Donor-advised funds first appeared in the 1930s, and were given Congressional blessing in the 1969 Tax Reform Act which allowed for private foundations to pool donations into a common fund. But they’ve really taken off in the past two decades, because they let philanthropically minded donors give appreciated assets (like stocks) to charities without the value being reduced by capital gains taxes, while still claiming a charitable tax deduction.
Assets in these funds have grown from $30.81 billion in 2008 to $53.74 billion in 2013, due to the growth in the number of funds and contributions (up 86 percent from 2008), as well as the overall rise in the stock market, according to the National Philanthropic Trust, an independent provider of DAFs.
There are now more than 217,000 DAFs, a 34 percent increase over the last seven years. Compare that to 84,350 private foundations.
But success can also bring scrutiny. Congress is looking closely at the funds, while some critics believe they have unfair advantages that deprive the government of tax revenue while enriching the fund companies that hold the money.
Private foundations are required to discharge 5 percent of their assets to charitable entities every year in order to maintain the foundation donor’s tax deduction for the charitable gift. There is no such requirement for donor-advised funds, which hold the money in investment accounts (and continue to pay fees to the investment management company) until the donor decides to recommend a gift.
The National Philanthropic Trust estimates these funds in aggregate have paid out over 20 percent a year for the last seven years, but a 2012 analysis by the Congressional Research Service found that more than 70 percent of DAF sponsors with a single DAF account paid out less than 5 percent a year to charity, while 53 percent made no grants at all. The average payout rate was 13.1 percent.
“The reason we have the charitable deduction is because we want money to be committed to charitable purposes,” says Ray Madoff, a professor at Boston College Law School. “But if the money is simply set aside in a warehoused account, then it’s not building the economy, it’s not helping hungry people, it’s not building museums or universities. It’s not doing any of those things.”
In late February 2014, Representative Dave Camp (R-Mich.) proposed tax reform legislation including a requirement that all donations to a DAF be paid out within five years of their contribution, or 20 percent a year. There are also efforts to cap all deductions.
“The days of the wild west of donor-advised funds are probably over,” says Robert F. Sharpe Jr., president and chairman of the Sharpe Group. “If I were advising a high-net-worth individual, I would not transfer large amounts of money to a donor-advised fund with the idea that it was going to be able to sit there and distribute minimum amounts for decades because I would wait and see how this all plays out.”
DAFs Explained
DAFs are basically accounts set up by donors that remain under the control of an IRS-sanctioned charity, usually a community foundation or an independent charitable affiliate of a national brokerage. Those charities will write checks drawn from the donor’s fund to beneficiaries selected by the donor, provided the beneficiaries are legally recognized charities in good standing. In some funds, the money can be invested in portfolios managed by the donor's financial advisor.
Donors can contribute cash or other assets, such as real estate or stock, to the DAF now and receive a tax deduction today based on the value of the contribution.
“It was designed to democratize major gifts,” Sharpe says. “A person can transfer $100,000 worth of appreciated stock from their Fidelity account over to their donor-advised fund, and then the donor-advised fund sells the stock free of capital gains and then they dole the cash out.”
DAFs can also be used by families with private foundations to meet the 5 percent required minimum distribution even if they haven’t yet decided on a charitable group to receive the funds, says Robert T. Napier, a partner at law firm Harrison & Held in Chicago. They can transfer funds to a DAF but postpone a decision on which charitable organization will ultimately benefit.
And gifts made through private foundations are made public on GuideStar.org, which can potentially lead to embarrassing disclosures. Consider the case of Brendan Eich, the co-founder of Mozilla, creators of the popular Firefox web browser, who was asked to step down from his position after a donation he made to a group supporting the ban of gay marriage in California was made public. Donations made through DAFs, on the other hand, are anonymous, Napier says.
“To mask the fact that donors may wish to support a potentially controversial charity, some donors are making contributions to a donor-advised fund,” Napier says. “The donor-advised fund then directs the gift to that charity.”
Is Tax Reform Coming?
“Since they provide so many tax benefits while providing ongoing control, you have more and more money flowing into donor-advised funds,” Madoff says. “It’s clearly something that's good for financial planners; it’s good for the organizations that manage the money, but it’s a question about whether it’s really good for society.”
There’s a certainly a drumbeat for tax reform. In September, Senators Mike Lee (R-Utah) and Marco Rubio (R-Fla.) wrote an opinion piece in the Wall Street Journal calling for an overhaul of the tax system, including curtailed deductions. In his 2015 State of the Union speech, President Barack Obama said he would work to close tax loopholes that benefit the rich. It’s unclear if donor-advised funds will be on the agenda, but Rep. Paul Ryan (R-Wis.), now the chair of the House Committee on Ways and Means, says that Camp’s proposal, which contained the recommendation on required distributions for DAFs, will be the starting point.
“Right now, I would say that the donor-advised funds are under close scrutiny by Congress,” says Sharpe. “For every $1 million that goes into a donor-advised fund, it costs the Treasury, say, $300,000 or $400,000 in taxes. They want to know that that money, if it’s costing the Treasury, they want the money going directly into the economy and into the non-profit world.”
“I think there’s every reason to think that tax reform in this area is coming, given the growth of donor-advised funds,” Madoff says.
Ken Nopar, principal of Nopar Consulting, who advises others about philanthropy, believes there’s little chance any DAF regulation will come down. He believes any rule would discourage advisors from recommending the vehicle and talking about charitable giving with their clients.
“Any type of legislation will curtail charitable giving, and have the complete opposite effect of what Congress will intend,” Nopar says.
“If somebody sells a business or has a huge liquidity event and may want to give over the next 20 years, then, ‘If I have to give it away in five years, forget it. I’m just not even going to create this,’” he says. “And chances are they’re not going to give away nearly as much to charity as they intended to do because it’s much easier to make contributions or grants to charities once you’ve set aside that money to be given to charity.”
