Donor-advised funds (DAFs) have dramatically grown in popularity and significance in recent years.1 First used in the 1930s as described below, DAFs have become the most flexible, least complicated and most economical way for many donors to irrevocably dedicate their resources to charity and yet retain an advisory role in how those resources are eventually deployed. Simply put, a DAF is a designated fund at a sponsoring organization (SO) that’s been recognized for federal tax purposes as a public charity. The donor or the donor’s designee has the privilege of making nonbinding grant recommendations to the SO.2
Impactful philanthropists don’t just give, they engage. While there are many ways for donors to be actively engaged, the act of committing one’s own resources, irrevocably, is perhaps the clearest expression of commitment. Historically, wealthier philanthropists have made that commitment by creating and funding their own private independent foundations (PIFs), and this strategy remains a common and attractive approach. However, creating a PIF has both initial and ongoing costs as well as technical requirements that present significant barriers. DAFs offer donors a choice by lowering the barriers to ongoing engagement.3 A comparison of the growth in these two approaches is illustrated in “Independent Foundations vs. Donor-Advised Funds,” p. 37.
The popularity and democratizing nature of DAFs is clear. There are now nearly 10 times as many DAFs as there are PIFs. While PIFs are required to use approximately 5% of their assets each year for charitable purposes,4 DAFs now annually distribute, collectively, over 20% of their asset value to support charitable needs.5 Despite their popularity and clear utility, some have questioned whether the public good is best served by DAFs operated in their present form. These concerns have been amplified recently by the clear needs created by the catastrophic spread of COVID-19 and the related economic recession.6
These concerns, discussed in more detail below, include:
- Donors should only get a tax deduction when DAF funds are distributed;
- The growth in dollars in DAFs prove they just warehouse dollars;
- DAFs impede rather than encourage the flow of charitable dollars;
- The same volume of emergency resources would be available without DAFs;
- DAFs are cash generators for SOs; and
- DAFs are a black hole and need more regulations.
It should be noted that these same concerns also have been raised about PIFs and are more a criticism of the historic tax incentive for charitable giving in general than a narrowly focused attack on DAFs alone. Indeed, the criticism often calls into question the very nature and benefit of endowed charitable giving.7
Historical Background
DAFs have existed in one form or another since 1931.8 While the legal status of component funds was clarified by the Tax Reform Act of 1969 and subsequent regulations, there was no statutory definition of DAFs until the Pension Protection Act of 2006 (PPA). That definition was designed to identify which funds would be subject to new, statutory limitations and excise tax penalties and which funds wouldn’t be.9
The first DAFs were operated by mission-based public charities such as community foundations and religious-based organizations or foundations. These organizations have a core mission and engage in a wide range of community and faith-based philanthropic activities. DAFs have been critical to the success of their charitable programs and activities. As a component part of mission-based charities, these DAFs represent a ready source of funds when donors and charities need to act quickly in response to specific problems or issues. They also create a welcoming environment for frequent dialogue between the charity and its donors, which serves to enhance the knowledge of both. In the early 1990s, a different form of national DAF program was created.10 (Recently, one commentator referred to these organizations as “commercial DAF sponsors.”11)
The explosive growth in the number of DAFs and the amounts contributed to them began in the early 1990s when Fidelity, followed by other financial services firms, created new charitable organizations, the sole purpose of which was to sponsor DAFs. These are sometimes referred to as “national DAFs” and include some large national DAF sponsors that aren’t affiliated with financial institutions, like the National Philanthropic Trust (NPT). NPT conducts a national survey of DAF sponsors that provides much of the most reliable public data on DAFs.12
The 2011 Treasury Report
Even with the passage of statutory rules for DAFs in 2006, Congress was concerned there might be more issues to address. Accordingly, a specific provision in the PPA directed the Treasury Department to present Congress with a study on the organization and operations of DAFs and answer a series of questions including whether the existing deduction rules for contributions were appropriate and whether DAFs should be subject to a distribution requirement.13 The “Report to Congress on Supporting Organizations and DAFs” (the Report) was completed and released in December 2011.14 Much of the Report was based on data that Treasury had begun to collect on DAFs from SOs in 2006. The Report concluded that little if any new regulations or restrictions were necessary.15 Nevertheless, some academics and donors critical of certain DAF operations continue to call for more restrictive rules or additional requirements.
