Help your client make informed decisions on funding, investment strategies and asset allocation to successfully run this charitable-giving vehicle
Choosing among various charitable-giving options can be a challenging proposition for your clients. The most common options are creating a private foundation (PF), contributing to a donor-advised fund (DAF) or making an outright donation. If your client is willing and able to commit both the time and financial resources (in the short- and long-term), then creating a PF may be the way to go. But making the decision to create a PF is just the beginning. Your client must consider how much, what and when to contribute. To help your client make an informed decision, you must consider the nature, value and basis of his assets, anticipated income tax rate increases and the imposition of a 3.8 percent Medicare surtax on net investment income (starting in 2013 for individuals with certain income levels).1 You must also consider the client's emotions and sense of financial security. These considerations have to be coordinated with a sound investment strategy and asset allocation2 directed specifically for the client's PF. We'll discuss the issues you must review with a client about creating and maintaining an effective PF. Analyzing these issues will help your client make an informed decision.
If a client approaches you about creating a PF, your first question should be whether the client is willing to make the significant financial commitment for this option. While some advisors may disagree, the client should be willing and able to contribute at least $5 million (with at least a $3 million initial contribution). The PF has upfront costs for: (1) preparing documents creating the PF (trust or non-profit corporation documents), (2) federal (Form 1023) and state tax filings, and (3) possible filing with the state attorney general's office or other government entities. Also, there are ongoing administration expenses for record keeping, grant making, determining the amount of annual qualifying distributions3 and preparing the Form 990-PFs and possible state filings. If the PF won't be funded with at least $5 million, it may not be cost effective for a client to implement this option.
Assuming the client meets the financial-giving threshold, the client must recognize and commit sufficient time to the planning, implementation and ongoing management of the PF. The client (with his advisors) must be able to:
- Determine the suitable structure for the PF (trust or non-profit corporation);
- Determine its purpose or mission;
- Determine how much, what and when to contribute to the foundation;
- Identify and delegate functions to PF managers, agents or advisors;
- Determine an appropriate duration for the PF (subject to changing circumstances) based on numerous factors;
- Work with advisors to establish an investment strategy, asset allocation model (with tactical reallocations) for the investments;
- Regularly monitor the asset allocation, underlying investments and fund managers;
- Create a grant-making program and evaluate grant recipients;
- Understand and adhere to PF rules and prudent investor standards;
- Comply with miscellaneous federal and state laws; and
- Evaluate excess business holdings4 and self-dealing5 issues, if applicable, to closely held business interests.
If the client primarily is interested in an income tax deduction, a PF probably is not the best approach.
Level of Contributions
If, after proper evaluation, a client decides to create a PF, the client must address how much, what and when to contribute. Those decisions generally depend on the anticipated size of the PF, the nature of available assets (cash, qualified appreciated stock6 or certain closely held business interests), the availability of income tax deductions and intended grants to support the mission. Clients should consider the benefit of contributing a single asset or combination of assets. Typically, clients choose among (1) cash (an income tax deduction up to 30 percent of adjusted gross income (AGI))7, (2) qualified appreciated stock (an income tax deduction up to 20 percent of AGI based on the asset's fair market value)8, or (3) other assets (an income tax deduction up to 20 percent of AGI based on lower of fair market value or basis) in a current tax year. If the allowable deduction is limited in the year of contribution, the client should consider whether she can use carryover deductions during all or some of the succeeding five tax years.
Some very charitably inclined clients make a substantial upfront contribution and knowingly forego using all or a portion of their allowable deductions over the six-year period. However, most clients will consider making additional contributions in subsequent years to maximize allowable deductions, especially if they already have carryover deductions. By contributing in different tax years, the client may be more likely to use all of his deductions and allow for additional or greater contributions in the future. Clients also may find comfort in the flexibility of spreading out contributions in different tax years while adjusting to changes in the investment climate, expected tax increases and increases or decreases in income or individual expenses. However, the benefit of a larger upfront contribution to the foundation is that the PF's net investment income is subject to only a 2 percent (or possibly 1 percent)9 excise tax, instead of the taxpayer's investment returns taxed at high income tax rates.
If the client is significantly motivated by the deductibility of charitable contributions, he may consider estimating his deduction capacity by forecasting AGI over the next several years. Given the expectation of higher income tax rates in the future, one might expect a dollar of charity may be worth more, in terms of tax savings, in the future than in the present.
If a client's goal is to maximize the amount donated to the PF, he may be inclined to make a large upfront contribution. Conventional wisdom tells us that income tax-free investing in a PF generally leads to greater amounts to charity in the long run. Naturally, there should be more for charity given that the assets in a PF aren't subject to income tax (only a 2 percent or 1 percent excise tax). But is this true in all cases? Most likely, but surprisingly not always. The answer may depend in large part on the difference between an individual's after-tax rate of return and the income tax-free rate of return that a PF can achieve. The gap between the client's taxable return and the PF's income tax-free return can be wide in the client's portfolio that produces significant ordinary income (dividend and interest). The gap potentially is diminished if the client's portfolio is geared more toward growth and less toward ordinary income and if the client contributes only long-term appreciated assets (with unrealized gain) to charity.
