Donor-Advised Funds

2015 was America’s most charitable year ever! According to Giving USA, Americans donated $373 billion to charity last year. Recipients included religion (32%), education (15%), human services (12%), foundations (11%), health (8%), and other (22%). While much is made of large corporate and foundation gifts, most money is given away by individual donors. In 2015, almost 80% of all charitable giving came from individuals. The Giving USA Foundation, The Giving Institute and the Indiana University Lilly Family School of Philanthropy compile a comprehensive (and fascinating) annual report on giving that you can find at www.givingusa.org.

As mentioned, most gifts are made by individuals and the majority of these contributions are funded by checks written directly to charities. While writing a check is a generous act and a perfectly acceptable way to support a charity, this article will make the case that there is an even better way to give away your money: the donor-advised fund. Meaningful philanthropy is not exclusively for the super-wealthy, nor must it be implemented through complicated vehicles such as private foundations or charitable trusts. The donor-advised fund, sometimes referred to as the poor man’s foundation, enables philanthropists of all means to achieve their charitable giving goals in a tax-advantaged, flexible, and cost-efficient manner.

A donor-advised fund (DAF) is a charitable giving vehicle that enables donors to make tax-deductible donations in the current tax year, while having the flexibility to direct grants to charities both in the current tax year and/or in future tax years. The set-up and on-going administrative costs of a DAF are extremely attractive when compared to other more complex and expensive charitable-giving alternatives.

Benefits

Tax-Advantaged

• Donor receives tax deduction in tax year when contribution is made to DAF.
• Donor avoids tax on capital gains by contributing appreciated securities owned more than 12 months.
• Proceeds from donated securities can be invested within a DAF. Any future investment earnings are tax-free, providing the donor with a potentially bigger charitable balance to fulfill future charitable obligations.
• Assets contributed to a DAF are not included in the donor’s estate and not subject to estate taxes.

Flexible

• Donors can contribute to the DAF in the current tax year but are not required to make grants to qualifying charities in the current tax year. Donors can make grants in current or future tax years.
• Most DAFs offer a variety of investment options, ranging from conservative to aggressive.

Cost-Efficient

• DAFs are easy to create, with very little paperwork.
• There is little on-going administration.
• The minimum initial funding amount is low. DAFs can be opened with as little as $5,000.
• DAFs allow donors to make grants to qualified charities in increments as small as $100.

Account Mechanics

Clients who have charitable intentions and an after-tax account with appreciated securities should be aware of the donor-advised fund gifting option. The mechanics behind opening, funding and managing a DAF are fairly simple. First, a donor opens an account with a qualified charitable sponsor such as a local community foundation (such as Foundation for the Carolinas), or a national provider, such as Schwab Charitable or Fidelity Charitable, to name a few. Most account opening paperwork can be completed in a few minutes, often on-line. This is in stark contrast to the complicated organizational documents and legal work needed to create a charitable trust or, even more onerous, a private foundation.

Once open, a donor completes an irrevocable transfer of appreciated securities from an after-tax account (not an IRA) to the new DAF. Positions with a low cost basis, missing basis, and/or concentrated positions are all good candidates for gifting. Cash may also be donated to the DAF, but it doesn’t have the same planning value as appreciated securities. Note that the donor’s deduction occurs when the DAF receives the security or cash, NOT when the ultimate charity (church, school, etc.) receives grants from the DAF. Deductions are subject to certain income restrictions (30% of adjusted gross income for appreciated securities, 50% of AGI for cash).

The donor can then recommend that the sponsor of the DAF (Foundation for the Carolinas, Schwab or Fidelity) make a grant to a qualified charity of the donor’s choosing (church, school or other non-profit). The charity must be a qualified non-profit and some restrictions apply. The grant recommendation process involves minimal paperwork and administration. Most DAF sponsors maintain an extremely comprehensive on-line database of qualified charities. The donor can recommend grants to the charity of choice with the click of a button. Again, it is this ease of administration and cost efficiency that can make DAF’s preferable to other charitable giving vehicles.

As previously mentioned, donated funds may accumulate within the DAF. In this case, the donor is usually able to invest the DAF dollars among a variety of investment options, allowing the gift to grow, resulting in a potentially bigger pool of funds available to fulfill future charitable obligations. The varied investment options can be attractive to donors who previously held undesirable concentrated positions in their after-tax portfolio but were tax-locked from diversifying because of capital gains concerns.

Lastly, as with many planning concepts, DAFs can be used to accomplish other estate planning goals. For example, in addition to funding a DAF for current use, a donor might create a DAF at death for children or grandchildren to use and manage, thereby passing down a legacy of philanthropy in addition to (or in lieu of) an inheritance.

