On Nov. 13, 2023, the Department of Treasury and Internal Revenue Service issued proposed regulations on what type of accounts qualify as donor-advised funds and when excise taxes will be applied to accounts and persons involved with DAFs. These regs could affect charitable giving through the use of DAFs.
Benefits of DAFs
First, some background. Over the past hundred years, charitably minded individuals have leveraged DAFs to pursue their giving goals in a tax-advantaged, flexible manner.
DAFs are used to lower their net after-tax cost while increasing their contributions to public charities. The key is that this vehicle allows taxpayers to separate the decision on which assets to contribute and when from the eventual distribution itself.
Whether through regular portfolio rebalancing, transferring assets to another manager or an upcoming liquidity event, contributing the most appreciated assets to a DAF avoids unnecessary capital gains recognition. At the same time, it creates a reservoir of charitable assets to distribute in the future. Typically, the amount contributed far exceeds what a donor might consider giving directly that year.
As tax laws have changed, fewer taxpayers receive a tax deduction for their donations. Many donors now contribute enough to a DAF to itemize in Year 1, then distribute grants in subsequent years—a technique known as “bunching.” This results in more money ultimately going to charity and more donors being more strategic about their giving.
Restrictions on Use
Yet, a DAF’s flexibility comes with certain restrictions. More specifically, the Internal Revenue Service may impose an excise tax, deeming interactions with the fund’s donors, advisors and related persons as either an “excess benefit transaction” or one resulting in “more than an incidental benefit” to the involved parties under Internal Revenue Code Sections 4958 and 4967, respectively. IRC Section 4966 imposes an additional excise tax on DAF distributions (1) to a natural person, (2) for a non-charitable purpose, or (3) over which the sponsoring organization housing the DAF doesn’t exercise expenditure responsibility, with such taxes potentially applying to both the DAF itself and a knowing sponsoring organization. This section scopes out all three excise taxes by defining the term “donor-advised fund” and identifying whose involvement may trigger them. (IRC. Sections 4958(f)(7)(A) and 4967(d).)
Overview of Impactful Elements
Here’s a high-level overview of some of the most impactful elements:
Subject to certain exceptions (this definition excludes a fund or account that: (1) makes distributions only to a single identified organization or governmental entity, or (2) makes grants for travel, study or similar purposes if the fund meets certain independence requirements). IRC Section 4966 defines a DAF as a fund or account:
(i) which is separately identified by reference to contributions of a donor or donors,
(ii) which 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.
Importantly, the parties included in (iii) are subject to greater oversight under the three excise taxes described above.
In building on this definition, the proposed regs first identify as a donor any person who contributes property to a DAF, other than certain public charities and governmental entities. Next, the regulations group donor-appointed or designated advisors under the term “donor-advisor,” which includes:
- The creator of a fund who retains an advisory role over its distribution and investment, even in the absence of actual contribution.
- Persons recommended by the donor to serve on the DAF’s advisory committee unless certain requirements proving independence are met.
- An investment advisor who manages both a donor’s personal assets and the DAF’s assets, except an investment manager who provides services to the sponsoring organization as a whole.
- Persons to whom a donor-advisor delegates any advisory privileges, with no need for formal documentation.
Lastly, the regulations state that the presence or reasonable expectation of advisory privileges is based on all relevant facts and circumstances, including service on an advisory committee and regardless of any actual exercise of those privileges.
With respect to IRC’s Section 4966 excise tax on taxable distributions, the proposed regs define a distribution as “any grant, payment, disbursement, or transfer, whether in cash or in kind” from a DAF. The regulations then proceed to add a class of “deemed distributions,” defined as: (1) any distribution that provides more than an incidental benefit to a donor, donor-advisor or related person or, (2) any expense charged against a DAF and paid to a donor, donor-advisor or related person. Notably, investments and reasonable investment or grant-related fees other than those qualifying as a deemed distribution are excluded from the larger distribution definition.
Effect on Charitable Giving
If finalized, what would these definitions mean for charitable giving? They would likely expand the number of accounts and funds that qualify as DAFs and the pool of persons involved with DAFs subject to the applicable excise taxes. For example, charities may need to examine whether granting a donor the right to designate a field of interest or larger purpose for a fund triggers DAF status—even in the absence of a direction to distribute funds. Additionally, classification of certain third-party consultants and investment advisors as donor-advisors may upend a DAF’s ability to pay for provided services. For instance, payment to an individual consultant would likely qualify as a taxable distribution. And compensation received by an investment advisor working with both the donor and the DAF could trigger excise tax as a taxable distribution, an excess benefit transaction and advice resulting in more than an incidental benefit.
The IRS is accepting public comments until Jan. 16, 2024. Any finalized regulations will take effect for the tax year in which they are adopted.
The author thanks Don Kent, Bernstein Principal, for his assistance with this article.
This material has been distributed for informational purposes only. Bernstein does not provide tax, legal, or accounting advice
