Donor Advised Funds: Useful New Tools for Charities and Donors

by McGuireWoods LLP
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Donor advised funds (DAFs) are among the most-discussed vehicles in the charity world today. Proponents see DAFs as useful alternatives to private foundations and supporting organizations when donors want to provide continuing support for their favorite causes. But skeptics — including some in Congress and academia — view DAFs as a means to generate tax deductions without actually funding current charitable activities.

In all events, gifts to DAFs make up an increasing share of support for charities nationwide. The four largest DAF sponsors were estimated to have received almost $12 billion in contributions and to have made $7 billion in grants in 2017.

Overview 

Giving to a DAF generates an immediate income tax deduction even if the DAF takes many years to pay out the funds, or the income generated, to other charities. In the interim, the DAF’s assets grow tax-free, and the donor may advise as to investments and charitable distributions. While not binding, few charities offering DAFs ignore a donor’s advice as long as the proposed distribution satisfies the broad criteria outlined below. 

Contributing to a DAF entitles a donor to an income tax charitable deduction even before the donor finally decides which cause or charity to support. Funding a DAF also can facilitate income tax planning by producing an immediate deduction for funds intended to support the donor’s favored charities over a period of years. An added attraction for many donors is the efficiency and cost-effectiveness of a DAF, particularly when compared to the costs and time involved with creating a private foundation. Unlike a foundation, a DAF gift does not require a separate entity or tax exemption and is subject to fewer tax restrictions.

The very flexibility and simplicity that attract donors to DAFs also serve as a source of concern for some. Without a mandatory payout requirement, some charities and regulators fear that funds held in DAFs may simply remain invested and never be used to fund charitable activities. They also worry that donors may be tempted to recommend grants that provide impermissible personal benefits or relieve the donor of financial obligations. These concerns have led to changes in the tax laws that restrict certain activities in a DAF. The IRS has expressed concern over a number of transactions associated with DAFs and more legislative or regulatory changes may be in store. 

DAF Defined

A DAF is not a separate charity; instead, it is a discrete fund or account within a public charity (the sponsor). A charity classified as a private foundation cannot be a sponsor. A DAF is separately identified by reference to gifts of one or more donors; and by virtue of those gifts, the donor or someone the donor designates (a donor advisor) is, or reasonably expects to be, able to advise the sponsor about how the DAF’s assets should be invested or distributed. 

Accounts that distribute only to a single identified organization are not DAFs. The DAF rules also do not apply to (i) accounts advised by a committee that the donor recommends due to their expertise or (ii) accounts from which a committee appointed by the sponsor awards grants for travel, study or similar purposes pursuant to sponsor-approved criteria. The tax code authorizes the IRS to exclude other accounts that (i) are advised by a committee not controlled by the donor or donor advisor or (ii) benefit a single identified charitable purpose, but the IRS has not yet addressed those issues. 

Advisory privileges may be inferred from the conduct of the parties and do not need to be set forth in writing. But DAF status does not generally result just from enforceable rights under a gift agreement or privileges arising from the donor’s position as a director, officer or employee of the sponsor. 

Permissible Distributions

A DAF may freely make grants to the sponsor or to another DAF. It also may make grants to other public charities (except certain supporting organizations) for charitable purposes, and it may make grants to other entities if the sponsor exercises “expenditure responsibility” over the grant as if the DAF were a private foundation. Other grants — including grants to entities for non-charitable purposes and all grants to individuals — result in tax penalties on the sponsor and any manager of the sponsor who approved the grant. 

Prohibited Transactions 

A DAF distribution may not confer any benefit on a donor, donor advisor, or related person that would have reduced the available tax deduction if the grant had instead been a direct gift to the recipient from that donor or other person. For example, a DAF may not make a grant that entitles the donor to attend the recipient charity’s gala. Any such benefit generates a substantial penalty tax on any person who advises as to the grant or receives a benefit from it, and on the sponsor’s manager who approved the grant knowing it would confer such a benefit.

A DAF also may not make any distribution to a donor, donor advisor, investment advisor, or their close family members or businesses owned by them. Any loan, grant, compensation, expense reimbursement or similar payment to one of those persons subjects that person to a substantial penalty tax. The person will also have to refund the entire payment to the sponsor to avoid punitive penalty taxes, and the refunded amount may not be added back to the DAF.

Permitted Business Holdings 

A DAF may hold interests in a business entity. If the DAF owns more than 2 percent, however, the aggregate holdings of the DAF, the donor, the donor advisor, their close relatives, and related entities cannot exceed 20 percent without subjecting the DAF to substantial excise taxes and requiring the parties to dispose of their excess holdings. Special rules provide an extended period for a DAF to dispose of a business interest acquired by gift or bequest.

Current Issues

The IRS and others have expressed concern about certain potential abuses of DAFs and have sought comments on those issues. The IRS intends to issue regulations to address several matters related to DAFs. In the meantime, it has provided the following interim guidance:

  • A DAF grant may not enable a donor to attend a charity event by paying the part of the admission price that would be deductible as a charitable contribution and allowing the donor to pay only the non-deductible part. 
  • A DAF grant can satisfy a donor’s binding pledge to the recipient charity, provided that the sponsor does not mention the pledge when making the DAF grant. 
  • In determining whether a recipient of a DAF grant satisfies the IRS public support test, the grant is treated as a gift from the donor rather than from the sponsor. This potentially causes less of the grant to qualify as public support for the recipient.  

Proposed Additional Restrictions 

Unlike private foundations, which must distribute roughly 5 percent of their net asset value each year, DAFs are not subject to any minimum distribution requirements. Statistics show that, on average or in the aggregate, DAFs makes significant grants each year to support charitable purposes, but DAF critics continue to push for legislation that would either mandate a minimum annual payout or limit the time that assets can be held in a DAF. 

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Despite the possibility of additional regulation, DAFs remain useful tools for charitable gift planning. Their flexibility enables donors to generate immediate income tax deductions and have the gift funds grow tax-free while the donors consider how best to apply those dollars in the community. Their simplicity and economy contrast favorably with the complexity of a private foundation for donors who are willing to advise, rather than direct, subsequent distributions. The current regulatory proposals seem unlikely to pose problems for donors who want to add their gift funds to the stream of charitable commerce within a reasonable time, and it has yet to be seen whether new DAF restrictions will be a congressional priority.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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