Recent Cases: Donor-Advised Fund vs Private Foundation
- Dec 7, 2021
As the year comes to an end, families are looking for the most effective way to donate to charities and minimize tax exposure. If you wish to stay in control of the management, liquidation or any aspect of what you donate to charities, then consider the outcome of two recent court case decisions on Donor-Advised Funds (“DAFs”) when weighing your charitable giving options. We will compare the DAF to the private nonoperating foundation (“PF”), an alternative charitable vehicle which typically offers donors full control of the donated assets. Then we will explore the recent court cases and discuss lessons learned.
Summary of Donor Advised Fund vs Foundation
A DAF is a separate account the donor establishes with a sponsoring organization (i.e., Schwab Charitable Fund). A sponsoring organization must be a public charity, not defined as a PF and hold one or more DAFs. The DAFs are run by fund managers (officers, directors, or trustees) of the sponsoring organization. Any cash, securities or other assets the donor transfers to the DAF account are immediately eligible for a tax deduction and sit in the account tax-free. The amounts in the account are invested and ultimately distributed to IRS-qualified public charities. The donor need not set up a new legal entity or comply with tax filings. Administrative fees vary and are generally based on the percentage of the assets held in the account. DAFs provide donors with advisory privileges on investing and distributing to charities. Typically, the DAF will follow the donor’s request, but it is not required.
A key disadvantage is the sponsoring organization has legal control over the donated assets not the individual donor. The DAF is commonly utilized to bunch charitable deductions in one year to maximize the immediate charitable tax deduction while spreading out the distributions to charities over several years. Donors may claim an annual charitable deduction of up to 60% of their adjusted gross income. DAFs require minimal administrative work and are a fraction of the cost of PFs. The donor typically sets up an account online, makes the contribution to the DAF and may advise the sponsoring organization.
Private Nonoperating Foundations
A PF is a separate legal entity typically formed and primarily funded by individuals or family members. The founder appoints a board of directors, forms a new legal entity, manages distributions to charities, and complies with tax filings and prohibitive transaction rules. PFs are exempt from income taxes, but subject to an approximate 1% excise tax on the PF’s net investment income.
A key advantage of a PF is the family founders have full control over the investing and granting of donated assets. A donor may also claim an immediate tax deduction upon transfer, similar to a DAF. However, the PF is subject to an excise tax for failure to distribute income to charities. The IRS closely regulates PFs through the imposition of various excise taxes. Donors may claim an annual charitable deduction of up to only 30% of their adjusted gross income. PFs tend to create an administrative burden and are costly.
In Fairbairn v. Fidelity Investments Charitable Fund, (United States District Court for the Northern District of California, February 26, 2021), Malcolm and Emily Fairbairn donate stock to Fidelity Charitable. Fidelity Charitable allegedly agrees to sell the stock in a manner that would not adversely impact the stock price. Fidelity Charitable’s published policy requires all donated publicly traded stock to be liquidated as soon as possible. In keeping with that policy, Fidelity Charitable immediately sells all the shares of the stock upon receipt. The Fairbairns contend the liquidation of all the shares resulted in a decline in the stock price and sues Fidelity Charitable. According to the Fairbairns, a decrease in stock price reduced their charitable tax deduction and resulted in less money available for charities. Experts in the case agreed, as well as Fidelity Charitable, that in hindsight the liquidation may have been managed differently. The court rules in favor of Fidelity Charitable stating that the sponsoring organization owns the assets and did not violate their fiduciary responsibility.
Case #1 Analysis:
- The court favors the party who holds legal title to the donated assets, which in this case is Fidelity Charitable. It is irrelevant if Fidelity Charitable fails to follow the donor’s advice even if the advice would have led to a better outcome.
- While donors may have advisory rights on the public charity’s DAF accounts, they do not have the final say. The court further emphasizes this point, by contrasting the donor-DAF sponsoring organization relationship to that of a client/portfolio manager relationship where the portfolio manager must act on behalf of their clients.
- The Fairbairns should have relied on Fidelity Charitable’s stock liquidation documented policy, not on verbal promises.
In Pinkert v. Schwab Charitable Fund (“Schwab Charitable”) (United States District Court for the Northern District of California, San Francisco June 17, 2021), Philip Pinkert makes a donation to a DAF sponsored by Schwab Charitable. Pinkert is of the opinion his donation was mismanaged and sues Schwab Charitable. Pinkert claims the custodial and brokerage fees Schwab Charitable paid to Charles Schwab & Co are excessive and Schwab Charitable should have used their negotiating power to lower the fees with their affiliated entity. In effect Charles Schwab & Co benefited while the charities received less money. In Pinkert’s view, Schwab Charitable chose to invest his donation in index and money market funds that were expensive as compared to other options available in the market, which required Pinkert to contribute more money to the DAF to reach his philanthropic goals. The court dismisses the case, because Pinkert no longer has control over the donated assets and therefore has no binding authority on how the donated assets are invested and distributed to charities.
Case #2 Analysis:
- Similar to case #1, the court favors the party with legal title (here Schwab Charitable) regardless of whether or not the sponsoring organization mismanaged the DAF.
- This case emphasizes the importance for donors to analyze the cost structures and investment options before selecting a DAF. If donors are not satisfied with the choices available by DAFs, then they should consider setting up a PF or other charitable vehicle, where the donor is in control.
- DAFs offer donors an easy less expensive mechanism to make donations, but the pitfall is the donor gives up legal title to the donated assets -- whereas PFs provide donors with control over the donated assets, but the downsides are the administrative costs and IRS scrutiny.
- If the DAF’s sponsoring organization does not follow the donor’s advice, no recourse exists for the donor according to the above discussed cases.
- Review the sponsoring organization’s policy for items such as the cost structure, investments and liquidation policies before choosing a DAF.
- Evaluate pros and cons of each charitable giving vehicle mindful of the level of control desired.
As always, consult with your advisors before making any decisions on the optimal charitable giving vehicle for you.
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Alyssa Rausch is a Senior Tax Manager in the Private Client Services Group. She provides comprehensive tax compliance and advisory services to high net worth individuals, closely held businesses and their owners, S corporations and partnerships.
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