Strategic charitable giving can help reduce income taxes during an individual’s lifetime and after a person’s death. Under the 2017 tax law, the “Tax Cuts and Jobs Act,” an individual can receive a charitable deduction from the person’s income taxes for charitable donations up to 60% of adjusted gross income. One way to take a charitable deduction is to make a contribution directly to a charity. However, another option that provides greater flexibility on the timing of tax benefits and charitable contributions is to use a donor advised fund (DAF).
A donor advised fund (DAF) is an individual account for charitable giving that is established at a qualifying sponsoring organization. Most sponsoring organizations are Section 501(c)(3) charitable organizations, although the IRS also allows war veterans organizations and domestic fraternal organizations to maintain DAFs. Many for-profit financial institutions will partner with an affiliated 501(c)(3) organization, which is a DAF sponsoring organization.
Because the sponsoring organization is a charitable organization, the donor gets immediate tax benefits for making contributions into the donor’s individual DAF. Once the donor makes the contribution, the sponsoring organization has legal control over it. However, a key feature of a DAF is that the donor retains advisory privileges over the investments and distributions of the DAF, meaning the donor can select when, how much, and to whom distributions are made. Because the IRS treats donations to a DAF as contributions to a public charity, the IRS does require that distributions out of the DAF must go to a public charity. This means that distributions cannot go to individuals, private foundations, or other entities.
Depending on the sponsoring organization, DAFs provide a donor with numerous options. For example, a sponsoring organization may structure the DAF so that the donor can have the DAF pay out everything upon the donor’s death, or the donor can select a successor to manage the DAF after the donor’s death. The donor often has privacy options; grants from the DAF can be anonymous, under the name of the DAF account, or under the donor’s name.
The flexibility of a DAF can provide tax advantages over making direct contributions to a charity, too. When an individual donates directly to a charity, the individual can only take the tax deduction in the year that the gift is made. For example, let’s say an individual wants to donate $1,000 each year for the next ten years to a public charity. If the individual makes these $1,000 contributions directly to the charity, the individual is only able to take a $1,000 tax deduction in each of those ten years.
However, if the individual donates all $10,000 in year one to a DAF, the individual can take the entire $10,000 tax deduction right away. The individual can then direct the sponsoring organization to make $1,000 donations to the public charity for each of the next ten years. The end result is the same: the public charity gets ten annual donations of $1,000. But by using a DAF, the individual can maximize tax benefits by strategically separating the year in which tax benefits are recognized from the year in which a public charity receives a contribution. This is particularly helpful now that the 2017 changes to federal tax law increased the standard deduction amount to $12,000 for individuals, $18,000 for heads of households and $24,000 for married individuals filing jointly (to be adjusted for inflation occurring after 2018). By “batching” donations in one tax year, taxpayers can sometimes take a larger deduction than the standard deduction.
One of the most efficient ways to make gifts to charities at death is through beneficiary designations of an IRA (or on other tax-deferred retirement assets such as 401(k)s). If clients die before using all of their tax-deferred retirement accounts, whomever they designate as beneficiary of the account will pay income tax on the entire amount when he or she receives the money. There is one, big exception: if the beneficiary is a charity, the tax is never paid, because charities are tax-exempt. If clients want to leave some assets to family or friends and some to charities, I recommend they chose their tax-deferred retirement assets (or some portion of them) to go to charities, and give the other assets, on which income tax was paid when the income was earned, to their loved ones. The charities will not have to pay income tax on tax-deferred retirement assets; individuals will. Thus, the clients can leave more to their loved ones by giving them assets that do not carry the obligation to pay income tax on the gift and the charities will benefit equally regardless of which assets they receive.
We have learned over the years that it can be difficult for a charity to receive an IRA directly, but using a DAF can be the perfect solution. The owner of the IRA can make the DAF the beneficiary of the retirement account, and leave the list of charities to which the funds should go with the organization holding the DAF. Because the sponsoring organization is a public charity, this results in a charitable deduction for the donor’s estate. Moreover, if the donor nominates an heir as a successor on the DAF, that heir will be able to direct distributions from the DAF to public charities of the heir’s choice.
In sum, DAFs provide flexibility in charitable giving, both by maximizing tax advantages during an individual’s life and by simplifying transfers to charity after the individual’s death.
By: Brendan A. O’Donnell, Esq.