Donor advised funds (DAFs) are among the most powerful philanthropic tools for entrepreneurs, particularly those seeking to optimize charitable giving while navigating tax implications during business growth and exits. These charitable giving vehicles offer entrepreneurs a unique combination of immediate tax benefits, investment flexibility, and long-term philanthropic impact.
Notably, they can accept contributions of private company stock, a significant advantage for our clients when planning for liquidity events or exits, or seeking to maximize their charitable impact while minimizing tax burdens. In this article, I’ll offer an in-depth overview of donor-advised funds, highlighting their key features, the setup process, and strategic approaches founders and entrepreneurs can leverage.
Understanding Donor Advised Funds
A donor advised fund is a private investment account established by the donor to manage and distribute charitable donations. When donors contribute to their donor advised fund, the assets are managed, while the donor maintains advisory privileges over how the funds are invested and ultimately distributed.
The operational framework of a DAF follows three main steps:
- First, donors contribute assets to their fund and receive an immediate tax deduction.
- Second, these contributions can be invested and grow tax-free over time, increasing the amount available for charitable purposes.
- Third, donors can recommend grants to qualified charitable organizations at their own pace, allowing for thoughtful and strategic philanthropy.
Unlike private foundations, DAFs offer more significant tax advantages with significantly less administrative burden. Donors can receive a federal income tax deduction of up to 60% of their adjusted gross income (AGI) for cash contributions and up to 30% of their AGI for appreciated securities they donate.
Donor advised funds also have an advantage over private foundations.They can accept private stock and receive a fair market value deduction of the private shares contributed.
Why Entrepreneurs Should Consider Donor Advised Funds
For entrepreneurs, especially those holding private shares, Donor Advised Funds (DAFs) present unique benefits that seamlessly combine their philanthropic aspirations with strategic financial planning. For those who are charitable or plan to be, DAFs offer a genuine win-win opportunity.
Tax Efficiency and Timing
Entrepreneurs often experience significant fluctuations in income, particularly during periods of business growth and exits. DAFs allow them to “bunch” charitable contributions in high-income years to maximize tax benefits.
By contributing to a DAF in a year with unusually high income (such as a liquidity event or exit), entrepreneurs can claim an immediate deduction. They can also spread their actual charitable giving over time.
Simplified Charitable Giving
For busy entrepreneurs juggling multiple priorities, DAFs offer administrative simplicity. Rather than managing donations to multiple organizations and tracking numerous tax receipts, donors receive a single tax receipt in the tax year of their DAF contribution. This streamlined approach simplifies record-keeping while maximizing tax efficiency.
Asset Flexibility and Diversification
One of the most significant advantages for entrepreneurs is the ability to contribute a wide range of assets beyond cash. DAFs can accept contributions of appreciated securities, real estate, cryptocurrency, and, most notably for our founders, private company stock. This flexibility enables entrepreneurs to utilize various assets to maximize tax benefits.
Optimizing Charitable Impact with Private Stock Donations
For many entrepreneurs, the most substantial portion of their wealth is tied up in their privately held business. Donating private company stock to a DAF presents a unique opportunity to maximize both tax benefits and charitable impact.
The Process of Donating Private Stock
When entrepreneurs donate shares of their private company to a DAF, they can claim an immediate income tax deduction for the full fair market value of the contributed shares, net of any valuation discount. The DAF can then hold the shares until an exit event occurs, at which time the proceeds can be reinvested in a diversified portfolio.
This strategy becomes particularly powerful for our clients before a planned company sale. By donating shares before the sale happens, entrepreneurs can eliminate capital gains exposure that would otherwise occur if they sold the shares first and then donated the after-tax proceeds.
Most founder stock typically has a zero cost basis, meaning the founder acquired the shares at the company’s inception for a nominal amount, often just a cent or two. For that reason, shares sold during an exit or liquidity event are many times fully taxed at capital gains rates.
Comparative Advantage: A Case Study
Consider this example.
A founder owns C-Corp private shares valued at $ 50 million and estimates that they will donate $ 10 million to charity over the next 10+ years. They have two options:
Option A: Donating Cash Post-Exit
- Long-term capital gains tax paid: Upon selling $10 million worth of C-Corp private shares, the capital gains tax would be approximately $2.38 million
- Amount given to charity: $10 million in cash.
- Total expense: $12.38 million (including the capital gains tax).
- Charitable deduction: $10 million, subject to adjusted gross income (AGI) limitations.
Option B: Donating Stock Directly to a Donor Advised Fund (DAF) Pre-Exit
- Long-term capital gains tax paid: $0, as donating appreciated stock held for more than one year to a public charity or DAF can eliminate capital gains taxes on the contributed shares.
- Amount given to charity: $10 million in stock.
- Total expense: $10 million.
- Charitable deduction: The deduction is typically based on the fair market value (FMV) of the donated stock, as determined by a qualified appraisal. Valuation discounts of 5%–10% may apply due to factors like lack of marketability or control, potentially reducing the deductible amount to $9.5 million with a 5% discount.
