The (Policy) Case for DAFs
In a recent post I offered some background on donor-advised funds (DAFs). Shortly after I wrote it, when speaking to a friend, I was trying to explain the core concept of DAFs and I actually had some trouble making clear that they are not actually illegal. Yes, the IRS knew about them, and, no, they would not come for you as the result of using one. As much as they might want to.
If you didn’t read my earlier post, or have not encountered DAFs previously, here is the IRS’s description:
Generally, a donor advised fund is a separately identified fund or account that is maintained and operated by a section 501(c)(3) organization, which is called a sponsoring organization. Each account is composed of contributions made by individual donors. Once the donor makes the contribution, the organization has legal control over it. However, the donor, or the donor's representative, retains advisory privileges with respect to the distribution of funds and the investment of assets in the account.
And if you didn’t read my earlier post, and do not know the policy consensus around DAFS, I will cut that knot by borrowing the very next paragraph from the IRS webpage:
The IRS is aware of a number of organizations that appeared to have abused the basic concepts underlying donor-advised funds. These organizations, promoted as donor-advised funds, appear to be established for the purpose of generating questionable charitable deductions, and providing impermissible economic benefits to donors and their families (including tax-sheltered investment income for the donors) and management fees for promoters.
The IRS’s “awareness” paragraph probably takes things a little far, but there is a pretty general policy consensus around the idea that they constitute a loophole. They are essentially a replacement for private foundations, in that they offer a way to make an immediate tax-deductible contribution with the intention of granting the money to an active charity at some future date, or over time. Since the sponsoring organization is a 501(c)(3), assets held by DAFs are not taxed. Any returns also are not taxed. And assets are eventually granted to charities according to the wishes of the donor. So, as practical matter, very similar a private foundation. But private foundations (theoretically) have accountability. There are registered with the state, they have officers, governance documents, stated purposes. They are (again, theoretically) subject to enforcement by your state’s attorney general, and they are recognized by the IRS –and this is the really important part—as private foundations. Meanwhile, organizations that sponsor DAFs get to be public charities under the public support test: they get more than one-third of their support from the general public. So. And even though it’s absurd on its face to think of the DAF-sponsoring subsidiaries of Schwab, Fidelity, and Vanguard, who hold and invest many of these accounts, as “public charities,” such is their tax treatment. Which, by the way, is significantly more favorable than the tax treatment of private foundations. Talk to your tax advisor. Finally, and perhaps most importantly to policy wonks, private foundations are not allowed to sit on their assets indefinitely. There’s a five percent minimum annual payout requirement. This means that every single year, a private foundation must cut into its untaxed assets to at least that extent, and grant them to a charitable organization that is actively providing charitable services or programs. DAFs need not. Ever.
If you’re mad at this point and think this is all crazy, please read my earlier post. You’ll find you’re not alone. But I would like to consider some points in favor of DAFs, up to, and including, their loophole status.
Private foundations are messy.
The state-level governance requirements for the private foundations that IRS eventually grants exempt status to are generally based on those of for-profit corporations. A minimal, clear governance structure for businesspeople with a shared profit motive.
What I am about to say will be deeply unfair to many private foundations. But the dynamics I am about to caricature do exist to the extent that they are an element in the philanthropic sector, and one that does not support the aims for which 501(c)(3) status was created.
In the process of establishing a private foundation, donors generally look to their immediate families for officers, and the dynamics can get complicated or downright unruly. Spouses become ex-spouses without losing their roles, children develop new values, marry, and want their spouses involved, relatives with strained personal relationships are required by law to meet periodically or lose their voice. Imagine a thanksgiving dinner that can’t end until everyone has agreed on which ideals to support from a shared pot of money. And all year long each member of the family may have been half-promising the whole pot to their favorite charity, church, museum, or school. At least some of the tax-exempt assets subject to the five percent rule are also subject to these dynamics, and as a result, so are active charities. They find it confusing, and draining.
