United States: A Word For Our Sponsors: Philanthropy & Giving Strategies By Fund Sponsors (Podcast)

On this episode of Ropes & Gray's podcast seriesA Word for Our Sponsors, hosts Deb Lussier and Paul Van Houten, the co-leaders of the sponsor solutions practice, are joined by Ropes & Gray tax partner Kendi Ozmon as well as tax counsel Morey Ward and Gil Ghatan to discuss a topic of increasing interest among fund sponsors: establishing a vehicle for implementing their philanthropic and charitable giving goals.

Transcript:

Deb Lussier:Hello, and welcome back to our podcast,A Word for Our Sponsors, where we talk with industry leaders about the issues that matter most to private equity sponsors. I'm Deb Lussier, and I'm here with my partner and the co-leader of the sponsor solutions practice at Ropes & Gray, Paul Van Houten. On this episode, we're thrilled to be joined by Ropes & Gray tax partner Kendi Ozmon as well as tax counsel Morey Ward and Gil Ghatan to discuss a topic of increasing interest among fund sponsors: establishing a vehicle for implementing their philanthropic and charitable giving goals.

Paul Van Houten:Today, we have a really interesting conversation in store for you. Usually, when we're advising our fund sponsor clients, we're helping them on the business side of their operations, but we've observed a growing interest among fund sponsors with giving back. So, today, we have the pleasure of talking with Kendi, Morey, and Gil about ways fund sponsors can become more engaged in philanthropy.

Deb Lussier:Kendi, why don't you kick us off—what are you seeing? Why are fund sponsors interested in a giving program or why should they be?

Kendi Ozmon:Well, we're definitely seeing increased interest in formalizing programs that support charities, whether based on geography or based on an area of philanthropic interest, like addressing climate change, combating discrimination, or helping veterans. This may be an outgrowth of the corporate social responsibility activities that have really gained momentum in the past decade or so, but we've noticed recently a movement toward establishing a separate charitable vehicle to operationalize the giving agenda. Although affiliated charitable vehicles have been around in the corporate world for many years, we've seen a real interest in this area recently among fund sponsors.

Paul Van Houten:Gil and Morey, how are these types of philanthropy operations typically structured?

Gil Ghatan:Most commonly, a giving program is either going to be set up as a private foundation under the rules for 501(c)(3) organizations or as a donor-advised fund, often referred to as a "DAF." A third option would be a public charity that is able to meet a numerical public support test, but this is relatively uncommon due to technical compliance issues. A private foundation is typically set up as a nonprofit corporation and it must apply for tax-exempt status by filing an application with the IRS. It tends to be funded by one or a small group of donors who control it—in this case, the fund sponsor, and potentially, individual partners. Using a DAF doesn't involve setting up a separate charity. It's not a separate legal entity, but is an account established with an existing 501(c)(3) public charity that accepts donations and segregates them with the understanding that the donors have the ability to make recommendations as to outgoing grants. Both can be branded with the sponsor's name, generating goodwill in the community from the charitable operations. But the rules that govern the operations of a private foundation and a donor-advised fund can be very different. Various considerations go into deciding which of these vehicles is the right fit for your giving program.

Morey Ward:That's right, Gil. For example, a donor-advised fund involves substantially less work and time by the sponsor to establish and operate. Unlike a private foundation, you don't have a new entity to form and maintain with registration and filing obligations, a tax exemption application, board meetings, and financials. You also don't have to navigate all of the complex tax rules that apply to private foundations that we'll touch on a bit later. With a DAF, however, you're giving up legal control over the funds. A representative selected by the donor, or the donor themself, called the "donor-adviser," can make recommendations for how amounts from the DAF will be distributed as grants. Although these recommendations are rarely rejected by the sponsoring organization, as a technical matter, the donor does not control the funds once given to the DAF. Also, while both private foundations and DAFs can make grants to U.S. public charities without issue, private foundations also can make grants to individuals (which sometimes requires prior IRS approval) whereas DAFs may not, except for a limited exception related to DAFs established to provide disaster relief payments. In addition, while private foundations can make grants to other private foundations and foreign charities with some additional steps involved, many DAFs will not permit those types of grants.

Deb Lussier:Are there any specific distribution requirements for these two vehicles?

Morey Ward:Private foundations are subject to an annual distribution requirement. They are required under the tax law to pay out each year at least 5% of the fair market value of their net investment assets for charitable purposes. If the private foundation holds an illiquid asset, this can create challenges. Currently, there is no tax rule requiring a minimum annual distribution from DAFs, although legislation has been proposed over the years that would impose a distribution requirement similar to the one that applies to private foundations. Also, some DAF organizations impose their own distribution requirements.

