"Conversions of Private Foundations to Donor Advised Funds"
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 is a growing trend to consider donor advised funds as alternatives to private grant making foundations. Some of this interest no doubt resulted from concerns raised by substantial depletion of private foundation endowments after the economic collapse of 2008. Private foundation directors and trustees, seeing a depletion in their grant making capacities, were looking for ways to decrease administrative costs and increase investment returns.
For many years, 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 raised accounting and related fees. And such foundations need to pay investment income taxes and always be cognizant of the need to meet the annual 5% distribution requirement. Smaller foundations are especially concerned that the costs outweigh the benefits of continuing their foundations.
In recent years, 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.
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, then the trust most likely needs to file a cy-près or equitable deviation action in court and involve the state 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 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 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 and that there is an adequate number of current board members under applicable state law 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.
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:
- 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.
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 at the recommendation of the donor advisors.
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 a receipt from the donor advised fund sponsor for all transfers, which includes a statement that the distribution to the donor advised fund avoids any assessment of a termination tax under Internal Revenue Code Section 507.
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 investment income 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.
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.
It should be noted that it is possible such funds will become more regulated like private foundations, including requirements of minimum annual distributions. Such increased regulation certainly started with the Pension Protection Act of 2006 where, among other things, such funds were made subject to stricter rules as to the giving of scholarships and the investments in certain excess business holdings. But overall, it seems highly unlikely that the administration of such funds will be as burdensome as private foundations, and certainly would not be as burdensome in compliance requirements for the donors and their families.
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.