The after-tax returns achieved outside a PF may lead to an increase in AGI, which increases the capacity to make tax-deductible contributions in the future. Furthermore, the value of the deduction attributable to the contribution of those after-tax returns to the PF may exceed the benefit gained from investing income tax free (with a 2 percent excise tax on net investment income) inside the PF. You have to crunch the numbers. A long-term forecast may actually reveal that holding on to assets earmarked for charity in a client's taxable portfolio may lead to greater overall contributions to charity than a one-time upfront gift.
The client also should consider whether tax loss harvesting (that is, selling securities at a loss to offset a capital gains tax liability) is available. With recent downturns in the market, the client may have carry-forward losses to be applied toward long-term realized gain from the sale of securities. The client can contribute cash to the PF instead of contributing long-term appreciated property. The client can use higher AGI limits and avoid the 2 percent excise tax on net-investment income.
Contributing Over Time
Clients may benefit from the flexibility of contributing over time. Those clients who can make large contributions to charity do so under the presumption that other plans such as retirement, education and wealth transfer will not be compromised. Balancing all goals into an integrated plan is important to ensure that implementation of any one plan doesn't significantly compromise the others. The recent financial crisis provides numerous examples of well-intended plans gone awry. Some clients are questioning the benefit of upfront contributing from the risk perspective. Studies of portfolio risk and return suggest that the expected return of a portfolio is greater in the case of upfront contributions than in the case of contributions over time (or dollar cost averaging). This is true, because most forecasting models generally expect positive rates of return. In a falling market, we expect that contributing over time would reduce downside risk. Clients considering making a substantial upfront contribution to a PF should recognize both the benefits and risks associated with substantial upfront contributions versus contributing over time.
Qualifying Distribution Requirements
The amount and timing of contributions affect the qualifying distributions, investment strategy and asset allocation model. Qualifying distribution requirements can create significant challenges for PF managers in making investment strategy and asset allocation decisions. To put these challenges in perspective — the manager is required to pay out 5 percent of the value of the PF's asset base each tax year. Grants, administration expenses (except investment advisory fees) and excise tax on net investment income apply toward the 5 percent requirement. There's the 2 percent (or 1 percent) excise tax on net investment income. The investment advisory fee is an allowable deduction to reduce the net investment income. The asset base's value is determined by using monthly averages for cash and marketable securities. A cash reserve equal to one and one-half percent of the PF's assets can be excluded from the calculation, regardless of whether cash is maintained in the account. Annual valuations usually are used for less liquid assets such as private equity, hedge funds, real estate investments and closely held business interests. Typically, values of illiquid assets are obtained from the fund managers or appraisers.
PF managers should regularly monitor the distribution amounts throughout the year. They should acknowledge the probability of regularly readjusting the asset allocation because typically liquid assets are used to pay out grants and expenses (including the excise tax on net investment income) to meet the 5 percent requirement. After the Form 990-PF is filed (four and one-half months after the end of the PF's tax year), the PF managers (and their advisors) can accurately determine liquidity needs due to additional required distributions, if any, and excise tax on net investment income. Additional liquidity demands must be anticipated if hedge funds or private equity investments have “gates” or lock-up periods that prevent withdrawals from the investments or require additional liquidity to pay private equity capital calls. Lack of liquidity can skew performance when disproportionate amounts of liquid asset classes or holdings are used to meet the 5 percent requirement. Also, in those cases, investment strategies and asset allocation models may be compromised. PF managers shouldn't lose sight of the presumption for diversification under the prudent investor standards.
Assuming the 5 percent qualifying distributions and a 1 percent investment advisory fee, the PF's portfolio requires an investment return of 6 percent to maintain its asset base. Even though inflation hasn't been a factor recently, it certainly may be during the PF's existence. For PFs supporting health or education, the relevant inflation factor is generally twice that of ordinary inflation. While most asset allocation models may show a greater than 50 percent probability of achieving an investment return over 6 percent over time, PF managers should be prepared for downturns in the market that can significantly affect grant-making programs.
During an unfavorable market environment, many PF managers and clients shift the asset allocation to overweight cash or fixed income which presumably helps reduce risk and provide sufficient liquidity. This shift may create performance drag on the portfolios and makes maintaining the PF's asset base and purchasing power more difficult. Presently, many clients remain underweight in public equities or alternative investments because they are reticent to reallocate to those asset classes. Consequently, some PF portfolios may underperform while paying out 5 percent distributions with a diminishing foundation asset base. The portfolio manager should be proactive in rebalancing the portfolio and consider returning to a more balanced asset allocation.
The PF manager should regularly review the investment strategy and asset allocation and possibly revise them. Many clients presume their PF will exist in perpetuity and future generations will gladly take the management reins. Family succession can be a predominant factor in a client choosing a PF. Clients must consider whether it's realistic to expect the PF's economic situation and mission to sustain the foundation over the long term. While some PFs may be able to sustain themselves indefinitely, the asset base and purchasing power is so diminished that the PF can no longer be effective. Consequently, the PF may have a shorter duration than originally contemplated. Managers must reassess the viability of the PF and determine if it will be more effective if its duration is shortened. In those cases the PF may have to terminate and pay out the remaining assets to charities or a DAF.
