Donor-Advised Funds: What You Should Know

Introduction

A donor-advised fund (“DAF”) is a charitable vehicle housed within a 501(c)(3) public charity that allows a donor to make a gift, take an immediate charitable deduction, and recommend, typically with strong persuasive authority, future grants made from funds in the DAF. Unlike private foundations that require a minimum annual distribution, a DAF has no distribution requirements and can allow investment funds within the account to build up for years or even decades. This is one reason why DAFs have come under fire by philanthropists and academics like Lewis B. Cullman and Ray Madoff, who together wrote The Undermining of American Charity published by The New York Review of Books (“Donor-advised funds (or DAFs) give donors all of the tax benefits of charitable giving while imposing no obligation that the money be put to active charitable use.”).

Growth

DAFs are growing ever faster, according to The Nonprofit Quarterly. The 2015 Donor-Advised Fund Report released by the National Philanthropic Trust in November 2015 and cited by The Nonprofit Quarterly provides:

Grants from donor-advised fund accounts to charitable organizations reached a new high at $12.49 billon …. This is a 27.0 percent growth rate compared to a revised total for 2013 grants of $9.83 billion.

 

Contributions to donor-advised fund accounts in 2014 totaled $19.66 billion, also an all-time high. This number surpasses the revised 2013 value of $17.23 billion by $2.4 billion …, an increase of 14.1 percent.

 

Charitable assets under management in all donor-advised fund accounts totaled $70.70 billion in 2014, an all-time high …. The increase in total charitable assets can logically be attributed to the growth in the number of funds (an 8.8 percent increase) and contributions (a 14.1 percent increase).

 

The number of donor-advised fund accounts increased by 8.8 percent in 2014, to 238,293 ….

 

Grant payout rates from donor-advised fund accounts annually exceeded 20 percent for the eighth consecutive year.

 

The 2014 average donor-advised fund account size reached $296,701, which is also an all-time high ….

Definition

A donor-advised fund is defined in the Internal Revenue Code as a fund or account:

  1. which is separately identified by reference to contributions of a donor or donors,
  2. which is owned and controlled by a sponsoring organization, and
  3. 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.

– IRC Sec. 4966(d)(2)(A)

The first prong of this definition may be met by (1) naming the fund after a donor, or (2) treating a fund on the books of the sponsoring organization as attributable to funds contributed by a specific donor or donors. Contrary to popular myth, giving a fund a generic name (e.g., “The Human Fund” (Seinfeld alert)) doesn’t result in a fund falling out of the DAF definition. The second prong requires ownership and control by a sponsoring organization, which generally includes most domestic public charities. The third prong may be met even if a donor doesn’t have advisory privileges codified in a written agreement so long as the donor has reasonable reason to expect to have advisory privileges with respect to distribution or investment of amounts held in the fund. For more information, see our earlier post What is a Donor Advised Fund?

Exceptions: Even if a fund meets three prongs required of a DAF, it may still be excepted from the definition if:

  1. it make distributions only to a single identified organization or government entity; or
  2. the donor or donor advisor provides advice regarding grants to individuals for travel, study, or other similar purposes, provided that:
    1. the donor’s, or the donor advisor’s, advisory privileges are performed in his capacity as a member of a committee, all the members of which are appointed by the sponsoring organization;
    2. no combination of donors or donor advisors (or related persons) directly or indirectly control the committee; and
    3. all grants are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization that meets the requirements of IRC 4945(g)(1), (2), or (3) (scholarship or fellowship grant to be used for study at a qualifying educational organization; prize or award to recipient selected from the general public; or grant with a purpose to achieve a specific objective, produce a report or other similar product, or improve or enhance a literary, artistic, musical, scientific, teaching, or other similar capacity, skill, or talent of the grantee; respectively).

Restrictions

No Distributions to Natural Persons

A sponsoring organization and its fund managers (including directors, officers, trustees, and employees having authority or responsibility related to any act or failure to act resulting in the prohibited distribution) may be subject to excise taxes if they engage in “taxable distributions” with respect to the DAF’s grants. A taxable distribution includes any distribution from a DAF to any natural person.

A taxable distribution imposes an excise tax of 20% on the sponsoring organization and 5% (with a $10,000 cap) on any fund manager who knowingly agrees to the distribution.

Unfortunately, the meaning of a “distribution” within the context of this rule has not been clarified by the IRS. A conservative view would suggest that payments to any individuals, even if goods or services of equal value were provided in return, are prohibited as a form of distribution. Under this interpretation, DAFs could only make payments to business entities for goods or services and not to any individuals or sole proprietorships.

Conditional Distributions to Organizations

A taxable distribution also includes any distribution from a DAF to any entity if:

  • the distribution is not for a religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals purpose; or
  • the sponsoring organization does not exercise expenditure responsibility with respect to such distribution.

However, excepted from the definition of a taxable distribution are distributions from a DAF to:

  • any organization described in section 170(b)(1)(A) (which includes most public charities and private operating foundations) other than a disqualified supporting organization (e.g., non-functionally integrated Type III supporting organizations, other supporting organizations controlled directly or indirectly by the donor or any donor advisor),
  • the sponsoring organization of such DAF;
  • any other DAF.

Accordingly, distributions from a DAF to most public charities (other than disqualified supporting organizations and public safety organizations) and private operating foundations will not be taxable distributions.

As noted above, a taxable distribution imposes an excise tax of 20% on the sponsoring organization and 5% (with a $10,000 cap) on any fund manager who knowingly agrees to the distribution.

