In the previous article, “How to Align Passion with Impactful Giving“, we discussed the fundamental aspects of philanthropic giving. In this article, we take a closer look at the different ways to structure charitable gifts and the advantages of each structure. We’ll start by discussing the role of foundations.

Conduit and Operating Foundations

Private foundations provide many of the same benefits of public charities if they are structured and administered as a conduit foundation or as an operating foundation.

A conduit foundation must distribute 100% of all property contributed to it before the end of the first quarter in the year following the contribution. For example, if you contributed $1,000,000 to a conduit foundation in 2024, the foundation would have to distribute that entire amount by April 15, 2025. Conduit foundations generally only make sense for benefactors who do not want to be directly involved in ongoing charitable activities, and who have several known public charities to which they want to distribute large amounts.

By contrast, an operating foundation does not just award grants; it is actively engaged in providing services that advance the tax-exempt purposes of the foundation. Although operating foundations require higher administrative commitment and overhead, they provide more beneficial charitable deduction opportunities for donors as well as additional flexibility and control. Private operating foundations may also create opportunities for family members to receive reasonable compensation for services they provide to the foundation.

The classification of a private foundation is determined on a year-by-year basis based on the foundation’s activities. In some years a foundation may be treated purely as a “private non-operating foundation” subject to the lower deduction limits and excise tax mentioned above. In other years the private foundation may be managed as a “conduit foundation” if it meets the 100% distribution test. And in other years it may qualify as a “private operating foundation” if it meets a specific two-prong qualification test discussed below. The key is to strategically manage the foundation’s investments and activities in a way that allows it to qualify as an operating foundation – at least in years that are most advantageous.

Private Operating Foundations

The most complex type of private foundation is a private operating foundation. If a private foundation satisfies both parts of a two-prong qualification test, it will be deemed to be an operating foundation. The first prong of the test is a mandatory income test that requires the foundation to spend at least 85% of the lesser of the foundation’s (1) adjusted net income (which does not include long-term capital gain income or contributions made to the foundation) or (2) its minimum investment return, on the “active conduct” of charitable activities. If the foundation does not meet the income test in a given year, it will not be treated as an operating foundation for that year regardless of any other test.

If the income test is met, then the foundation must also satisfy at least one of the following additional tests:

• Assets test – At least 65% of the foundation’s assets are devoted to the direct conduct of tax-exempt activities; or
• Endowment test – The foundation distributes at least 2/3 of its minimum investment return in the active conduct of its tax-exempt activities.

The foundation may meet the assets test in some years, and the endowment test in other years. It must meet the income test every year. In each prong of the qualification test, expenditures and distributions must be made in ways that advance the exempt activities of the foundation itself, rather than through grants to other individuals or organizations.

Defining “Active Conduct” for the Qualification Test

The following are general examples of expenditures and grants that may qualify as “active conduct:”

• Amounts paid or set aside to acquire or maintain assets used directly in the foundation’s exempt activities.
• Reasonable administrative expenses such as salaries, travel expenses, and other operating costs necessary to conduct the foundation’s exempt activities.
• Grants made as part of an active program in the foundation.
• Grants made with continuing supervision by the foundation (and with the grant recipient reporting back to the foundation).
• Tax on an operating foundation’s net investment income may be treated as a qualifying distribution.

By contrast, administrative expenses and operating costs that do not directly advance the foundation’s tax-exempt purposes do not constitute qualifying distributions.

As the above discussion demonstrates, private operating foundations are complex, but where you wish to fund a cause that is not being adequately addressed by other existing charities, a private operating foundation may be your best choice.

Private Non-Operating Foundations

A private non-operating foundation is a charity that primarily functions as a grant-making entity; i.e., it primarily makes grants to other charities rather than conducting its own operations. Like operating foundations, non-operating foundations are typically funded by an individual or single family.

Private non-operating foundations must annually distribute at least 5% of their net investment assets for charitable purposes, and their investment income is subject to a 2% excise tax. Moreover, when funding a non-operating foundation, you can deduct up to only 30% of your adjusted gross income for cash contributions, 20% for non-cash contributions (e.g., appreciated stock). Significantly, you can carry forward unused deductions for up to five additional years (i.e., six years total). Conversely, with a contribution to a conduit or operating foundation (or any direct contribution to a public charity), you can deduct up to only 50% of your adjusted gross income for cash contributions, 30% for non-cash contributions.

Donor Advised Funds

A popular alternative to non-operating foundations is the Donor Advised Fund (DAF). DAFs are separately identified accounts maintained and operated by public charities, known as sponsoring organizations. Once the donor makes the contribution, the sponsoring organization has legal control over it. However, the donor, or the donor’s representative, retains advisory privileges with respect to the distribution of funds and the investment of assets in the account. Significantly, the donor requests that the sponsoring organization make a distribution, but the sponsoring organization retains the right to deny that request.

