Baruch S. Littman is vice president of development for the Jewish Community Foundation of Los Angeles, which manages total charitable assets exceeding $700 million.
With the wealth creation of the past 25 years, a generation of recently minted millionaires is now contemplating the philanthropic options that are a fortunate byproduct of success.
For many, the prestige of establishing a private family foundation (PFF) to dispense charitable gifts to favored causes is alluring — a dream come true. But is it really? As the old adage goes, be careful what you wish for.
Along with the hope of becoming a philanthropist in the vein of Rockefeller, Gates or Buffett, the creators of PFFs assume considerable burdens, as well, in the form of administrative and investment-management obligations, reporting requirements, minimum gifting of assets as required under the tax code and a loss of privacy. The unfortunate reality is that the expense ratios of private foundations holding assets of less than $10 million often make them woefully inefficient as philanthropic vehicles.
According to a 2001 study (the most recent year for which data is available) by the Foundation Management Series on the administrative expenses of private foundations, the mean expense ratios of operating PFFs rose sharply as net charitable assets declined. Specifically, the study showed that the expense ratio of undistributed assets was 2.79 percent for those PFFs with assets of $5 million to $9.9 million, with some paying in excess of 40 percent of assets. For PFFs with assets below $5 million, the expense ratio averaged 1.1 percent but ran as high as almost 13 percent. While this survey is now several years old, it is a fair assumption that those expense ratios have only increased over time.
So given this philanthropist’s conundrum, what are the viable alternatives?
One of those solutions comes in the form of donor-advised funds (DAF), the charitable-gifting instruments that can be established at most community foundations, charitable-fund host organizations and many commercial investment-management firms with as little as $10,000 to $20,000. For that comparatively small amount, the charitable-minded individual or family can have the personal equivalent of a PFF with complete privacy and no back-office headaches. There are no tax returns to be completed, no annual meetings to conduct. In short, the philanthropist leaves the administration to the host organization and is able to experience the pleasure of distributing charity to needy causes through the DAF. The donor receives an immediate tax deduction on assets used to establish the DAF and can continue to add to the fund over time and realize further deductions on those contributions.
Of course, there are a lot of zeros between $10,000 and $10 million, and the obvious question is whether a DAF makes sense for someone with significant charitable assets and who is considering establishing or folding up a PFF. The short answer is a resounding yes, and, in many instances, it actually makes the most sense.
Case-in-point: At the Jewish Community Foundation of Los Angeles, the largest DAF account has a balance in excess of $50 million. Certainly, this philanthropist could create his own PFF or family support organization (FSO), the actual community foundation equivalent of a private family foundation. He has already fulfilled funding of his children’s DAFs, FSOs and PFFs for them as they wished. With his vast remaining charitable dollars, our donor’s own DAF represents the easiest option. Each year, he contributes additional funds to his DAF with either low-basis marketable securities or fractional interests in real estate, which, unlike PFFs, community foundations can accept and offer a fair-market-value tax deduction (more about this to follow).
There are, as well, a significant number of other reasons and advantages why an individual or family should consider establishing a DAF or FSO as an alternative to creating or folding up a PFF. Among them:
• Lower costs for management of charitable assets. In general, the management fee for a DAF with assets of $1 million to $10 million will never be more than 1.5 percent. Even better, a comparably sized FSO will have all-inclusive management fees of approximately 80 basis points, or 0.8 percent. Consider these fees in contrast to the aforementioned study of private foundations. In that same data, expenses as a percentage of the annual payout were outsized: PFFs with assets of $5 million to $9.9 million had a mean expense ratio of a whopping 16.3 percent. Those PFFs with less than $5 million still had mean expenses in relation to payout of 7.2 percent.
• Contribution of C-corp stock or low-basis real estate. PFFs are prohibited under the tax code from receiving contributions of C-corp stock, which is regarded by the IRS as self-dealing. With respect to both low-basis and fractional real estate donations to a PFF, as referenced above, the donor’s deductibility is limited to the tax-adjusted basis (i.e., the depreciated value). As such, a fully depreciated piece of real estate can be contributed to a PFF, but would not qualify for a deduction. By contrast, a DAF can accept both of these asset classes and offer your clients a fair-market-value tax deduction, avoidance of all capital-gains taxes on the donated interests and, in the case of real estate, eliminate the recapture of previously claimed depreciation.
• Undistributed assets as part of the required 5 percent minimum asset distribution. Commonly known is that a PFF must make charitable gifts of 5 percent of its total assets annually to maintain tax-exempt status. Less known, however, is that DAFs are an ideal repository for these undistributed assets. In the eyes of the IRS, once transferred to a DAF, the assets from the PFF have been given away for proper charitable purpose. Once in the DAF, your client can then take as long as he or she likes to determine how and where to distribute.
• Second generation (G-2) family issues. Establishing and maintaining a PFF can be a lonely venture. Where to turn for resources? How to engage your children — the second generation — in a shared philanthropic vision? While counsel can be obtained for PFFs, consulting fees can be considerable and add to the above-referenced and onerous operating expenses that cut into available funds for good works. By contrast, community foundations and other host organizations offer a substantial array of resources designed to assist donors: programs on issues in charitable giving, intergenerational planning and assistance in tapping philanthropic passions, for example.
Before a client accelerates full speed into establishing a private family foundation with less than $10 million in assets, financial advisers would do well to flash the yellow caution light, encourage the philanthropist-to-be to yield, and consider the full range of giving options available before opening the charitable throttle. Doing so are critical first steps in becoming a committed, informed philanthropist.