Over the last few decades, a revolution in charitable giving has taken place. Donor-advised funds (DAFs), once a relatively small funding source for community foundations (CFs), have evolved into a significant avenue for charitable giving. Some DAFs now rival prominent private foundations (PFs) in their size. Because of their growing popularity, the use of DAFs for estate planning and charitable giving purposes is increasingly the subject of heated debate. Let’s review the history of DAFs, explore how and why they’re used today and consider the recent proposals to change them.
History of DAFs
In 1931, the New York Community Trust first used the term “donor-advised fund.”1 However, this fund, and other early funds like it, had limited similarities to the DAFs of today. Instead, these funds functioned more like endowments and were largely created by wealthy individuals to benefit CFs.2 Donors setting up these endowment funds would give them a name and often suggest a charitable purpose for the use of such funds, in connection with the applicable CF’s mission.3 The funds would then be managed by a board of local business leaders who would oversee distributions.
The path that led to the creation of DAFs as we know them today started, in no small part, thanks to an astute former Internal Revenue Service lawyer named Norman Sugarman.4 Seeing an opportunity out of the 1969 Tax Reform Act’s distinction between public charities and PFs, Sugarman advised clients of the benefits of placing endowed funds within public charities and making sure that the benefiting charities knew the donor’s intentions for those funds.5 Such an approach offered immediate tax benefits for the donor while giving that donor a limited degree of control. As Sugarman saw it, CFs would get the benefit of building endowments that would ensure their long-term survival.6 In exchange for an increased endowment, the CFs would give a limited degree of control to the donors. Due in part to Sugarman’s insights, some CFs began to accumulate large endowed funds that could be distributed, on the donor’s recommendations, for purposes unrelated to the CF’s mission.7
Throughout the 1980s, 1990s and 2000s, commercial investment managers increasingly embraced the model Sugarman championed.8 Fidelity, Vanguard, Schwab and other commercial financial firms created public charities (sponsoring organizations) to receive and store a donor’s charitable dollars through individual DAFs, from which charitable distributions would be made at a later date.9 However, unlike the smaller CFs of the 1930s, these commercial funds have grown to manage billions. They also explicitly market this fund management arrangement to a broad array of potential clients, not just the extremely wealthy.10 As these large sponsoring organizations at commercial financial firms grew in size and prominence, Congress took note, addressing concerns that, without formal legal guidelines, there was the potential for DAFs to be exploited for the personal benefits of the donors.11 These concerns led to the enactment of provisions in the Pension Protection Act of 2006 (PPA), which, for the first time, codified the definition of a “donor-advised fund” and adopted provisions regulating DAFs similar to the rules already in place for PFs.
Defining and Regulating DAFs
The PPA defines a DAF as “a fund or account (i) that is separately identified by reference to the contributions of a donor or donors, (ii) that is owned and controlled by a sponsoring organization and (iii) with respect to which a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor.”12 Funds that aggregate contributions of multiple donors don’t qualify as DAFs under this definition. Nor will a fund qualify if the donor has control over the fund (except with respect to advisory privileges over distributions or investments).
Once property is contributed to a DAF, it’s the property of the sponsoring organization, subject to the advisory privileges of the donor.13
Similar to provisions for PFs, the PPA imposes excise taxes on certain transactions with DAFs. Any “taxable distribution” from a DAF (to an individual or for any non-charitable purpose) will be subject to a tax equal to 20 percent of the distribution, with an additional 5 percent tax (up to $10,000) imposed on any manager of the sponsoring organization who knowingly approved the distribution.14 In addition, distributions to certain tax-exempt organizations that aren’t public charities are deemed to be taxable distributions unless the sponsoring organization exercises oversight over the distributions through a process called “expenditure responsibility.”15 Many sponsoring organizations have adopted policies prohibiting these types of distributions to avoid the need to exercise expenditure responsibility over grants.
The PPA doesn’t impose minimum distribution requirements (MDRs) on DAFs (unlike PFs, which are generally required to distribute at least 5 percent of the average asset value from the preceding tax year for charitable purposes). However, some sponsoring organizations have imposed requirements as to the number of grants or amounts that must be distributed from each DAF to charity each year.
In addition, if any “disqualified person” (a donor, donor-advisor, family member or 35 percent controlled entity of a donor or donor-advisor) receives a benefit from the DAF that’s more than incidental, a tax of 125 percent of the benefit is charged on the recipient of the benefit and the donor-advisor who recommended the distribution, with an additional 10 percent tax (up to $10,000) imposed on any manager of the sponsoring organization who knowingly approved the distribution.16 For example, public recognition arising from charitable activities is generally deemed to be an incidental benefit.
DAFs are also subject to the “intermediate sanction rules” on “excess benefit transactions.”17 Although typically the intermediate sanction rules impose a
25 percent penalty excise tax on the benefit received by a disqualified person who transacts with a public charity in excess of the value provided to the charity, the rules applicable to DAFs also provide that a 25 percent penalty excise tax is imposed on the entire amount of any grant, loan, compensation or similar payment from a DAF to a disqualified person.18 A 10 percent excise tax may also be imposed on any manager of the sponsoring organization who knowingly approved the transaction.19 If an excess benefit transaction isn’t timely corrected (undone), an additional 200 percent excise tax is imposed on the disqualified person.
