By Kirk Hoopingarner, Attorney & Partner, Quarles & Brady, Chicago
For many years, donors have utilized private grant making foundations for charitable giving. Organized as either trusts or corporations, such entities have served as a means for making substantial tax deductible contributions while spreading out the actual contributions to charities over many years.
They have provided families with a structure to enable them to consolidate and organize their giving for greater impact, and often family members and advisors find this to be a very fulfilling process of charitable giving. Much of the most significant charitable impact has resulted from private foundation grant making or program related investments. Well-known names in philanthropy such as the Ford Foundation come to mind and many communities are blessed with substantial contributions from such private foundations.
Growing Trend of Donor Advised Funds
But with this said, in recent years there has been a growing trend to consider donor advised funds as alternatives to private grant making foundations as a means of obtaining immediate tax deductions while spreading out over time actual contributions to charities in a fashion similar to the deferral provided for contributions to private foundations. Much of this continues to be driven by interest in donors in simplifying the administration of their charitable giving.
Private foundation directors and trustees have increasingly been concerned over the administrative burdens associated with the various federal and state rules relating to private foundations, including regulations on the types of authorized investments and the compensation that can be paid to family members who administer the private foundations.
Annual reporting, especially the federal form 990PF, has become more cumbersome and resulting in accounting and related administrative expenses that only decrease the funds available for charitable giving. Also, private foundations need to pay investment income excise taxes and always be cognizant of the need to meet the annual 5% requirement to make qualified charitable distributions. Smaller foundations are especially concerned that the costs may outweigh the benefits of continuing their foundations, including the control they retain over their private foundations.
Donor advised funds, sponsored by commercial entities, community trusts, charitable organizations and independent programs such as American Endowment Foundation, have provided families with an alternative structure for their charitable giving that:
- substantially reduces administrative burdens and costs;
- provides anonymity where preferred;
- enables relatively turnkey processing of grantee due diligence and grant processing.
The private foundation directors and trustees can retain advisory roles over the distribution of the new donor advised fund and can set general parameters on the types of distributions to be consistent with the private foundation’s mission. The family name can still be associated with the giving if this is desired and often the investment advisors of the private foundation can continue to manage the investments of the donor advised funds if certain minimum deposits in the new donor advised fund are made. The family can also create multiple donor advised funds with each branch acting as advisors for each separate fund.
Use of donor advised funds as alternatives to private foundations and also the use of donor advised funds to complement private foundations for family charitable giving both reflect the substantial growth in the philanthropic sector of donor advised funds. It now exceeds $125 billion and will likely continue to receive attention as donors’ net worths continue to grow and tax rates climb. Like private foundations, donor advised funds allow a donor to obtain an immediate income tax deduction while spreading out the actual distributions of the charitable funds over a number of years. But unlike private foundations, donors can establish donor advised funds expeditiously and relatively simply.
Terminating a Private Foundation
To terminate a private foundation and transfer its balance to a new donor advised fund does require careful adherence to Internal Revenue Code Section 507. Care must be taken to avoid the assessment of any special termination tax which can be as much as the aggregate tax benefit, including interest, received by both the private foundation and all substantial contributors to the private foundation.
Internal Revenue Code Section 507(b) provides that there is no termination tax assessed against the organization upon termination if it distributes all of its net assets to one or more organizations described in Code Section 170(b)(1)(A) (other than private foundations or a 509(a)(2) or 509(a)(3) organization) each of which has been in existence and so described for a continuous period of at least 60 calendar months immediately preceding such distribution.
In addition to following the guidelines of Internal Revenue Code Section 507(b), it is important that the private foundation also adhere to its own governing documents and applicable state law in connection with its termination.
If the Private Foundation Was Formed as a Trust –
If the private foundation has been formed as a trust, determine if the trust agreement has any specific restrictions on the distribution and administration of the trust. If the trust specifies a particular set of principles for distribution, including a specific purpose such as supporting environmental programs, then the new donor advised fund must be established with such specific guidelines and focus on its future distributions.
If the trust calls for perpetual existence( or restricts distributions to income only), then the trust most likely needs to file a cy-près or equitable deviation action in court and involve the state charitable enforcement body (often the state attorney general’s office) to give consent to terminate the private foundation and transfer all assets to the new donor advised fund.
If formed as a trust, all trustees( unless the trust agreement allows for decisions by a majority of the trustees) need to execute in writing an approval of the termination of the foundation and transfer to a new donor advised fund and it should be confirmed that all acting trustees have so approved this action. Such written approval should include as an exhibit the documentation supporting the establishment of the new donor advised fund, including any gift agreements and designation of the advisors.
If possible, the trustees should also confirm in writing that there are no restrictions or conditions of the investments or distributions of the new donor advised fund that otherwise would be considered unacceptable under Treasury Regulation Section 1.507-2(a)(8)(iv), such as requiring the donor advised fund sponsoring organization to give the donor a first right of refusal over the assets that are transferred to the donor advised fund.
If the trust agreement or related trust documentation designates successor trustees, then if possible, such successor trustees should also sign consents and presumably should be named as successor advisors. If the trust calls for there to always, if possible, be a descendant of the donor as a trustee, then again such a designation of donor advisors should be provided in the donor advised fund agreement.
If the Private Foundation Was Formed as a Corporation –
If the private foundation is formed as a corporation, then the articles of incorporation should be reviewed to determine if there are any restrictions on the distribution of the foundation on termination– most likely the language provides that upon termination the remaining assets must be distributed to an Internal Revenue Code Section 501(c)(3) charitable organization, but may have some additional restrictions which may not necessarily apply to donor advised funds and thus require an amendment.