Timing of Income Tax Benefit
Should donors be entitled to an income tax benefit when they make the gift to a DAF or only when the funds are deployed for a charitable purpose? Should these gifts be treated differently from gifts to other endowment funds?
It’s long been a feature of the U.S. Tax Code to incentivize taxpayers to contribute assets to charitable organizations, through charitable income tax deductions, including for irrevocable gifts, the impact of which might be delayed for years.16 In the case of endowed funds, the societal benefits can be perpetuated indefinitely. In the case of gifts to establish endowed funds, such as an endowed chair at a university, few seem to question the rationale for providing donors charitable income tax deductions for gifts in the year the assets are transferred to the charity. Nevertheless, some people do argue that institutions that have amassed “huge” stockpiles of reserves/endowments should be taxed or forced to distribute more than 4% or 5% annually.17
Some refer to this form of giving as “legacy giving” or “leaving a legacy” that lives on after a donor dies. DAFs are a form of endowment, but the spending rate for a DAF is often many times higher than that of a traditional endowment. The option of funding a DAF is an incentive to irrevocably commit funds to charity early that would otherwise remain the private, uncommitted assets of the donor.
At the heart of this concern is the belief that DAFs allow donors to benefit from an immediate income tax deduction, yet the societal impact is delayed. Compounding this concern is that there are no legal requirements for annual distributions from DAFs. The Report put the answer to this concern in the proper perspective:
The issue of the lag between contribution and final use of assets is no different at DAF Sponsoring Organizations … than it is for other public charities that may operate charitable funds or maintain endowments. Thus, it is appropriate that the contribution deduction rules faced by donors … DAF Sponsoring Organizations are the same as those applicable to donors to other public charities.18
Accordingly, the Report concluded that minimum distributions weren’t necessary.19 The actual payout rates for DAFs annually are illustrated in “Annual Payout Rates,” p. 39.
Many donors treat DAFs as transactional vehicles that need to be replenished on a regular basis. This helps explain why there’s such a high distribution rate and yet the total value of assets held in DAFs increases year over year. Any attempt to impose a minimum distribution level for DAFs may well have an unintended and unfortunate consequence. If a minimum distribution requirement were imposed on DAFs (such as the 5% minimum applicable to PIFs), DAF donors might gravitate to the defined minimum rather than reflect their overall goals and philanthropic impulses.20
Efficient administration, sound investment policies, stewardship and educational programming—all hallmarks of DAFs of mission-based charities—continue to build relationships of trust that increase the likelihood of enhanced giving and involvement over time—providing more insight into individual donor priorities and opportunities for broader donor engagement in the community.
Accordingly, there’s nothing static or passive about DAFs. More akin to “greenhouses” than “warehouses,” DAFs often permit donors time to engage in strategic philanthropy and to grow support and participation in the SO’s charity—whether that means temporarily saving for a significant charitable project, remaining active in philanthropy in retirement, enthusing succeeding generations by involving them in the donor’s philanthropy or responding to the most urgent current needs of the SOs and other worthy charities, especially during economic and communal adversity.
Increase in Charitable Giving
Has the increase in the number of DAFs and dollars being contributed to DAFs reduced the dollars available to public charities to address urgent needs today? Although DAF contributions had been rising steadily over the last decade, there was a spike in DAF contributions in 2017 and 2018 after the passage of the Tax Cuts and Jobs Act of 2017, which dramatically reduced the number of taxpayers who are eligible to itemize their deductions.21 By generously funding a DAF in one year, a donor can aggregate and set aside enough charitable dollars to warrant itemizing their deductions for that year. Then, currently and for years to come, distributions can be recommended from the DAF, resulting in the same flow of charitable contributions as historically would have been made by the donor directly. However, in the years following the funding of the DAF, donors can simplify their tax reporting by relying on the standard deduction.