Besides possibly changing the PF's investment strategy, asset allocation or underlying investments, clients can take steps to mitigate the diminution of a PF's asset base. To help maintain the PF's asset base and increase duration, the PF's managers should determine if they can carryover excess qualifying distributions for up to an additional five tax years. If yes, the PF managers may apply the excess distributions to reduce the current year's (or additional years') required distribution to maintain and grow the PF's asset base. Also, family members may choose to make additional contributions to the PF directly or through charitable remainder trusts and charitable lead trusts to enhance the PF's asset base and increase its duration.
Due to economic challenges and the changing landscape of asset class performance, portfolios tend to be more actively managed now than in the past. In recent times investment strategies and asset allocations are modified more regularly than in the past, and tactical adjustments are far more commonplace. A PF's need for liquidity may require even further rebalancing of the portfolio. PF managers must regularly set aside time to properly manage these issues.
Not all clients will be able or willing to go the PF route. Clients who choose not to create or continue with a PF may consider contributing to a DAF. For example, the client may want a current income tax deduction, but isn't ready to contribute to a particular charity. Generally, DAFs have much greater flexibility as to distribution requirements than PFs. While the Internal Revenue Service requires most DAFs to pay out at least 5 percent of the aggregate of the DAFs assets each year, individual account holders aren't required to make minimum annual distributions as long as the DAF meets the 5 percent requirement. Congress periodically has discussed imposing a 5 percent annual minimum distribution requirement for each account holder. In the meantime, the account holder has greater flexibility with a DAF than with a PF as to the timing and amount of distributions to charity. Therefore, a DAF potentially may last longer than some PFs (with mandatory distribution requirements and higher expenses).
Even though a client's involvement with a DAF requires less time and financial commitment than with a PF, the client still should conduct adequate due diligence when selecting a DAF. The client must consider various aspects of the DAF, including its sponsor's viability, investment and succession options and distribution and contribution limitations. For instance, a client should determine whether other family members can succeed the account holder's right to recommend donations from the account or whether the account will have to be terminated at the account holder's death. The investment strategy and asset allocation should be coordinated with the account holder's anticipated distributions from the DAF. The account holder can take advantage of the less stringent distribution requirements and need for cash when deciding on the investment strategy and asset allocation. Also, a DAF account holder's contributions and donations aren't subject to public scrutiny. A PF's grants and assets are listed on its Form 990-PF and available to public review. Another advantage of a DAF over a PF is the donor of a DAF has higher income tax deduction limits for donations (up to 50 percent of AGI for contributions of cash and 30 percent for long-term appreciated securities and other assets). Those higher limits may provide an incentive for additional or more current contributions to the DAF.
The disadvantages of a DAF can, in part, depend on the specific DAF. Some DAFs have minimum contribution or distribution amounts that may not appeal to a particular account holder. Also, some DAFs may limit the types of assets it will accept or family succession opportunities. The potential donor may not like a particular DAF's investment options or who manages the DAF funds. Generally, PF managers have more flexibility with investment options and types of assets to be managed. They have more control over the management of the assets than DAF account holders. Also, unexpected consequences can occur. For example, the National Heritage Foundation filed a plan of reorganization in the bankruptcy court.10 The court held that the DAF's assets (donor's contributions) under the bankruptcy plan were available to satisfy creditor claims, instead of for their intended purpose — charitable donations.
- Patient Protection and Affordable Care Act and the Health Care and Education Tax Credits Reconciliation Act of 2010.
- Asset allocation can't eliminate the risk of fluctuating prices and uncertain returns.
- Internal Revenue Code Section 4492.
- IRC Section 4493.
- IRC Section 4491.
- IRC Section 170(e)(5). “Qualified appreciated stock” is long-term appreciated stock that is publicly traded stock on an established securities market. No more than 10 percent of the corporation's stock can be donated.
- IRC Section 170(b)(1)(B)(ii). The amount of the allowable deduction is based on taking into account the amount, type and timing of all the contributions, not just each contribution viewed separately. A discussion as to how to calculate the deductions is beyond the scope of this article. Adjusted gross income (AGI) is typically referred to instead of contribution base (AGI without net operating loss carry back).
- IRC Section 170(b)(1)(D)(i). For contributions of long-term non-cash assets (other than qualified appreciated stock), the deduction is based on the lesser of basis or fair market value.
- IRC Section 4490. This excise tax differs from unrelated taxable business income (that the foundation may have) under IRC Section 512(a), which is taxed separately to the foundation at the tax rates customarily charged to trusts or corporations.
- U.S. Bankruptcy Court for the Eastern District in Alexandria, Va.
This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate-planning strategy. The content represents thoughts of the author(s) and does not necessarily represent the position of Bank of America. U.S. Trust Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of American Corporation. Bank of America, N.A., Member FDIC.
Douglas Moore, far left, is a managing director of the U.S. Trust Family Office and Neil P. Murphy is a senior vice president and investment strategist with U.S. Trust, both in New York City