DAF assets can be invested and grow tax-free, potentially increasing the amount available for charitable grants. With a DAF, the donor receives an upfront charitable deduction for the amount contributed to the DAF (using the higher deductibility limits), even though the funds may not be distributed to charity for some time. In fact, this benefit has caused DAFs to recently come under scrutiny in Congress, with recent proposals requiring a minimum annual payout and maximum term before all funds must be distributed to charity.

Benefits of Giving Appreciated Assets

Donating appreciated assets, such as marketable securities, provides unique benefits to both the donor and the receiving charity. With a contribution of marketable securities, you will receive a tax deduction for the current fair market value of the stock and any public charity can easily sell the stock, convert it to cash, and not pay any tax. By donating the marketable security itself, as opposed to selling the security and donating cash, the donor may avoid capital gains tax on the sale of the security and receive a charitable deduction, while the charity receives the full value of the security.

Structures for Making Charitable Gifts

As discussed above, a Donor Advised Fund is one structure through which charitable contributions can be made but it may have some limitations. Some DAF sponsoring organizations permit the contribution of other types of appreciated assets, such as real estate or digital assets such as bitcoin. However, not all sponsoring organizations will accept these assets, and with few exceptions, most DAFs will require the sale of these assets upon contribution. Thus, it is imperative that you communicate with the DAF sponsoring organization to ensure it will accept the asset(s) you wish to contribute and/or, that it will hold the appreciated assets for some future sale date.

Capital Gains Deferral Trust

Rather than giving appreciated assets directly to a charity or DAF, another option is to give those assets to a specific type of charitable trust, recognized and accepted by the IRS, that can then sell the assets and not pay the tax. As a result, the full value of the appreciated assets can then be invested.

The trust then pays a fixed percentage, typically to you and/or your spouse for life, based upon the value contributed. At the end of that term, the remaining balance is paid to the charity or charities of your choice.

With this strategy you receive an income tax deduction for the present value of the hypothetical amount going to charity, and the assets are protected from your creditors and are outside of your estate for purposes of the estate tax. This is an excellent way to give to charity in the future, while providing you a tax-deferred income stream now.

For example, suppose as a Colorado resident you own Microsoft stock worth $1 million with zero tax basis. Thus, if you sold the stock today, you would pay $200,000 in federal capital gains tax (20%) and $43,300 in Colorado capital gains tax (4.33%), netting you $756,700. (In all likelihood, the net investment income tax would also apply, further reducing your net by 3.8%.)

If instead you transferred the stock to this type of tax-deferral trust, the trust would sell the stock and have $1 million to invest. There are several options but with the most common type, the trust would pay you (and your spouse, if any) a fixed annuity (say 5%) for your lives. Thus, you would receive $50,000 per year for the rest of your lifetimes(s), subject to tax.

Annuity to Charity Trust

Another option is to contribute assets to a different type of charitable trust–one that pays an annuity to charity for a specified number of years and then transfers the remaining trust balance to your heirs.

This type of trust is perfect to establish a long-term charitable giving strategy during your lifetime (for example, if you want to contribute $x to your favorite charity for the next 20 years).

And under certain circumstances, this trust can even provide you with an upfront income tax deduction for the present value of the annuities paid to charity. Additionally, assets within this type of irrevocable trust are protected from creditors and free of gift or estate tax.

Distributions Directly from Your IRA

If you are over 70 1/2, you can distribute directly to charity up to $100,000 per year from your IRA or qualified plan. This reduces or eliminates your required minimum distribution by the amount of the direct charitable contribution (up to $100,000) and, significantly, removes the direct charitable contribution from that year’s taxable income, thereby reducing your taxable income by the amount of the direct distribution to charity, up to $100,000. For example, if your required minimum distribution is $85,000, rather than taking that distribution and turning around and making a cash contribution to charity, consider making the distribution directly from your IRA. By making a direct contribution from your IRA, the $85,000 will not be included in your taxable income, thus reducing your overall taxable income.

Conclusion

Charitable giving is a dynamic process with many different strategies that can be levered to achieve a lasting impact and bring additional meaning to your legacy. The Bespoke Group provides strategic guidance at every step—helping you craft a personalized giving strategy that reflects your values, ideals, and passions. We work closely with you to ensure your philanthropy drives meaningful impact in the areas that matter most.

If you’re interested in learning more about Bespoke’s approach to private wealth management and how we can help you build a secure financial future, we invite you to reach out to us directly. We’d be happy to set up a confidential consultation at your convenience.

Thank you for considering Bespoke as your partner in wealth management. We look forward to the opportunity to work with you.

This information is intended for general educational purposes only and should not be construed as legal or investment advice.