Recently, I was asked by some of the readers of this website to explain donor-advised funds and charitable trusts. In this post, I will address the donor-advised fund or the DAF, as some refer to it.
Like many things, the DAF was created to satisfy a need. A donor wants to provide financial support to charity and part of the impetus for the donation is the tax benefits. Regardless of how philanthropic an individual is, since there are tax benefits associated with charitable giving, most individuals want to be sure they are maximizing their tax benefits when they make a charitable gift. For this reason, much planning goes into the making of the larger charitable gifts.
The wealthy philanthropist (and even the normal donor) is attracted to the concept of separating their income tax planning from their charitable giving decision. Wouldn’t it be great if the philanthropist could do his or her tax planning, setting aside the maximum charitable gift amount that provides the maximum tax benefit and then, sometime later, decide the charities toward which to direct the charitable gift? What a great situation! Perform your tax planning near the end of the year, set aside the charitable gift amount and then take your time during the subsequent year, or later, to decide which charities you will support. Meanwhile, you are already enjoying the tax benefit from the amount you set aside at the end of the previous year.
This is the exact result you achieve by contributing to a donor-advised fund. It allows donors to make a charitable contribution, receive an immediate tax benefit and then recommend charitable distributions from the fund over time. An easy way to understand this is to think about a donor-advised fund as if it were a charitable savings account: a donor contributes to the fund at one time and then recommends grants to their favorite charity or charities only when they are ready—months or years in the future.
Let's run through that once more: You make an irrevocable contribution of personal assets—usually cash or securities. You immediately receive the maximum tax deduction that the IRS allows. Your contribution is placed into a donor-advised fund account where it can be invested and grow tax-free. At any time afterward, you can recommend grants from your account to qualified charities.
The DAF functions in a manner very similar to a private foundation without the need for the philanthropist to incur the costs of establishing the foundation or the foundation’s annual operating costs. The administrative costs charged by the DAF are almost certainly going to be less than similar costs associated with a private foundation. Better yet, there's no annual payout requirement for donor-advised funds, as with foundations, and fewer disclosure requirements about where money is going.
One potential drawback, however, is that the donor is actually only making recommendations to the DAF operator relative to the charities that should receive donations from the fund. The donor is only “advising” the DAF operator of the amounts and charitable recipients and the final decision is up to the DAF operator. In reality, the DAF seldom rejects the donor’s advice.
Donor-advised funds have been around since the 1930s but Congress and the IRS did not legally formalize their structure until 1969. As a result, DAFs have grown in visibility and popularity, and today they are among the fastest growing philanthropic vehicles. They currently account for more than 3 percent of all charitable giving in the U.S. One DAF, the Fidelity Charitable Gift Fund, established in only 1991, is now among the largest endowments in America.
A donor-advised fund must be established, maintained and operated by a charitable organization, exempt from income tax under IRS Section 501(c)(3). Although Fidelity is a for-profit company, its Charitable Gift Fund is “an independent public charity with a mission to further the American tradition of philanthropy by providing programs that make charitable giving simple and effective.” Other charitable organizations can establish DAFs, and while some charities with very specific program missions may do so, most DAFs are established at community foundations or other similar broad, public charities. Why? What’s in it for the charity that operates a DAF?
Fidelity and everyone else who is operating a DAF has a fair amount of work to do. They must maintain a separate account (the DAF) for each contributor, correspond with each contributor, consider the donations that the donor advises and then make the distribution. The DAF operator charges a fee for doing all of this. Usually that fee is charged as a percentage of the value of the account. With enough investments under management in DAF accounts, a charity can enjoy a reasonable source of steady income. (And Fidelity is investing DAF money in many of its own funds.)
As DAFs have increased in popularity, the IRS has had to tighten its review and enforcement over the potential abuses of these vehicles. Abuse of the law can easily occur when a donor who may not fully understand the law and an equally uninformed DAF operator are matched together. For example, it is obvious that a parent cannot take a charitable contribution deduction for making tuition payments for a child’s school or university.
Therefore, when a DAF operator receives instructions from a DAF donor to “send $10,000 from my DAF to ABC School,” the DAF operator must take certain steps to ensure that the amounts transferred are received by the charity as a donation and not in settlement of some financial obligation of the donor. And it is not just the large $10,000 payments that are at issue. The DAF operator also must be sure that the $200 or $500 payment to a charity is not payment for tickets to the charity’s annual dinner dance or golf tournament.
In summary, the DAF is a fast, inexpensive and easy way to separate your charitable gift tax planning from your charitable gift giving. The IRS has implemented new rules and regulations, created a list of prohibited payments and requires a certain amount of documentation, but these conditions are not onerous. In response to the clearly established regulations, more and more charities are now accepting donor-advised funds, some with fairly low minimum deposit requirements, making these DAF opportunities available to many charity-minded individuals and families.