Finally, under the excess business holding rules, a 10 percent excise tax is imposed if the aggregate holdings of a DAF and its disqualified persons exceed 20 percent of the voting rights in a business entity (although a safe harbor rule permits a DAF to own up to 2 percent of the voting rights in any business entity).20
Tax Treatment of Donations
A donor who gives appreciated long-term capital assets (those held for more than one year) to a DAF is entitled to an income tax deduction for the full fair market value of the gift, which is limited to 30 percent of the donor’s “contribution base.21” Generally, a donor’s contribution base is equal to the donor’s adjusted gross income.22 Gifts of cash to a DAF have a deduction limit equal to 50 percent of a donor’s contribution base.23 Amounts that the contribution limits prevent a donor from deducting in the year of the contribution may be carried forward for deduction in the five following tax years.24 A donor is permitted to take these deductions in the year the gift is made to the DAF—even if no distribution is made from the DAF to charity in that year.
DAFs vs. PFs
These higher deductibility limits are one feature that make DAFs attractive to donors who are considering a DAF versus a PF. A donor who gives cash to a private non-operating foundation is entitled to an income tax deduction limited to 30 percent of the donor’s contribution base, and a contribution of appreciated long-term capital assets is limited to 20 percent of the donor’s contribution base.25
Another reason a donor might prefer a DAF to a PF is that the donor isn’t burdened with the administrative, governance and maintenance requirements that are incumbent with PFs. A DAF isn’t a distinct legal entity, so it has no governing documents, board of directors, annual corporate filings or separate tax returns. In fact, a DAF can even be created in a 5-minute phone call.26 The donor isn’t responsible for monitoring or tracking donations. It’s the sponsoring organization that must ensure the suitability of any potential beneficiary of a DAF and is responsible for all of the administrative, tax, legal and other matters regarding the operation of the DAF.
Also, donors who are concerned about privacy may prefer a DAF, as distributions can be made from the DAF to a charity without disclosing the name of the individual donor.27 In contrast, PFs are required to make their annual information returns available to the public, which include a list of all of the grants made, as well as a schedule listing the name of any donor who contributed more than $5,000 to the PF and the amount contributed.
Of course, these benefits of DAFs are offset by an ongoing lack of control by the donor (who retains only advisory privileges). A donor to a PF may retain significant legal control of the PF’s assets through an ongoing role on the PF’s governing board.
Growth of DAFs
There’s been substantial growth in the use of DAFs in recent years. According to the “2015 Donor-Advised Fund Report” prepared by the National Philanthropic Trust, 2014 was another record year and continued the trend of the increased use of this charitable giving vehicle over the past decade.28 Distributions from DAFs totaled $12.5 billion in 2014, up from $9.8 billion in 2013.29 Contributions to DAFs were $19.66 billion in 2014, an all-time high.30 Continuing a double-digit trajectory of growth, total charitable assets in DAFs grew by over $13 billion in 2014 to over $70 billion.31 The average DAF account size reached an all-time high of $296,701 in 2014.32
According to the same report, most DAFs are held by large national charities, many formed by commercial financial organizations such as Fidelity. That said, CFs and single-issue charities have seen continued increases in recent years in the establishment of DAFs.33 Interestingly, although the aggregate value of grants from DAFs to other public charities increased in 2014, the total payout rates appear to have declined (except with respect to payout rates for DAFs at CFs).34 The National Philanthropic Trust projects that future years will see an increase in the size and number of distributions made to charities, continued contributions to DAFs, especially at CFs, and the continued use of illiquid gifts to fund DAFs.35
Controversy
Because of their popularity, DAFs have generated controversy in the philanthropic and estate-planning communities.
The critiques of DAFs leveled by philanthropist Lewis B. Cullman and Boston College Law School Professor Ray D. Madoff highlight many of the more common concerns raised about this charitable giving vehicle.36 They suspect that a donor feels less urgency to actually make distributions to charity from a DAF once the tax benefits of charitable giving have been claimed.37 In addition, they argue that sponsoring organizations associated with financial organizations are incentivized to encourage donors to consider DAFs as charitable “assets” that are to be managed, not distributed, as fees are earned from managing the funds rather than from making distributions to charities.38 They also contend that DAFs ultimately hinder the distribution of funds to charity, especially as a PF can, under current law, make a distribution to a DAF that counts toward the PF’s MDR.39 They question why the tax benefit received by a donor who makes a contribution to a DAF without producing a corresponding social benefit should be the same tax benefit received by a donor who makes a contribution to The Salvation Army or the American Red Cross.40 Finally, they also point out that financial organizations associated with sponsors of DAFs are able to avoid federal disclosure rules that otherwise require charities to disclose salaries of top paid employees.41
Supporters of DAFs argue that DAFs often have payout rates above the 5 percent minimum distribution required of PFs—most notably, Fidelity Charitable calculated its payout to be 26 percent for its fiscal 2016.42 Critics respond by claiming the calculation by Fidelity is over-inflated (because it’s determined using a 5-year rolling average of year-end assets) and note that it’s based on aggregates of funds rather than on a fund-by-fund basis. The potential, they argue, is for large distributions from certain funds to offset others that distribute nothing, with the donors to each fund receiving the same tax benefits. Supporters in turn claim that mandating minimum spending amounts on DAFs would increase administrative burdens on charities43 and question why DAFs should be treated differently from endowment assets at colleges and universities, which may sit in perpetuity.44 They look to sponsoring CFs and suggest these entities are using the fees generated by their DAFs to create a charitable benefit through direct charitable programs.