DONOR-ADVISED FUND IN PRACTICE, EXAMPLE #1
Sally has an annual charitable giving budget of $10,000 that she sprinkles among ten different charities. Sally is in the highest tax bracket and has ample income from which to deduct her charitable gifts. Sally has seen her after-tax account value grow significantly. For example, she purchased $3,000 of XYZ stock five years ago. The shares are now worth $10,000.

We often encourage clients to “Never write another check to charity!” This usually raises some eyebrows but then we explain that appreciated stock should be given instead. Let’s examine the planning behind this advice by using the scenarios below to illustrate the positive impact of DAFs over other gifting options.

Scenario 1 – Sally Sends Checks Totaling $10,000 to her Favorite Ten Charities

• Capital Gain: No gain realized because no stock was sold. However, the client has depleted her cash reserves by writing checks to charities. More importantly, she has missed an excellent planning opportunity to raise the cost basis of her portfolio. More on this later.
• Charitable Gift & Tax Deduction: $10,000. However, Sally must track and maintain ten different charitable gift confirmations for her tax return preparation—unfavorable from a record-keeping perspective.

Scenario 2 – Sally Sells $10,000 of XYZ Stock, Donates Net Proceeds to Charity

• Capital Gain: $7,000 long term gain ($10,000 value – $3,000 basis) and $1,400 in capital gains taxes ($7,000 x 20% capital gains tax rate).
• Charitable Gift & Tax Deduction: $8,600 ($10,000 sale proceeds – $1,400 in capital gains taxes). Unfavorable in that the charities receive less money and Sally receives a smaller deduction.

Scenario 3 – Sally Donates Stock Directly to Charity

• Capital Gain: No gain realized because Sally donated appreciated stock directly to her charities.
• Charitable Gift & Tax Deduction: In theory, the charities should receive $10,000 and the client should receive $10,000 in total charitable deductions. Simple enough when donating one stock to one charity. However, remember that Sally has ten different charities. In practice, many charities do not like to process stock gifts for smaller amounts. Moreover, some charities may report stock gifts net of their broker’s cost to sell the stock, meaning the actual gift may be lower than intended. While this scenario is more favorable than the previous two, directing ten separate stock transfers to ten different charities could be a costly and time-consuming gifting option.

Scenario 4 – Sally Donates Stock to her DAF, Makes Grants from the DAF to Charity

• Capital Gain: No gain realized because the DAF is itself a qualified charity.
• Charitable Gift & Tax Deduction: $10,000. Sally receives the full $10,000 charitable deduction when donating to a DAF, just as she did when she gifted stock directly to the charity. Moreover, while she directed the DAF to make ten different grants to her ten different charities, she only needed to keep track of her initial stock gift to the DAF, NOT the ten different grants. Remember, Sally received the tax deduction when she funded the DAF, NOT when she made the grants from the DAF to the charities.

For Sally, Scenario 4 (Donating Stock to a DAF) is the most favorable. When you consider some of the planning techniques often used in conjunction with DAFs, this scenario becomes even more compelling. We referred to a missed planning opportunity in Scenario 1. Instead of donating cash to charity, Sally could have first donated stock to a DAF, then added cash to her portfolio to replace the recently gifted stock. Her portfolio value remains approximately the same, but she has increased her portfolio’s cost basis. By increasing her portfolio’s basis, she has reduced the capital gains she could pay on future personal portfolio draws. Perhaps a little beyond the scope of this article, but important to point out nonetheless.

DONOR-ADVISED FUND IN PRACTICE, EXAMPLE #2
An oversimplified summary of tax planning is the practice of matching income with deductions. Deductions are more valuable in higher tax brackets. For those with lumpy incomes and charitable inclinations, a DAF may be just the deduction they need. DAFs can help taxpayers match deductions with income, while still providing the flexibility to direct money to the end charity on the donor’s timeline. Lumpy income could be the result of many different factors: a business sale, an unusually large bonus, final year of employment before retirement, etc.

Let’s consider Sam, a business owner who sells his company in 2016 for $1,000,000, and who also personally contributes $20,000 to charities annually. Given the sale, Sam’s income will be higher in 2016 than it will be in the future. Sam decides to open and fund a DAF with $100,000. The $100,000 charitable contribution is five times what Sam normally donates to charity in one year. However, because Sam’s income in 2016 is much higher than it is normally, a deduction is much more valuable now than it will be next year and the years to come. Remember, however, that while the deduction occurs in 2016, Sam can stretch his donation to his ultimate charitable beneficiaries over the next five years or more to match his $20,000 in annual charitable obligations.

Summary

Donor-advised funds are an important wealth and legacy planning tool that can help you achieve your philanthropic goals in a tax-advantaged, flexible and cost-efficient manner. Please let us know if you would like to discuss how Bragg Financial Advisors can help you coordinate your charitable giving with your portfolio management and financial planning.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.