Paul Van Houten:Kendi, are there particular tax benefits for donors with one structure versus the other?

Kendi Ozmon:There definitely can be. A gift to a DAF is a gift to a public charity, and generally, gifts to public charities are more tax advantageous for a donor who is an individual (or a partnership that consists of individuals) than gifts to private foundations. This is for two main reasons. First, the income tax deduction limits for the charitable contribution deduction are higher for gifts to public charities and, second, public charities provide a more advantageous income tax deduction for gifts of non-cash property. With respect to deductibility limits, this is really only relevant for those very generous individuals who contribute a significant portion of their adjusted gross income to charity. However, the deduction related to gifts of property can be quite meaningful. A gift of a partnership interest or a private company stock to a private foundation is limited to the donor's tax basis in the property (which may be close to zero), but if the gift were made to a DAF, the full current fair market value, including appreciation, would generally be deductible. Note that public company stock can generally be deducted at fair market value, whether contributed to a DAF or to a private foundation.

Now, how relevant these differences are for donors, of course, depends on the type of assets to be contributed as well as the donor's personal income tax situation. It's also worth noting that not at all DAFs may be willing to accept or retain long-term illiquid assets, whereas a private foundation controlled by a fund sponsor can accept and retain illiquid assets, subject to compliance with some specific tax rules that apply to private foundations.

I'll just add a quick note here about privacy. A private foundation is required to file an annual return with the IRS that's available to the public, and that discloses information about its assets, donors, and grants. A DAF organization is also required to file an annual return with the IRS that's publicly available, but that return is filed on behalf of all of the DAF accounts it holds in the aggregate. So, there's no IRS filing on an individual DAF basis.

Deb Lussier:Morey, both you and Kendi alluded to private foundation rules. How are those most likely to weigh into the analysis?

Morey Ward:While some of the rules applicable to private foundations are fairly straightforward—such as the imposition of an annual excise tax on net investment income—others can be quite complex and need to be managed carefully. For example, private foundations and donor-advised funds each need to be attentive to certain limits imposed on their holdings of businesses combined with the holdings of their insiders (such as the sponsor and its partners) under the excess business holdings rules. A private foundation would also need to satisfy its 5% annual payout requirement, so, as I mentioned earlier, understanding how a particular illiquid gift may affect cash flow is important.

Deb Lussier:I see—that's very interesting. I think many sponsors thinking about giving vehicles would like to enable donors to be able to contribute carry or co-invest with the charitable vehicle in underlying funds. What are some of the main considerations in that space?

Gil Ghatan:Private foundations co-investing alongside their insiders must be mindful of the self-dealing rules that can often be thorny to navigate. Those rules would also implicate payment of carry and management fees, which often are waived for an affiliated private foundation in light of these rules. DAFs, on the other hand, generally have a much more limited set of investment options that are controlled by the DAF public charity, and, depending on that organization, it may not be possible to hold investments outside the defined options offered by the DAF. Similar but slightly different rules than the private foundation self-dealing rules prohibit a donor-advised fund from paying compensation (including management fees) to any donor or donor-adviser of the account. And for both types of vehicles, it's important to understand any financial exposure to the charity under the partnership agreement, such as capital calls and clawbacks; the board of the charity—whether it's a private foundation or a DAF—has fiduciary duties to that organization that need to be taken into account.

Paul Van Houten:What about contributions of carry to these vehicles? Is that possible?

Kendi Ozmon:The short answer, Paul, is "yes, but it can be complicated." If a fund sponsor is considering a gift of carry, this requires a pretty detailed analysis, taking into account the family partnership rules, the partial interest rules related to the charitable income tax deduction, appraisal requirements, as well as potentially navigating the self-dealing and excess business holdings rules Morey and Gil just mentioned. There could also be tax implications for the charitable vehicle, which could generate unrelated business taxable income as a result of holding such an interest.

Deb Lussier:Kendi, Morey, Gil—thanks so much for joining us and giving us just a little flavor of some of the considerations involved with setting up a giving program by a fund sponsor. I suspect there's a lot more we could get into and that we've only just scratched the surface on these issues. I'd also like to thank our listeners for joining us today. For additional information and insights, please visit our website atropesgray.com. And of course, we can help you navigate any of the topics that we've discussed today, so please don't hesitate to get in touch with us. You can also subscribe to this series wherever you regularly listen to podcasts, including onApple,Google, andSpotify. Thanks again for joining us today.