Advise clients about donor-advised funds

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Affluent individuals may be less inclined to establish or continue a private foundation.

Private foundations can involve substantial start-up costs and annual administrative fees. Some clients may consider another option that is growing in popularity.

Strategy: Explain the benefits of donor-advised funds. A client may be inclined to create a new fund or convert an existing private foundation. Recent tax law changes have increased scrutiny of donor-advised funds, but they’re still a viable alternative.

Background information: For starters, the client donates a lump sum to the fund, usually managed by an experienced charity. In return, the client receives a current tax deduction. Then the client doles out the money to designated charities. Although the fund legally controls the money, the client essentially decides who gets what and when.

Tax penalties to avoid

Under the PPA, the IRS can tax distributions that don't further the organization's charitable function. In addition, the IRS may impose a 25 percent tax on the economic benefit (other than an incidental benefit) received.

Violations can include the following penalties:

  • A tax equal to 20 percent of the amount distributed, which the sponsoring organization pays
  • A tax equal to 5 percent of the amount distributed, if the fund manager knowingly agrees to such a distribution
  • A tax equal to 10 percent of the value of the economic benefit received by the recipient, if the manager knew the distribution would result in such a benefit.

Advisory: The PPA also increased reporting requirements on Form 990 by sponsoring charitable organizations.

A donor can claim a tax deduction of up to 50 percent of adjusted gross income (AGI) for cash contributions and up to 30 percent of AGI for securities. In comparison, deductions for private foundations are limited to 30 percent of AGI for cash contributions and 20 percent for securities.

Typically, a donor-advised fund requires an up-front gift between $10,000 and $25,000. It will also charge a fee (e.g., equal to 1 percent of the assets) for administering and investing the money. Donor-advised funds have operated without much regulation for decades. The Internal Revenue Service doesn’t require a fund to give away specified amounts or to disclose contributions. In effect, they act like mini private foundations.

Key point: The Pension Protection Act of 2006 (PPA) now imposes fines and penalties if donors use designated funds to benefit themselves or their families (see sidebar). The PPA also authorizes the IRS to ramp up tougher measures if it deems necessary. If your client hasn’t done so already, have him or her grant control over the fund assets. For instance, the fund should have final authority over how to invest and distribute the money. Also, the law strictly prohibits gifts to a fund that benefits a donor, his or her family, or a related party.

Advisory: Clients should avoid any self-dealing practices that allow them to line their own pockets while the fund operates.

Reprinted with permission from The Tax Strategist, December 2010. For continuing advice on this and numerous other tax strategies, go to Receive 2 FREE Bonus reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.

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