As you can see, for the charitable entrepreneur example above, the direct donation of private stock (Option B) saves the entrepreneur well over $2 million.
Valuation Considerations
When donating private company stock, entrepreneurs should be aware that a qualified appraisal will be required to substantiate the fair market value of the contributed asset. Typically, a valuation discount (often between 5-10%) may be applied due to minority interest and lack of control. This step in the process requires careful planning and professional guidance to ensure compliance with IRS requirements.
Using DAFs for Entrepreneurs
Beyond the basic tax advantages, entrepreneurs can employ several sophisticated strategies to maximize the impact of their donor advised funds.
Timing with Business Milestones
Strategic timing of DAF contributions can significantly enhance their value. For entrepreneurs approaching a business sale or other liquidity event, contributing shares before the transaction can produce substantial tax savings.
That said, you don’t want to wait too long, or have the donation occur too close to the transaction. In doing so the IRS may consider it a pre-arranged sale, resulting in a tax liability for the donor.
Bunching Donations
The “bunching” strategy involves combining multiple years’ worth of charitable donations into a single tax year. For entrepreneurs who may have inconsistent income from year to year, or for example, a once-in-a-lifetime exit event, this approach can be efficient.
Portfolio Rebalancing
For entrepreneurs with diversified investment portfolios, DAFs can serve as an effective tool in portfolio rebalancing. Rather than selling appreciated securities and triggering capital gains taxes, donors can contribute these assets to their DAF as part of their rebalancing strategy. This approach helps maintain desired asset allocation while supporting charitable objectives without the tax consequences of selling winners.
Practical Considerations for Entrepreneurs
Selecting the Right DAF Sponsor
Entrepreneurs should carefully evaluate potential DAF sponsors based on several factors:
- Breadth, Scale, and Capabilities: DAF sponsors can vary significantly from startups to large institutions. It’s essential to conduct thorough due diligence on a range of sponsors to ensure the right fit. For instance, we maintain relationships with multiple sponsors for various strategic reasons.
- Fee structure: DAF sponsors typically charge administrative fees based on a tiered structure related to the account balance.
- Investment options: Different sponsors offer varying degrees of investment flexibility and oversight.
- Expertise with complex assets: For entrepreneurs planning to donate private stock or other illiquid assets, it’s crucial to choose a sponsor with expertise in handling and liquidating these types of contributions.
Due Diligence Requirements
Donating private company stock requires entrepreneurs to navigate the sponsor’s due diligence process. This often involves many of the following but not limited to:
- Cap Table & Share Class: The DAF will want to review the capitalization table and details about the specific shares being donated.
- Corporate Documents: Provide articles of incorporation, bylaws, shareholder agreements, and any transfer restrictions (e.g., right of first refusal, co-sale rights).
- Board or Shareholder Approval: Some shares cannot be transferred without company approval.
- ROFR/Drag-Along/Tag-Along: DAFs need to ensure these won’t hinder a future sale or compromise charitable status.
- Company Buyback Rights: These must be disclosed and may affect the DAF’s willingness to accept the gift.
This entire process requires coordination with corporate counsel, the DAF sponsor(s), the board, and the founder. With extensive experience, we excel at navigating these complexities. Our expertise comes from years of collaboration with founders and their companies, combined with a deep understanding of donor advised funds and sponsors.
Conclusion
The strategic use of Donor Advised Funds can help entrepreneurs maximize both their charitable impact and tax benefits, particularly around significant business events like growth phases or exits.
For entrepreneurs considering charitable giving strategies, consulting with those familiar with this process is essential to developing an approach that optimizes both financial and charitable outcomes.
FAQs
How does a donor advised fund work?
A Donor Advised Fund (DAF) is a charitable giving account managed by a public charity that allows individuals and families to make tax-deductible donations to charities while retaining control over the timing and distribution of the funds. Here’s how it works:
- The donor contributes cash, securities, or other assets
- The donor receives an immediate tax deduction for the donation.
- The donated assets are invested and can grow in value over time.
- The donor can recommend grants from the fund to qualified charities at any time.
- Once the grant is approved by the sponsoring organization, it is distributed to the chosen charity.
What is the downside to a donor advised fund?
While donor advised funds offer many benefits for donors and charities alike, there are some potential downsides to consider. One of the main concerns is that once a donation is made to a donor advised fund, the assets technically belong to the sponsoring organization rather than the original donor. This means that although the donor can recommend grants from the fund, they do not have complete control over how their donated assets are ultimately used.
How much money do you need for a donor advised fund?
The amount required to establish a donor advised fund varies depending on the sponsoring organization. Some organizations have minimum initial contributions as low as $5,000, while others may require significantly higher amounts.
It is important to research and compare different sponsoring organizations before committing to a donor advised fund. Consider factors such as minimum contribution amounts, fees, investment options, and grant-making policies.
Additionally, donors should consider their long-term giving goals when determining how much to contribute to a donor advised fund, and whether it should be implemented over multiple years or all at once. It is recommended to consult with financial advisors or tax professionals for personalized advice on the appropriate amount for your specific situation.
