF:
As you can see, the general trend here is that a DAF is for small-time charitable work and a foundation is a much bigger thing. However, DAFs of tens of millions or even hundreds of millions of dollars can be created. AUM fees at the best providers (Vanguard, Fidelity, Charityvest) drop rapidly as assets grow, and the fees are much cheaper than the taxes on a taxable account. There are really only three good reasons to go with a PCF over a DAF:
- You want maximum control over how the foundation is run, including the ability to appoint family members to the board (and possibly pay them salaries to do so).
- You want maximum control over the investments of the foundation, including private companies, real estate, and individual securities.
- You want to give money to somebody other than a 501(c)(3) charity.
In exchange for that flexibility, you will need to pay some legal fees to set it up, file a tax return every year, pay a small excise tax, and be sure to distribute/spend at least 5% a year.
A DAF has another huge advantage over a PCF. Imagine you have built up a successful small business that you started from scratch, and you now have more wealth than you will spend and even more than you want to leave to your heirs. You want to sell the business, but you want to give a chunk of it to charity before selling. That will allow you to get a charitable deduction for the donation and avoid paying capital gains taxes on the portion you give to charity. With a DAF, you can give 30% of the business to charity, and then when the business is sold, you will pay capital gains taxes on the 70% of the business that was not given to charity. With a PCF, you can sell the business, pay the capital gains taxes, and then give 30% of the proceeds in cash to charity. The difference? Capital gains taxes on 30% of the business. If it were a $10 million business, 23.8% × 30% × $10 million, = $714,000. Advantage DAF. If it were a $100 million business, 23.8% × 30% × $100 million = $7.14 million. In that second scenario, it works out like this:
Sell business using DAF:
The DAF ends up with $30 million. You end up with $53.34 million or a total of $83,34 million.
Sell business using PCF:
The PCF ends up with $30 million. You end up with $46.2 million for a total of $76.2 million. You basically end up with 13% less if you use a PCF instead of a DAF. Is that extra control really worth more than $7 million to you? More and more, wealthy benefactors are deciding it isn't, and they are just going with a massive DAF instead of a PCF.
More information here:
The Best of Both Worlds
Katie and I had this great plan that, if we were ever to sell WCI, we would start a charitable foundation the year it sold. We thought this would reduce the tax bite and help us fulfill our charitable goals. However, given that our basis in WCI is almost zero, doing a charitable foundation instead of a DAF could be a very costly mistake. We would end up paying more in taxes instead of leaving it to heirs or charity. However, we wondered if there was some kind of workaround to this. Perhaps we could use a DAF the year of the sale and then have the DAF donate to a PCF. Nope. The IRS doesn't allow DAFs to donate to PCFs. PCFs are currently allowed to donate to DAFs, but there is talk about requiring the DAF to distribute that donation to actual charities within a year.
We could also split the difference. We could put some of the business into the DAF before selling and put some of the cash from the sale into a PCF. That would decrease the tax drag on the transaction. Future contributions to charity from appreciated shares of publicly traded securities could then go to the PCF where they would have gone to our DAF in the past. Then we (and our heirs) could just use the DAF when we give to 501(c)(3) charities and the PCF when we give to entities that are not 501(c)(3)s. Is it worth the hassle of dealing with two entities just to cut Uncle Sam out of the loop? For now, that is hard to say.
What do you think? Have you or do you plan to establish a large DAF or PCF? Why one over the other? Comment below!