The steady increase in dollars in and out of DAFs has resulted in a rise in dollars flowing to operating charities through DAF grants. This appears to have increased charitable giving overall. For example, grants from DAFs increased from $16 billion in 2016 to $23 billion in 2018, a 48% increase.22 This increase far exceeds by nearly 10-fold the increase in charitable giving by individuals over this same period, according to data reported in Giving USA.23
Meeting Emergency Needs
Are current emergency needs being met from DAFs? It’s important to note it’s difficult to raise funds to support emergencies while in the middle of the emergency. This is particularly true when the emergency is exacerbated by an economic downturn. Indeed, the process of raising resources takes time, often years, of work and preparation. A key societal benefit of robust DAFs is that funds are already committed to support charitable needs and are readily available in a time of sudden need. Of all the charitable vehicles, DAFs have proven to be the most flexible and responsive to changing and sudden needs. The fact that donors have dramatically increased the dollars held in DAFs has enabled them to quickly respond to current crises and deliver the dollars where they’re needed most. The two examples below are representative of the DAF universe. National Philanthropic Trust (NPT) reports that in March, April, May and
June 2020, the volume of NPT grants increased an average of 69%, and the dollar value increased an average of 159% compared to the same time period in 2019.24 Similarly, Fidelity Charitable reports that, despite the stock market crashing, grants from Fidelity Gift Fund DAFs increased $330 million to $2.4 billion in the first four months of 2020, compared to the same period in 2019. Grants to food banks skyrocketed from $10 million in the first four months of 2019 to $75 million in 2020.25
SO Fee Income
Do SOs only sponsor DAFs to generate fee income? It’s best to differentiate among the different categories of SOs in framing an answer to this question. Historically, most SOs that created DAF programs to increase donor engagement were in existence long before DAFs became a common gifting vehicle. Most donors who establish DAFs with these mission-based charities do so because they’re attracted to the mission of the SO and welcome input from the charitable professionals who work for the charity.26 The fees charged by these SOs tend to be quite low, and the corresponding value of donor engagement and philanthropic guidance tends to be quite high.
As noted above, some of the largest SOs have been created by financial services institutions, such as Fidelity Charitable Gift Fund, Schwab Charitable and Vanguard Charitable. These charities were created to host DAF programs. The fees that they charge, especially for the smaller DAFs, are far cheaper than the costs of establishing and administering a PIF. On the other hand, the level of engagement with donors is often more limited than the support provided by mission-based charities. And, one can be cynical and opine that these charities were established to prolong the period that the related financial services institution can collect investment management fees. This might have been one of the motivating factors that led Fidelity and so many others to create affiliated SOs to host DAFs. But, these charities have thrived and are providing a tremendous societal benefit.27 The question remains for some whether these SOs should be treated the same as those that aren’t created by and affiliated with financial services institutions.
Regulation
DAFs are highly regulated and carefully maintained. In sponsoring a DAF program and offering donors an alternative to PIFs, the principal oversight responsibility shifts from the Internal Revenue Service and individual states’ attorneys general to the SOs and their board of trustees, all of which are themselves subject to oversight and scrutiny. This oversight requires a clear and consistent set of policies and procedures and a high level of professional management by the SO. The IRS carefully monitors and audits many SOs.28 Where necessary, administrative adjustments are made, and, sometimes, penalties are assessed, including excise taxes added by the PPA. Given the reduction in IRS personnel and the uneven enforcement available at the state level, the current model of “self-regulation” provided by SO professionals results in far greater oversight than would be possible if the government assumed the responsibility for policing each and every DAF. The costs for managing DAF programs also would skyrocket if this level of reporting were required.
An Important Role
While some may continue to question whether there should be additional rules and regulations associated with DAF programs, it’s clear DAFs play an increasingly important and significant role for donors and the charities they support. The multitude of benefits that flow to DAF donors, sponsors and, ultimately, the community, best explain their growing popularity. Still not as large, in aggregate, to the funds held in PIFs, DAFs provide a ready resource that can be deployed on short notice to address pressing charitable needs. Reforms may eventually be introduced. Hopefully, any adjustments to our public policy will serve to facilitate and increase rather than frustrate and discourage donors who seek ways to help support present and future societal needs and benefits.