Also, the governance documents of the private foundation may limit the universe of potential grantees to the point of absurdity or even impossibility. Many are founded with the money of a single donor with a very specific worldview, perhaps a long time ago. Even if not, a private foundation whose mission was one of gravest concern decades ago may have trouble finding charities doing impressive work in the same field today.
Private foundations are not subject to serious scrutiny
Even though the state has theoretical oversight over all the nonprofits created under its law, enforcement is practically nonexistent. I am not aware of any enforcement actions from state’s attorneys general that was not a corollary to some other criminal endeavor. This is a case where the compliance department of a big bank may actually be an improvement. And I say this as someone who used to go after big banks for the government.
Ambiguous status can lead to better behavior
Everyone in the DAF sector knows the IRS is not happy with them, and the best they can hope for is maintaining the status quo as long as possible. The best way to do this is to actually be a good thing. As silly as it seems to think of Fidelity as a public charity, they do have a lot of in-house expertise about how not to bring down the wrath of regulators. And here they can only do that by conspicuously not doing worse than private foundations.
People are scared of the IRS, but only when they don’t have a safe harbor. Prior to 1969 there was no distribution requirement for private foundations either. Once the five percent rule came in, distributions plummeted to its current level of about eight percent. What was (presumably?) meant as a floor became a virtual ceiling. In fact, if you accidentally distribute more than five percent, you get a credit to give less next year. When the IRS talks, people listen. There is no reason to think the same wouldn’t happen with a “minimum” payout requirement for DAFs.
As for the current annual payout of DAFs, it’s around 18%. This fact is worth stopping on. Without being required to give anything, donors who use DAFs give more than twice as much on average. Certainly this number hides a lot of individual variation, but since we’re discussing this at the policy level, who cares? (Plus, wouldn’t variation reflect a funding source responding appropriately to changeable needs? More on that later.)
DAFs actually are very useful tax planning and planned giving tools
We support philanthropic giving in the tax code for a reason. As I wrote in another post about the history of public charities in the U.S., the idea of positive societal good being best left in the hands of individual citizens acting within their communities has been part of the American experiment from the beginning. And DAFs are a very useful and versatile tool for this purpose. For better or worse, we have a tax code that incentivizes some taxpayers to make larger contributions in some years than others, and DAFs also fill this useful niche for people with no interest setting up (or putting up with) a private foundation.
Or they might simply want an easy way of setting aside a certain amount for later charitable giving with a familiar-feeling financial institution. These are exactly the financial mechanics that we encourage in other contexts: placing money in an account that can grow until they find a good use for it, without burdensome regulations or requirements. As for the final use, it just has to be qualified, and the since the sponsoring organization is responsible for making sure that the funds only go to an allowable charity, the donor doesn’t even need to worry about getting that wrong. It’s the perfect vehicle for people who care about giving, may have an interest in tax planning, but don’t have deal with the whole philanthropy lifestyle unless they want to. The only argument against it is that we don’t trust these people not to misuse the freedom to give away their own money.
Ok, that may too reductive. The (unstated) premise of most policy discussion about DAFs seems to be that untaxed assets and returns are not as desirable as current charitable programs. As I elaborate below, just in case that isn’t always true all the time, it may be good to encourage some versatility in the system. But if that if we are sure about that, then pushing donors towards what we know the alternative to be, vis, relatively inflexible organizations with high transaction costs, a very specific set of norms, often run by families, giving a steady five (or eight) percent of assets in perpetuity, should not be our goal. We should at least leave it as it is, unless something changes.
The philanthropic sector benefits from a variety funding dynamics
At the macro scale, money in DAFs represents a large pool of assets, earmarked for charitable purposes, that is ready, but not required, to be allocated at any time. And in the meantime, growing. This does not bother me. There is no reason to think that the charitable sector is better at predicting the future than anyone else. Of private funds already set aside for charitable purposes, plenty is already subject to a steady annual payout requirement. Having another pool that can be allowed to stay invested for as long as it takes for the individuals donor to find appropriate causes creates versatility and resilience in the philanthropic sector, which contributes to resilience to society as a whole.