As a client's personal wealth increases, it is common to notice a corresponding increase in the individual's interest in philanthropy. Whether their charitable inclination results from a desire to support a particular philanthropic cause or is driven by the tax benefits associated with charitable giving, their wealth managers must design financial plans to meet those charitable goals.
Some advisors have a misconception that charitable planning for the high-net-worth individual is relegated to a specific tool-the private foundation-and it is easy to understand why. Visit your local museum, zoo, or hospital, and you will find a wall of plaques recognizing donors who bestowed generous gifts through their private foundations. But not all wealthy clients have the desire to create their own foundations. Many prefer to stay clear of the complexity associated with establishing and maintaining a private foundation. Such clients may be able to meet their charitable goals through another excellent tool-the donor-advised fund (DAF).
In simple terms, a DAF is an agreement between individual donors and a charity, which may be a single non-profit organization such as The Red Cross, or operated via a fund group or other financial entity. In either case, the charity maintains bookkeeping entries that track donations of separate donors. Upon establishing and contributing to the DAF, the donor assumes the role of grant advisor.
Although the charity always has the final say as to how donations are used, the grant advisor may submit a request citing which of its various charitable efforts he or she would like the contribution used to support. In most instances, the DAF honors the grant advisor's request as long as the distribution goes to a qualifying charity-one that maintains current exempt status with the IRS. The charitable distribution can be made on behalf of the DAF, or the grant advisor can request that it be made anonymously. Anonymity may be a particularly attractive feature of a DAF because private foundations are required annually to file IRS Form 990-PF, which provides a publicly available inventory of all assets and charitable distributions made throughout the year.
Until such time as the DAF makes a distribution to the qualifying charity, that amount can be invested in a portfolio of marketable securities managed by the client's financial professional with recommendations from the grant advisor. Of course, the client's wealth manager can be compensated for managing the DAF contributions.
DAFs are relatively easy to establish through a charity such as a community foundation or through investment companies like Schwab and Fidelity. Generally, there is no need for legal documents to be drawn up as there is when establishing a private foundation. And the sponsoring charity or the investment firm performs all associated administrative tasks.
This simplicity translates into lower expenses for setting up and participating in a DAF than would be incurred by establishing a private foundation. In fairness to private foundations, however, the DAF's simplicity is purchased at the expense of the flexibility a private foundation affords.
Income Tax Advantages
When a client contributes to a DAF, he gains an immediate income tax deduction-the amount of which depends on the size of the donation. Several DAFs accept gifts in forms that go beyond the traditional contributions of cash or securities. In an attempt to maximize tax benefits, many clients fund their DAFs with long-term capital gain property. If that is the primary funding source, the client receives a deduction equal to the fair market value of the property on the date of the contribution. Moreover, there is a second tax advantage: Upon contribution, the property's built-in capital gain is not recognized.
But there are limits. Before making a charitable contribution, the client must understand that charitable deductions are limited to 50 percent of a taxpayer's adjusted gross income (AGI) in any single year. However, when long-term capital gain property is contributed, the limitation is reduced to 30 percent of AGI. If AGI limitations prevent the client from making use of the full deduction in the year of contribution, the deduction is not wasted; the client has five years after the initial year of contribution to use the full deduction.
An Ideal Scenario
While it is clear that establishing a DAF carries significant benefits, there are certain situations that wealth managers should recognize as ideal for implementing a DAF. As an example, consider clients who regularly make annual charitable donations to their church, library, alma mater, and so on.
Many of these clients make those contributions from cash flow and make charitable giving a line item in their annual budgets. If those same clients have a portfolio that contains positions at a gain, they can contribute those positions to a DAF, establishing a pool of charitable dollars from which they can continue to make annual contributions. The client avoids paying capital gains on the appreciated position(s), receives an income tax deduction, and increases annual cash flow. The position can be liquidated without incurring taxes, and the portfolio can be reallocated to potentially grow the funds available for future charitable gifts. If appropriate, the increased cash flow can be reinvested in the client's taxable portfolio to effectively reset the client's allocation with a higher tax basis in the positions.
This also presents a planning opportunity for clients with a concentrated equity position. The client reduces concentrated risk exposure by contributing shares to the DAF and uses the income tax deduction to reduce the tax bite associated with selling a portion of the shares in a taxable account. The client can front-load charitable contributions for distribution to charities in later years, while receiving an income tax deduction at a time when she is expected to incur a higher tax bill due to the liquidation of shares in taxable accounts. This is especially attractive to clients in higher tax brackets who can use the charitable deduction to offset ordinary income tax liability.
Trusts and Estates
Other benefits could be incurred by incorporating a DAF into an estate plan as a beneficiary of retirement plans or of other items considered income in respect of a decedent (IRD). The DAF's tax-exempt nature makes it an ideal recipient of IRD assets.
Or consider naming a DAF as the remainder beneficiary of a charitable remainder trust (CRT). By doing so, the client can receive the benefits of CRT planning with the added benefits of the DAF once the CRT term ends. In the right situation, this may be an excellent way for a client to efficiently liquidate appreciated assets, receive an income stream, receive a tax deduction, and create a pool of charitable dollars that he (or his heirs) can distribute to various charities over time.
Likewise, the DAF can serve as the lead beneficiary of a charitable lead trust (CLT) providing the donor with increased flexibility over traditional CLT planning.
While many of these strategies are complex, even these brief examples show how a DAF can be an appropriate charitable planning tool for clients at all levels of net worth-and certainly something to consider before next tax season rolls around.
Gavin Morrissey (email@example.com) is the director of advanced planning at CommonwealthFinancial Network in San Diego, Calif.