To respond to the criticisms, a number of fixes have been proposed by members of the philanthropic and academic communities, as well as by members of Congress. One of the more common proposals is to require that an MDR be applicable to DAFs. In 2014, Congressman Dave Camp (R-Mich.) proposed legislation that would mandate a 5-year spend down for DAFs, with funds that failed to meet this deadline being subject to a
20 percent tax on any unspent amounts.45 Still others, such as Madoff, have proposed longer spend down terms of 10 years to 20 years.46 Another proposal from Prof. Michael Hussey of Widener University, Commonwealth Law, Harrisburg, Penn., would treat DAFs like individual retirement accounts, with MDRs after a certain point and penalties for failing to distribute.47
The IRS took a step toward addressing concerns about PF distributions to DAFs by adding a question to Form 990-PF, required to be filed by all PFs annually. Starting with the 2011 form, PFs are asked if they made a distribution to a DAF over which the PF or a PF insider had advisory privileges.48 If the answer is “yes,” the PF is required to attach a statement explaining how the distribution will be used to accomplish a charitable purpose.49 It’s unclear whether this requirement has had any effect on the use of distributions to DAFs to satisfy a PF’s required payouts.
Ongoing Debate
DAFs will likely remain an important and growing part of the U.S. charitable giving landscape for some time. So long as they present a simple means to facilitate charitable giving while allowing for generous tax deductions, donors will continue to use them. That said, the debate around the use of DAFs will also remain unabated. Estate and financial planners, as well as the charitable giving community, would be well advised to stay informed of any developments in this important avenue of philanthropy.
Endnotes
1. Lila C. Berman, “Donor Advised Funds in Historical Perspective,” Boston College Law Forum on Philanthropy and the Public Good (October 2015), at pp. 5-27.
2. Ibid., at p. 13.
3. Ibid.
4. Ibid., at p. 17.
5. Ibid., at p. 19.
6. Ibid., at p. 21.
7. Ibid., at p. 22.
8. Ibid., at p. 23.
9. Michael Hussey, “Avoiding Misuse of Donor Advised Funds,” 58 Clev. St. L. Rev. 59, 63 (2010).
10. Berman, supra note 1, at p. 24.
11. Razoo Foundation, “The Role of Donor Advised Funds in the Democratization of Philanthropy,” http://razoofoundation.org/wp-content/uploads/2013/10/Role-of-Donor-Advised-Funds-RF-White-Paper-2014.02.13.pdf.
12. Internal Revenue Code Section 4966(d)(2)(A).
13. IRC Section 4966(d)(2)(A)(iii).
14. Section 4966(a)(1).
15. Section 4966(c) and IRC Section 4945(h).
16. IRC Section 4967(a).
17. IRC Section 4958.
18. Ibid.
19. Ibid.
20. IRC Section 4943.
21. IRC Section 170(b)(1)(C).
22. Section 170(b)(1)(G).
23. Section 170(b)(1).
24. Section 170(d)(1)(A).
25. Section 170(b)(1)(B) and (D).
26. See www.fidelitycharitable.org/setup-account.shtml.
27. Ibid.
28. National Philanthropic Trust, “2015 Donor-Advised Fund Report,” www.nptrust.org/daf-report/.
29. Ibid.
30. Ibid.
31. Ibid.
32. Ibid.
33. Ibid.
34. Ibid.
35. Ibid.
36. Lewis B. Cullman and Ray D. Madoff, “The Undermining of the American Charity,” The New York Review of Books (July 14, 2016).
37. Ibid.
38. Ibid.
39. Ibid.
40. Ibid.
41. Ibid.
42. Mark Hrywna, “Fidelity Charitable Reports 14–Percent Increase in Grants,” The NonProfit Times (July 19, 2016).
43. Ellen Steele and C. Eugene Steuerle, “Discerning the Trust Policy Debate Over Donor-Advised Funds,” The Urban Institute (October 2015), www.urban.org/sites/default/files/alfresco/publication-pdfs/2000481-Discerning-the-True-Policy-Debate-over-Donor-Advised-Funds.pdf.
44. Ibid.
45. Ibid.
46. Ibid.
47. Hussey, supra note 9, at p. 88.
48. Form 990-PF, Part VII-A (Statements Regarding Activities), line 12.
49. Instructions for Form 990-PF for Part VII-A, line 12.
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