— This material contains the opinions of the authors, but not necessarily those of AllianceBernstein or its affiliates or other institutions affiliated with the authors and such opinions are subject to change without notice. Bernstein does not provide tax, legal, or accounting advice.
Endnotes
1. A summary of the increase in donor-advised fund (DAF) accounts and DAF funds can be found in Eileen Heisman, “The Decade in Donor-Advised Funds,” Accounting Today (Jan. 6, 2020).
2. Internal Revenue Code Section 4966; added by the Pension Protection Act of 2006 (PPA).
3. For a comparison of the options between a DAF and a private independent foundation (PIF), see Jane Winton, “‘Donor-Advised Funds: An Examination of Their Popularity and Legal Underpinnings,” New York Community Trust (April 2, 2019).
4. IRC Section 4942.
5. “The 2019 DAF Report,” National Philanthropic Trust, www.nptrust.org/reports/daf-report/.
6. See Aaron Dorfman and Ellen Dorsey, “Now is the Time for Philanthropy to Give More, Not Less,” The Chronicle of Philanthropy (March 19, 2020).
7. See Herwig Schlunk, “Why the Charitable Deduction for Gifts to Educational Endowments Should Be Repealed,” 71 U. Miami L. Review 702 (2017).
8. Lila Corwin Berman, “Donor Advised Funds in Historical Perspective,” Boston College Law School Philanthropy Forum (2015).
9. Exceptions to the statutory definition of a DAF can be found in IRC Section 4966(c)(2)(B).
10. The early history of the Fidelity Investments Charitable Gift Fund is described in an article in the Wall Street Journal published in 1998. See Monica Langley, “Fidelity Gift Fund Soars, But the IRS Is Skeptical,” Wall Street Journal (Feb. 12, 1998).
11. Brian Galle, “What Do Commercial DAFs Have in Common with Donald Trump’s Tax Returns?” Medium.com (Aug. 15, 2018).
12. See supra note 5.
13. Section 1226 of the PPA 2006 directed the Secretary of the Treasury to undertake a detailed study of DAFs.
14. “Report to Congress on Supporting Organizations and DAFs,” Department of the Treasury (December 2011), www.treasury.gov/resource-center/tax-policy/Documents/Report-Donor-Advised-Funds-2011.pdf.
15. Ibid.
16. See the Joint Committee on Taxation Report JCX-4-13, “Present Law and Background Relating To The Tax Treatment Of Charitable Contributions.”
17. The Tax Cut and Jobs Act of 2017 imposed an excise tax on the investment income of private colleges and universities. For a discussion of university endowments and distribution requirements, see Sandy Baum, “The Role of College and University Endowments,” Urban Institute (July 2019).
18. Supra note 14.
19. Ibid.
20. “The 5 percent rule was enacted to provide a floor for charitable giving, but most private foundations use it as a ceiling as well.” Ray Madoff, “A Better Way to Encourage Charity,” New York Times (Oct. 5, 2014).
21. Erica Yorke, “Nearly 90 Percent of Taxpayers Are Projected to Take the TCJA’s Expanded Standard Deduction,” Tax Foundation (Sept. 26, 2018).
22. See supra note 14.
23. Giving USA 2020: The Annual Report on Philanthropy for the Year 2019, https://store.givingusa.org/.
24. See supra note 5.
25. See Fidelity Charitable publication, www.fidelitycharitable.org/content/dam/fc-public/docs/insights/communities-in-crisis-how-donors-are-responding-to-covid-19.pdf.
26. For an example of the benefits to a donor of a mission-based DAF, seewww.jewishcleveland.org/news/blog/daf_a_first_step_to_family_philanthropy/.
27. See the annual reports of the Fidelity Charitable Gift Fund, www.fidelitycharitable.org/insights/2020-giving-report.html, Schwab Charitable, www.schwabcharitable.org/public/file/P-11987754 and Vanguard Charitable, www.vanguardcharitable.org/2019annualreport.
28. The Internal Revenue Service has issued a detailed DAF Guide Sheet and DAF Guide Sheet Explanations, www.irs.gov/pub/irs-tege/donor_advised_explanation_073108.pdf.