What is a DAF? Demystifying Donor Advised Funds

What is a DAF? And, what are the benefits of giving to a DAF? At its core, a Donor Advised Fund (“DAF”) serves as a bridge between donors’ intentions and the realization of their charitable goals, offering a sophisticated yet accessible means to support causes close to their hearts. However, DAFs are one of the most misunderstood areas of philanthropy. And, DAFs are often unfairly villainized in the media. So, to help clear the air, this post will explain what DAFs are and why donors might use them.

What’s a DAF?

DAFs are typically registered public charities created to manage charitable donations on behalf of many donors including other charities, corporations, and individuals.

When considering why DAFs exist, it helps to understand the tax rules surrounding charitable status. There are three main types of registered charities in Canada: charitable organizations, public foundations, and private foundations. One main difference between charitable organizations and foundations is that many charitable organizations only hold assets used directly for their charitable purpose. This means charities might own the building they operate from but avoid passively holding investment portfolios for the purposes of earning income. Oppositely, passively holding investment portfolios is one of the main purposes of foundations.

Wait, why would a charity want to passively hold an investment portfolio?

To outsiders, it might not seem like charities should be hoarding capital at all. But, consider your local animal shelter as an example. The shelter employs three people to care for neglected, abused, and abandoned animals. There are costs to operate the charity including rent, supplies, and the salaries of employees. Total expenses for the shelter come to $250,000 per year.

Now, let’s imagine a local animal lover and long-time supporter who leaves a bequest to this charity in their will. The bequest is for $5 million dollars. Sounds great right? Should the shelter accept this donation? Yes, but maybe they need help. Since the shelter operates on a $250,000 per year budget. Spending $5 million in a single year may be foolish. The charity is better off to save their $5 million endowment using a DAF where it can earn investment income to be used for on-going expenses. With a yield of 5% per year, the charity could fund itself in perpetuity by saving it’s bequest in a DAF and investing it wisely instead of blowing the windfall in a single year.

So, should the animal shelter create their own foundation to hold their endowment instead of using a DAF?

What’s the difference between a foundation and a DAF?

Most DAFs are registered as public foundations. Many DAFs operate as community foundations such as the Toronto Foundation or the Hamilton Community Foundation. Other DAFs are created by financial firms such as the Aqueduct Foundation (Scotiabank) or the TD Private Giving Foundation. All DAFs are foundations, but not all foundations are DAFs.

Our animal shelter could create their own foundation to hold their endowment. But, as a small organization, it probably has more expertise caring for animals than managing investment portfolios. So, the shelter turns to a DAF who can provide expert financial services on their behalf. Much like an investor would use a mutual fund or an investment advisor.

Why do donors use DAFs?

There are lots of good reasons why donors use DAFs. Including:

• Earning tax free income (for the benefit of charity, not themselves)
• Ability to issue charitable tax receipts
• Anonymity
• Handling complex donations (appreciated securities)
• Speed
• Economies of scale

1.      Earning Tax Free Income

Let’s be totally clear. When DAFs earn tax free income from their investments, it cannot be used for the private benefit of their donors. The income earned by DAFs cannot be withdrawn and used by account holders. However, income earned by investments held in a DAF means more to charity and less to tax.

To understand why, consider a retiree with a high income paying 50% tax on each dollar of income earned.

They’ve determined their assets far exceed their personal consumption needs, so they decide to make charitable donations with their excess capital. They take part of their investment portfolio and donate it to a DAF. Once this is done, each dollar earned by the DAF is now tax free and will therefore increase the amount of donations the investor can make to specific charities compared to if they held those investments in a taxable account in their own name. Sure, once money is donated to a DAF, it can’t be used for private benefit anymore. But, DAFs are often used by donors who are giving their capital away for the benefit of charity. If they were looking to benefit personally, they wouldn’t be so charitably inclined.

2.      Issue Tax Receipts

DAFs (since they are typically registered charitable foundations) can issue tax receipts for donations they receive. This is a benefit for donors who wish to use these tax credits to offset the taxes they would otherwise owe on income earned. Yes, charities can also issue tax receipts for donations, and so can both public and private foundations.

There is no financial gain for donors giving to charities, foundations, or DAFs. Tax benefits for charitable donations only provide some tax relief to donors. For example, depending on their tax rate, a high income donor may get 50 cents of benefit for each dollar of charitable donations. Obviously, if the goal is to benefit financially, the donor should avoid making any charitable donations at all.

3.      Anonymity

When large donations are made to charities and foundations, the details of the donor are made public. This can bring unwanted attention (in the form of solicitations) to donors and breach their privacy. But, when donations are made from a DAF, the details of the DAF account holder may be kept private. As you can imagine, there are lots of donors who may want to remain anonymous for a variety of reasons while still providing financial support to their favorite charities.

4.      Handling Complex Donations

Capital gains taxes are eliminated when appreciated securities (stocks) are donated to charity. But, not all charities have brokerage accounts and so they cannot accept these types of donations on their own. So oftentimes DAFs help make donations of stocks possible. DAFs will receive gifts of stocks, issue tax receipts for their value, sell those stocks, and donate the proceeds to the recipient charity at the donor’s discretion. DAFs often charge a small fee for this service.

5.      Speed

Creating a private foundation can take time. Documents need to be drafted and an application for charitable registration needs to be processed by the CRA. Unfortunately, donors often need to make donations in a specific year for a variety of tax reasons including death and the sale of a business, etc. Since DAFs stand-at-the-ready, willing to help donors in a pinch. Many donors park capital in a DAF account while further plans are being made (either to decide which charities should be the ultimate recipients of their gift or to wait for charitable registration of their private foundation to arrive as two examples of many).

6.      Economies of Scale

DAFs are in the business of providing charitable services and managing investment portfolios. Therefore, they’ve developed lots of expertise in these fields. And, DAFs are pooling the resources of many different donors, so they can provide certain services more efficiently then individuals could themselves.

An example is investment management. A DAF managing hundreds of millions of dollars can obtain investment management services at much lower fees than most donors can individually. Or, consider book-keeping and tax preparation. Since DAFs are managing large pools of capital, they can develop efficient financial management systems that spread the cost over large numbers of accounts. These economies of scale are some of the benefits of using DAFs.

Want to learn more about DAFs?

At Markdale Financial Management, we are a family office dedicated to guiding our clients through the intricacies of philanthropy. Whether you’re considering establishing a DAF, seeking to optimize your philanthropic strategy, or exploring ways to contribute to the causes you care about, we can provide expert advice and administrative support to philanthropists.

We invite you to reach out to us for a deeper exploration of how Donor-Advised Funds can fit into your philanthropic vision. Sign up for our free weekly newsletter for insights into effective charitable giving or schedule a complimentary review of your situation.