In his article, Professor Samuel D. Brunson trots out an argument popular among those seeking to find a cause to challenge—alleged abuses with the donor-advised fund (DAF) strategy.
Boiled down to its urban folklore basics, the author’s premise is that DAFs allow donors to skirt the protective requirements of private foundation (PF) law while retaining the benefits of the PF. The author identifies the problem to be that DAFs provide donors “with the expedited deduction and control over private foundations, while at the same time providing the privacy and higher deduction limitations of public charities.”
As a practitioner who’s been involved in hundreds of PFs and contributions to DAFs, I think the pragmatics of both entities undermine the author’s argument.
The fundamental distinction is correct: PFs are subject to 1969-era requirements on their administration; DAFs are public charities that don’t share those requirements and have slightly different charitable deduction limitations.
With regard to the latter distinction, a major theme throughout the article is that a donor to a DAF, because of the higher deduction limits, is at a substantial advantage that isn’t justified by the structure of a DAF. I personally think this is a distinction without a meaningful difference. Here’s why.
Giving appreciated stock, including stock in an initial public offering to a PF, entitles the donor to a deduction maximized in any given year to 20% of the donor’s adjusted gross income. Giving the same donation to a DAF increases that ceiling to 30%. In most cases, this is a distinction without any true practical value. Few donors run up against the 20% limitation to begin with, and even if they exceed it, they can either carry over that excess to a future year or deal with the excess by giving a percentage to a public charity. I haven’t had one client who chose a DAF because of the 30% (versus 20% with a PF) ceiling.
Second, another theme throughout the article is that DAFs “function like private foundations.” This is an oft-cited reason that DAFs are abusive in nature.
And yet, they really don’t function like PFs. I advise all clients that, with a DAF, they’ll give up substantial and important client control of the charitable funds. For example, until DAFs implement more creative structures, DAFs don’t: have full family control of investments; have family hiring of employees to administer the charitable gift; allow the family to make unfettered gifts to selected public charities; allow families to easily create rules and restrictions (unfettered) on gifts to public charities; and have the mechanisms (like paid employees) to monitor the use of those funds by the charities. Most DAFs merely allow donors to “request public charities to support,” while at the same time, offer some decisions with regard to investments.
Rather than refer to DAFs as the “poor man’s private foundation,” as the author notes, I would refer to them as “the give-up-control substitute for private foundations.”
In 1969, Congress imposed substantial requirements on PFs to eliminate abuses. These requirements don’t apply to DAFs, nor should they. The author believes otherwise and that skirting the PF rules is a major advantage to DAFs.
For example, PF rules mandate a distribution of approximately 5% of the funds annually for charitable purposes. Distribution of funds to charities is important. The 5% rule was imposed so that donors would have guidelines and incentives to make charitable contributions and not just hold charitable funds for investments forever. However, it’s been my experience that most families that have segregated funds into a charitable entity want to make charitable contributions. Specifically, families contributing to DAFs make contributions out of the DAFs to designated charities. Sometimes the amount is greater than 5% per year, sometimes less. But, the 5% limitation isn’t a requirement needed for DAFs for charitable distributions from those funds to occur.
Another requirement of PFs are limitations on the investments in closely held businesses (providing generally five years to distribute interests in certain private companies held by families). There are also requirements against self-dealing (for example, hiring a family member and providing that family member excessive compensation or renting space from a building owned by the donor). Potential for self-dealing and private inurement opportunities are just not as prevalent in DAFs, and those latter funds now have a similar prohibition against self-dealing imposed by Internal Revenue Code Section 4958.
Further, another rule specific to PFs is on jeopardizing investments. Congress wanted to make sure that PFs were invested prudently. That rule, of course, doesn’t specifically apply to public charities, but once again, DAFs and donors to those funds have all the incentives to invest prudently and enhance the return of these funds.
In an effort to raise revenue, Congress imposes a net investment income tax on PFs; that tax isn’t imposed on DAFs. Although there’s no reason for the tax, avoiding it isn’t very meaningful to donors and not a compelling reason to give to DAFs versus PFs.
The author indicates that the “status quo is not optimal” for DAFs. On that statement, I would agree, primarily for the following two reasons: (1) DAFs don’t have the succession stewardship required in PFs. The donor’s right to suggest charities in DAFs often disappears after the donor’s and one or more designees’ passing and after the family loses track of their designation ability;1 and (2) with DAFs, there isn’t as much effort as with PFs in: (i) making charitable contributions, (ii) creating accountability standards, and (iii) undertaking due diligence with selecting charities and with monitoring use.
The author proposes that “an easy—and effective—way to solve all the problems, then, would be to treat donor-advised funds like private foundations for tax purposes.” If done that way, that may be the end of DAFs. And, for DAFs in excess of a certain amount, such as $5 million, that rule may result in these donors going back to creating PFs, which operate very effectively and importantly for families.
DAFs should, however, be retained for smaller contributions when the effort and cost of setting up a PF isn’t justified.
Though the author does an excellent job crafting solutions to what he identifies as problems with DAFs, we’re still left with the question of whether DAFs are abusive. I would tend to disagree with the statement in the last paragraph of the article that says, “donor-advised funds create ‘the ability of the wealthy to take charitable tax deductions without oversight and without actually donating the money….’”
Families providing contributions to DAFs do so because they want to benefit charity. Funds in DAFs are used by families to benefit charities. Most advisors recommend DAFs as an administratively easier way to contribute to public charities, not as a means of avoiding PF status. In my opinion, there isn’t abuse here that needs to be corrected.
Endnote
1. I wonder how much undesignated funds are in the Fidelity Charitable Fund that Fidelity designates as charitable recipients?