There should be confirmation of the current board of directors that there is an adequate number of current board members under applicable state law (and the bylaws) to conduct business and enter a resolution calling for the dissolution of the corporate private foundation and distribution of assets to a new designated donor advised fund. Where necessary, Articles of Dissolution should be filed with the applicable Secretary of State.
Final Steps
In either the case of a trust or a corporation, the trustees or directors, working with the private foundation’s accountants, attorneys and investment advisors, should ensure that before final distribution to the donor advised fund:
- administrative expenses associated with winding down the foundation have been or will be paid,
- that all liabilities are satisfied, including any rent for offices or related equipment expense,
- and that all outstanding pledges made by the private foundation will be paid.
It is suggested that retainers be given to the accountants and attorneys to cover final costs of termination. A review of any multiyear grant agreements is warranted, as the donor advised fund cannot be used to satisfy any pledges made by the private foundation, because based on the Treasury Department’s Notice 2017-73 proposing guidance for donor advised funds, such satisfaction of irrevocable pledges would be considered prohibited benefits to the donor, unless the following requirements are satisfied in accordance with these proposed guidelines:
- the sponsoring organization makes no reference to the existence of a charitable pledge when making the DAF distribution; and
- the private foundation does not receive, directly or indirectly, any other benefit that is more than incidental (as discussed in the notice and as further defined in future proposed regulations) on account of the DAF distribution.
Note that these are merely proposed guidelines and remain subject to revision. But it is really best to avoid having the donor advised fund satisfy any multi year grant of the private foundation after the transfer to the donor advised fund is made.
The private foundation should also consider contacting its grantees to inform them of this plan of termination and use of a donor advised fund for future giving. The likely result is that the key contacts of the private foundation would continue to work with the grantees for possible future grants but they would come through the donor advised fund sponsoring organization and be made only at the recommendation of the donor advisors of that fund.
The entire balance should be distributed to the new donor advised fund if a complete termination of the private foundation is intended and the final form 990PF should show zero remaining balance in the private foundation. The private foundation should obtain receipts from the donor advised fund sponsor for all transfers, which includes a statement that the sponsoring organization meets the requirements of Code Section 507(b)(1)(A).
If the private foundation is interested in making a substantial contribution to one public charity and such contribution could cause the recipient charitable organization to lose its public charity status, when considering a donor advised fund the private foundation should be aware of the implications of the IRS Notice 2017-73 which indicated that the IRS is anticipating proposed changes to regulations Section 1.170A-9(f)(6)(v) which would provide that a donee organization, for purposes of determining the amount of public support, must treat:
- a sponsoring organization's distribution from a DAF as coming from the donor (or donors) that funded the DAF rather than from the sponsoring organization;
- all anonymous contributions received (including a DAF distribution for which the sponsoring organization fails to identify the donor that funded the DAF) as being made by one person; and
- distributions from a sponsoring organization as public support without limitation only if the sponsoring organization specifies that the distribution is not from a DAF or states that no donor or donor advisor advised the distribution.
Investment Review
As soon as there is a decision to terminate the private foundation and a selection of a new donor advised fund sponsor, there should be a review of the current investments of the private foundation and consideration on whether there should be liquidation of all or a portion of the investments and distribution of cash to the donor advised fund or a distribution in kind.
If there is a liquidation by the private foundation, then it must set aside a reserve for the net investment income excise tax of 1 to 2% on net investment income. There should also be coordination regarding future investing of the donor advised fund.
If the private foundation has an investment policy statement and would like such an approach continued with the donor advised fund, this should be discussed with the donor advised fund sponsor to see if this is feasible. Also, as stated above, if the private foundation would like its current investment advisor to continue in advising the donor advised fund, it should discuss this possibility with the donor advised fund sponsor. Many donor advised fund sponsors allow for an outside investment advisor if certain minimum balances are met.
Closing Thoughts
In the end, with proper planning and thought, the conversion of a private foundation to a donor advised fund can go very smoothly and result in a much easier administration of charitable giving by the family. Many donor advised fund sponsors such as American Endowment Foundation are well equipped to handle this transition and former private foundations have provided many testimonials in the financial press indicating much satisfaction with the process.
And while donor advised funds have been subject to scrutiny by various members of Congress, overall they have demonstrated a strong contribution toward increasing charitable giving and overall philanthropic impact. With this said, it should be noted that the recent legislative proposal of Senators Grassley and King (the Accelerating Charitable Efforts Act) could signal more regulation of donor advised funds, including the transfer of funds from private foundations to such funds. The Act includes a provision that distributions from a private foundation to a donor advised fund shall not be considered qualifying charitable distributions under Code Section 4942 and this prohibition could be expanded to not allow such transfers to be considered Code Section 507(b)(1)(A) transfers. Also, if the intention for such transfers is to keep the same investments and investment approach, this may be reduced by such legislation. With this said, the proposals seem to be focused primarily on restricting individual donors' rights to take immediate and full income tax deductions and such deductibility is not needed in the context of a private foundation termination and transfer to a donor advised fund.
If a private foundation is considering terminating but would like to first see how a donor advised fund works, then a family may want to consider establishing a donor advised fund with a relatively small initial contribution and work with the sponsor to see how it works, including the processing of grant requests. This is especially important if the private foundation is accustomed to relatively quick turnaround for satisfying grants and have grantees with time sensitive cash needs
Kirk Hoopingarner is an Attorney & Partner at Quarles & Brady, Chicago. He is a member of the AEF Council of Advisors.
Call us at 1-888-660-4508 or contact us to learn more about how to convert a private foundation to a donor advised fund at American Endowment Foundation.