No Prohibited Benefits to Donors, Donor Advisor, or Related Persons

A donor, donor advisor, or related person* may be subject to a tax penalty if they advise a distribution, or receive, directly or indirectly, more than an “incidental benefit” resulting from a distribution. The penalty tax is 125% of the prohibited benefit, and any prohibited benefit must be returned to the DAF. As an example, a distribution from a DAF to a college for payment of a donor’s child tuition would be a prohibited benefit warranting a penalty tax.

* A related person includes a member of the donor or donor advisor’s family (spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren) and any 35-percent controlled entity (i.e., entity in which the donor and donor advisors own more than 35% of the total combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or estate).

Furthermore, any fund manager (e.g., director, officer, or employee having authority or responsibility with respect to the act in question) who knowingly agrees to make a distribution that confers a prohibited benefit faces a 10% tax amount of the benefit amount, not to exceed $10,000 per transaction. Note, though, that taxes for a prohibited benefit will not be imposed if the taxes for an excess benefit transaction are imposed instead on the same transaction.

No Excess Business Holdings

Generally, a DAF and its disqualified persons together may own no more than 20% of the voting stock, profits interest, capital interest, or beneficial interest in a business enterprise. For these purposes, a disqualified person includes the donor, donor advisor, and related persons. The penalty for a violation of the excess business holdings rule is a first-tier tax of 10% of the value of such excess business holdings and a second-tier tax of 200% if the foundation still has excess business holdings at the end of the taxable period. The amount of excess holdings is determined as of the day during the tax year when the foundation’s excess holdings were the greatest.

There are a few exceptions to this general rule, including:

  • Where the DAF (together with certain related DAFs) owns less than 2% of the voting stock and 2% of the value of all outstanding shares of all classes of stock.
  • Where the DAF and disqualified persons with respect to the DAF own up to 35% of the business enterprise but one or more persons who are not disqualified persons have effective control of the business enterprise.

No Excess Benefit Transactions

An excess benefit transaction is defined as any transaction in which an economic benefit is provided by the organization directly or indirectly to or for the use of any disqualified person, and the value of the economic benefit provided exceeds the value of consideration (including the performance of services) received for providing the benefit. For these purposes, a disqualified person is a person in a position to exercise substantial influence over the affairs of the organization at any time during the five-year look back period from the date of the excess benefit transaction, and, with respect to a DAF, includes the donor, donor advisor, and related persons (which also includes for these purposes, the donor’s and donor advisor’s brothers and sisters (whether by the whole or half blood) and their spouses).

If an excess benefit transaction has occurred, the IRS can levy taxes, commonly referred to as intermediate sanctions, on both the disqualified person who received the excess benefit and the organizational manager(s) who knowingly approved the excess benefit transaction:

  • 25% excise tax of the excess benefit on the disqualified person who received the excess benefit; and an additional 200% excise tax of the excess benefit if the violation is not corrected within the taxable period.
  • 10% excise tax of the excess benefit on the organizational manager who knowingly participated in the transaction (maximum of up to $10,000).

Resources

Donor-Advised Fund Guide Sheet Explanation (IRS)

Donor-Advised Funds (Council on Foundations)

Is the Fund a Donor-Advised Fund? (Council on Foundations)

What are the issues with donor-advised funds? (Urban Institute)

Discerning the True Policy Debate over Donor-Advised Funds (Urban Institute)

An Analysis of Charitable Giving and Donor Advised Funds (Congressional Research Service, 2012)

Regulations

Well, we’ve been waiting for regulations on DAFs for almost a decade since a DAF was first defined in the Pension Protection Act of 2006. DAF guidance has been on the IRS priority guidance list for years. The Treasury Department completed and released a study on DAFs in 2011, though it was criticized as “disappointing and non responsive” by Senator Chuck Grassley, Senate Finance chairman at the time of the 2006 legislation, and I can no longer access the report from the link on the IRS site.

You can read comments about prospective regulations from the American Bar Association’s Charitable Planning and Organizations Group of the Section of Real Property, Trust and Estate Law (“RPTE Section”) here and download comments from the RPTE Section in a letter to Treasury dated August 18, 2016 here. My personal view is not to expect proposed regulations before the Presidential election because of the growing controversy with DAFs, whether they should be treated more like private foundations with minimum annual distribution requirements, and how this all fits in with broader tax policies.

Benefits to Donors

  • An immediate income tax deduction
  • Avoidance of capital gains taxes if the gift is appreciated property
  • Reduction of the gross estate by the amount of the excluded asset

Advantages Over Setting Up a Private Foundation:

  • Donations to a donor-advised fund qualify for the more favorable charitable deduction treatment of a gift to a public charity than donations to a private foundation
  • Donor-advised funds are not subject to the self-dealing and payout rules applicable to private foundations
  • Sponsoring organization generally takes care of all the administrative work
  • Typically, low contribution minimums
  • Ease and relative low-cost in establishment
  • Privacy, if donor desires
  • Ability to receive donations from private foundations, charitable remainder trusts, charitable lead trusts

Disadvantages Over Setting Up a Private Foundation:

  • Lack of control over distributions (grant-making)
  • Lack of control over investments
  • Less visibility and prestige than family-named private foundation
  • Lack of flexibility (e.g., grant-making areas)
  • No ability to hire staff (such as the donor and his or her family members)
  • No distributions to individuals