A short time ago, I wrote about the basics of donor-advised funds (DAFs). I have recently discovered that buried deep in the House Ways & Means Committee tax reform plans is a proposal that would require DAFs to distribute contributions within 5 years of their receipt. This would result in a substantial change in how the DAF philanthropic vehicle currently works and opinion is divided on whether this would be a favorable or unfavorable change.
While private foundations have a minimum distribution rule, DAF can operate without any distributions to charity for years. Some have referred to this ability as a form of tax shelter rather than a charitable vehicle. When the DAF retains funds, those funds are not benefiting needy charities. Others argue that the DAF has democratized endowed giving by making a private foundation-like philanthropic vehicle available to people of lesser means.
The truth as I see it: Referring to the DAF as a form of tax shelter is misleading at best and totally inaccurate at worst. A tax shelter is a vehicle that allows a taxpayer to shelter money from taxation while still enjoying the benefits of the money or having the ability to enjoy the benefits of it sometime in the future.
Money given to a DAF will never benefit the donor other than being the source of a charitable gift that brings the donor notoriety or a naming right. Would you think you were “sheltering” your exotic sports car if you placed it in a building from which you were prohibited from taking it out for a spin, ever? Of course not. When you “shelter” money or any item, you are protecting it from something today so that you can use it tomorrow.
The government recognizes that funds contributed into a DAF escape taxation. Let’s be honest, taxes are the most important thing to governments. Each tax dollar that escapes them is a drag on their spending ability and spending is what maintains their popularity.
What does the government have to gain by requiring DAF assets to be distributed within 5 years? When the DAF makes a distribution to a charity, that charity spends the money on efforts to achieve its mission. The majority of the money goes to taxable compensation of employees and the remainder goes to supplies and services that also produce taxable income for the recipients. So the $5,000 that is contributed to a DAF and escapes taxation today, if required to be distributed within 5 years, would produce taxable incomes in a relatively short period of time.
I do not believe that the government is interested in moving money out of DAFs and into the charitable sector for the benefit of charity. Rather, the House Ways & Means Committee fully understands that funds inside DAFs will not be subject to taxation until they are out in the community and taxation is their ultimate goal.
Should there be some prohibition against a DAF holding onto funds indefinitely? Absolutely! But there's an obvious solution here: The required distribution rules in place for private foundations impose mandatory distribution levels that provide for annual distributions without requiring the complete distribution of the amounts held by the foundation. If this set of regulations were ported over to the DAF entities, it would likely work just as effectively.