Donor-advised funds are the fastest-growing charitable giving vehicle in the United States—and for good reason.[1] Donor-advised funds are a simple, flexible and tax-efficient way of supporting the charities you care about. With their ability to accept complex assets such as private company stock, real estate and venture capital fund partnership interests, donor-advised funds are an important charitable planning tool for Silicon Valley.
In 2015, grants from donor-advised funds to qualified charities reached a record high of $14.5 billion.[2] New contributions to these funds reached an all-time high of $22.2 billion and represented 8.4% of total charitable giving by individuals in the U.S. At year-end 2015, total donor-advised-fund assets stood at an astounding $78 billion.
What Is a Donor-Advised Fund?
A donor-advised fund is a charitable account you set up with a donor-advised-fund sponsor, which is a public charity. You create and fund an individual account by contributing to the public charity. You receive a charitable tax deduction for your donation in the year you make your contribution. Then you recommend grants to other public charities over time from the funds in your charitable account. Using your investment preferences, your donations grow tax-free while you decide which charities to support with your grants.
A Variety of Sponsors
Donor-advised funds are available from a variety of sources, including mutual fund companies, brokerage firms, community foundations, faith-based charities and independent providers. Fidelity Charitable sponsors the largest donor-advised fund, with 132,000 donors who recommended grants totaling over $3.1 billion to support over 106,000 nonprofit organizations in 2016.[3] Schwab Charitable and Vanguard Charitable are in the top five donor-advised funds ranked by value of grants. Silicon Valley’s own Silicon Valley Community Foundation is the nation’s largest donor-advised fund sponsored by a community foundation based on the value of assets. National Christian Foundation was the top faith-based sponsor with its donors recommending grants of $966 million in 2015. Top independent sponsors include National Philanthropic Trust and American Endowment Foundation.
Sponsors provide essential services to their donor-advised funds, including receiving and selling contributed assets, ensuring that potential grants recommended by donors are to IRS-qualified charities, recording transactions in donor accounts, providing investment alternatives and maintaining compliance with complex laws and regulations.
How Donor-Advised Funds Work
An important point to know about donor-advised funds is that your donations are completed gifts for estate planning purposes. What that means is that the money or assets you contribute to a fund are no longer your property; rather, they are owned by the sponsoring public charity. You cannot change your mind and later decide that you would rather have the money or assets back in your personal accounts. There are no exceptions to this rule. The assets you contribute are owned and controlled by the sponsoring public charity.
Even though you no longer own or control the money or assets you contribute, you retain two essential advisory privileges for your account that allow you to (1) recommend grants to other public charities and (2) select your investment preferences.
The grant process involves recommending to your fund sponsor a grant to another public charity. The sponsor researches whether your recommended grant recipient is an allowable U.S. tax-exempt nonprofit organization under Internal Revenue Code Section 501(c)(3). Depending on the donor-advised fund, you may be able to select from an online list of pre-approved 501(c)(3) organizations, which speeds up the process. If your recipient is allowable, the sponsor will follow your recommendation and make the grant. Sponsors honor grant recommendations in all but the rarest of cases. Despite the complicated-sounding process, in practice, the grant process is simple and will appear to you as if you made a grant to the charity of your choice from your account. The minimum grant amount from a donor-advised fund is as little as $50.
Besides recommending grants, you also can recommend investments for your account. Depending on the donor-advised fund, you may have an online list of investment options similar to the way an online employer 401(k), 403(b) or 457 retirement plan works. You may also have the ability to use a third-party investment advisory firm to manage the investments in your charitable account. Typically you will have enough options to create a well-diversified portfolio that meets your investment goals and time horizon for the funds in your account.
For their services, donor-advised-fund sponsors charge administrative fees. Pricing is typically based on the value of your account. The largest mutual fund and brokerage firm donor-advised funds have the lowest pricing, with fees ranging from about 0.60% of the value of your account per year on balances under $500,000 down to as low as 0.20% or less per year for balances of $1 million and more. Donor-advised funds can be opened with a minimum initial balance of as little as $5,000.
Fun with Naming Your Account
With a donor-advised fund, you get to select the name of your account. Many people have a good time with this part of the process. You might name your account for your family—for example, the Washington Charitable Fund or Adams Family Foundation. You might name your account to reflect your family’s charitable mission—for example, the Jefferson Cancer Research Source, Madison Educational Trust or Monroe Philanthropic Fund for the Arts. Or you might create a donor-advised fund to honor the memory of someone who has passed away—for example, John Q. Adams Legacy Fund for Humanitarian Relief. There are few restrictions on what your account can be called, so have fun in coming up with a name.
You can also not name your account so grants can be given to your charities anonymously. Some people prefer this option to reduce the number of solicitations they receive from nonprofit organizations. Your donor-advised fund may also be able to make grants anonymously even if you have named your account.
What Assets Can Be Contributed?
Donor-advised funds can accept a wide variety of contributed assets, including cash and publicly traded securities, and complex assets, including private company stock, real estate and partnership interests in venture capital funds, private equity funds and hedge funds.
Cash is typically the worst asset to give to charity, which is why it is important that donor-advised funds can accept other types of assets. Many people make the mistake of selling an appreciated asset such as a stock or mutual fund, paying income tax on the capital gain and then donating the after-tax proceeds to charity. In California, with our top income tax rate of 13.3% and a maximum federal long-term capital gains tax rate of 23.8% (including the 3.8% tax on net investment income), your combined tax on sales of stock, mutual funds or other appreciated assets could be as high as 37%, or over one-third of the value of your potential contribution.
By contributing an appreciated asset directly to charity, tax on embedded capital gain is never paid. You do not pay the tax because you donated the asset to charity rather than selling the asset and recognizing capital gain. The charity does not pay tax on the gain when it sells the appreciated asset because it is a tax-exempt nonprofit organization. Capital gains tax on appreciated assets disappears when you donate the assets to charity, including donor-advised funds. The net result is that you have as much as 37% more assets available to donate to charity, which is good for you and the organizations you donate to.
In addition, if you sold an appreciated asset and donated cash to receive a charitable tax deduction, your income would increase by the capital gain on the sale of the appreciated asset. Because of the increase in income, you might lose tax deductions (other than the charitable deduction) that are partially or entirely phased out at high-income levels. Losing deductions further increases the tax you pay and reduces the amount available to donate to charity.
The same is true for complex assets, including private company stock, real estate, and limited or general partnership interests in private equity funds, hedge funds and venture capital funds. These investments are private, complicated and unique in their individual features. Many, if not most, charities cannot accommodate donations of complex assets because they lack the expertise or because the size of the donation would overwhelm the charity. Sophisticated donor-advised-fund sponsors play a valuable role, acting as an intermediary in accepting complex assets, selling them or holding them until they are sold, and then leaving the cash proceeds in your account for you to distribute among as many charitable organizations as you like.
For example, you might donate private company stock for which you paid little (low cost basis) to your donor-advised fund. The fund becomes a shareholder in the private company for as long as it takes to sell the company or until the company goes public. Once the company is sold or goes public, the cash proceeds are put in your account.
Tax Deductions
When you contribute to a donor-advised fund, you receive an immediate tax deduction in the year of your contribution. Your charitable tax deduction is the full market value of the assets you contributed, as long as you held the assets for one year or longer (capital gain property). If you owned the contributed assets for less than one year, then the value of the contribution is the cost of the property you contributed.
There are limits on the amount of the charitable deduction you can use in any one tax year. The maximum allowable amount of your deduction is equal to 50% of your adjusted gross income for contributions of cash and 30% of your adjusted gross income for contributions of stock, mutual funds, real estate, partnership interests and other assets. If you cannot deduct all of your donation in the year you contributed it, a five-year carry-forward on contributions that exceed adjusted gross income limits is available. You can use the charitable deductions in future years.
There are other rules regarding charitable donations of property; however, this article briefly covers the most common cases.
Timing as a Planning Opportunity
There are several scenarios where using a donor-advised fund provides unique income tax planning opportunities besides the tax savings that can be achieved by contributing appreciated assets. Each case involves the timing of contributions to your donor-advised fund.
In the most common planning strategy, you adjust the timing to coincide with high-income years. By doing so, you create large charitable tax deductions that help reduce your taxable income. In low-income years, you reduce or skip your regular fund contributions. For example, if you received a large bonus or sold employee stock options during the year, make a large contribution to your donor-advised fund in that year. When you contribute, you receive a tax deduction immediately in that year, and you can make grants from your account many years into the future. This “front-loading” accelerates your regular contributions and bunches them into a high-income year to reduce taxable income without changing the timing or amounts of your regular contributions to charities from your account.
High-income years may occur unexpectedly and infrequently—because of a liquidity event, for example—or they may happen periodically, as is commonly the case with sales and business development professionals. When high-income years occur periodically, timing your fund contributions to coincide with those years can help smooth out taxable income. Income smoothing with donor-advised-fund contributions is powerful because the timing of contributions to your fund is detached from the timing of your grants to charities. The two can happen independently. Timing strategies are more difficult to implement with direct gifts to charities. Using a donor-advised fund allows you to maintain steady giving despite fluctuations in income.
The final few years before retirement are another time to consider “topping off” your donor-advised fund and accelerating your future contributions into your final few working years when you will receive more benefit from the charitable tax deduction.
Accelerating charitable contributions also may make sense if you expect lower income tax rates in the future or if you expect tax code changes that will reduce the benefit of charitable deductions. In these cases, you may consider front-loading contributions to your account because the value of the charitable tax deduction may be less in the future. Conversely, if you expect higher tax rates in the future or higher charitable tax deductions, then it may make sense to delay your contributions to future years when they will be more valuable. This planning is popular when Congress or a new presidential administration consider changes to tax laws.
Where Can You Donate?
From your donor-advised fund, you can donate to any Internal Revenue Code 501(c)(3) tax-exempt nonprofit organization, also commonly known as a public charity. In fact, depending on your fund sponsor, you may transfer your entire charitable account to another sponsor, which is itself a public charity.
Knowing where you may not donate from a donor-advised fund is as important as knowing where you may donate. You may not donate to individuals—all grant recipients must be 501(c)(3) organizations. Typically you cannot donate to foreign charities; however, there are U.S.-based nonprofits with operations in other countries to which you can contribute. Also, the rules against private inurement prevent you from making distributions that will benefit you or your family personally. You also cannot make contributions for which you receive something of value. This makes it difficult to use your donor-advised fund to buy tickets to a charity fundraising event in which part of the ticket price includes dinner, as is often the case.
Criticism and Potential Changes
Interestingly, there are no rules for donor-advised funds that require you to make grants of a certain amount, or any amount, from year to year. In theory, the rules allow funds to stay in your account in perpetuity. However, sponsors monitor accounts and will themselves make grants if they determine the account has been abandoned.
The lack of rules requiring donations to charities from fund accounts has sparked criticism from some people in the philanthropy industry, who claim less money is being directed to charities as account balances grow. Sponsors have responded with studies that indicate the use of donor-advised funds has increased giving to charities among their donors and that most funds are dispersed to charities within five years of contribution. The sponsors also contend that the use of donor-advised funds has allowed for more planning and intentional giving, which has helped charities and donors. Congress is monitoring the use of donor-advised funds to decide whether legislation is necessary. There may be changes to this valuable charitable vehicle that warrant keeping an eye on.
[1] The National Philanthropic Trust, “2016 Donor-Advised Fund Report,” 2016.
[2] Ibid.
[3] Fidelity Charitable, “2016 Giving Report,” 2016.
