Giving Now and Later: An Overview of Current and Future Donor Advised Fund Rules
Donor advised funds have been around for almost a century. The first donor advised fund (DAF) emerged in the early 1930s. DAFs became more popular and commercialized in the 1990's with the creation of charitable arms of large financial institutions. Tax law evolved over the years to distinguish public charities from private foundations, without codifying DAFs until 2006. Congress passed the Pension Protection Act (PPA) of 2006, which introduced DAFs formally into the tax code and defined the rules related to DAFs. Since the passage of the PPA, the rules regarding DAFs have remained relatively unchanged. Over the years, there have been calls to regulate and reform DAFs.
This article will discuss the DAF basics, including the benefits to both donors and nonprofits as well as some of the rules governing DAFs. This article will provide a sample agreement for nonprofits interested in hosting DAFs. Part II of this series will focus on pending legislation related to DAFs.
Basics of a Donor Advised Fund
A DAF is a separately identified account that a donor establishes with a sponsoring Sec. 501(c)(3) nonprofit organization. A DAF allows the donor to irrevocably dedicate assets for charitable purposes and generate an immediate charitable income tax deduction, while retaining flexibility to later recommend which charitable entities should receive grants from the DAF. Many donors gravitate to DAFs due to the flexibility and advisory control they offer.
There are three requirements under Sec. 4966(d)(2)(A) that define a DAF. The account must be separately identified by reference to contributions of the donor. When contributing to a DAF, the donor must give complete control over the donated assets to the sponsoring charity. The donor can remain involved through advisory privileges by making non-binding recommendations to the public charity as to investment policy and DAF distributions. If distributions are only made to a single organization, the segregated fund is not considered a donor advised fund. Sec. 4966(d)(2)(B). With a DAF, the donor is able to fulfill philanthropic goals in a flexible, tax-favored and cost-effective way.
Typically, sponsoring organizations will make their best efforts to follow donors' wishes when donors are exercising their advisory privileges. However, sponsoring organizations are not legally obligated to follow a donor's advice. Due to the unique functions of a DAF, the donor relinquishes title and complete control over the contributed property on the gift date. This is important for the sponsoring nonprofit's protection and liability. If the donor advises a gift that is impermissible, either under IRS rules or the sponsoring charity's mission or standards, the sponsoring charity may refuse to make the distribution.
DAF Charitable Deductions
The donor's charitable contributions to a DAF generate an income tax deduction in the year of the contribution. Taxpayers may deduct donations in the same way they would deduct for other charitable contributions to public charities. Typically, the charitable deduction will be for the fair market value of the contributed asset. Because DAFs are held by Sec. 501(c)(3) sponsoring nonprofits, cash contributions are deductible up to 60% of the donor's adjusted gross income (AGI) and appreciated property contributions are deductible up to 30% of the donor's AGI. The donor does not receive an additional charitable deduction when making grants from the DAF to qualified charities, because the deduction was received when the donor made the initial gift to the DAF. If the donor meets or exceeds the deduction limits in the year of the charitable contribution to the DAF, the donor is able to carry the deduction forward for up to five additional years.
The DAF can be beneficial for donors wishing to simplify their charitable giving. The donor can make donations to the DAF and at a later time exercise advisory privileges on the grant distributions from the DAF. This will allow a donor flexibility to make donations, without being required to determine the ultimate charitable purpose for the donation until a later time.
Some donors may find the benefit of bundling deductions particularly attractive with DAFs. Many taxpayers may not itemize their tax deductions due to large standard deductions. For taxpayers who do not itemize deductions, a charitable donation does not generate tax savings on their tax return. Taxpayers who do itemize on their tax returns will receive the tax benefits of their itemized charitable deductions. Those who typically do not itemize might consider "bunching" several years' worth of charitable gifts together to cross the standard deduction threshold and take a charitable deduction in one year.
Mallory typically takes the standard deduction when she files her income tax returns. She is a loyal supporter of her local social service charity and generally makes gifts totaling $5,000 per year. However, because she does not itemize, she does not realize tax benefits for her charitable contributions. Her tax preparer mentioned she could make one large gift this year to a DAF, essentially "bunching" her donations. By bunching, she could have the same charitable impact, but also realize the tax benefits of her charitable donations. If Mallory contributes $15,000 to a DAF, she can "bunch" her charitable contributions and stretch out her charitable impact to future years. She can use the DAF to make charitable gifts to her favorite charity for the next three years at her current giving level of $5,000, while taking a charitable deduction in the current year.
DAFs also offer the donor the ability to instill philanthropic involvement in the next generation. Many DAF agreements permit advisory privileges to be passed on to successor family members after the donor has passed away. These successor advisors would have the same involvement with recommending the DAF's investments and grant distributions allowing them the unique opportunity to be included in philanthropy.
DAFs are not subject to minimum distribution requirements. However, sponsoring charities may include periodic grant making requirements in the DAF agreement. The lack of minimum distribution requirements positions DAFs as particularly attractive for donors who wish to make a deductible charitable gift now but want more time to decide which charitable organizations will receive grants. Despite the lack of distribution requirements, average DAF distribution rates have reached over 20% every year on record according to annual reviews.
Excess Benefit Transactions
Donor advised funds are subject to Section 4958 excess benefit transactions rules. An excess benefit transaction occurs between the charity and a disqualified person. An excess benefit transaction is triggered when a charity engages in any transaction which results in a disqualified person receiving a direct or indirect benefit from the charity if the value of the economic benefit exceeds the value of the consideration received. Sec. 4958(c).
For the purposes of a DAF, a disqualified person is defined as the donor or similar person who expects to have advisory privileges, members of the family of a donor or similar person and entities that are controlled 35% or more by one of the aforementioned individuals. These rules are designed to minimize the potential for donors to abuse the DAF structure and receive inappropriate benefits.
In addition, any grant, loan or payment of compensation to a disqualified person is an excess benefit transaction. Sec. 4958(c)(2). The excess benefit recipient will be assessed a tax equal to 25% of the excess benefit. Sec. 4958(a)(1). The fund manager will be subject to a 10% tax on the amount of the excess benefit transaction if the manager knowingly and willfully participated in the excess benefit transaction. Sec. 4967(a)(2). There are limited exceptions to the excess benefits transactions. One exception is for fixed payments made under a written binding contract, as long as the individual was not a disqualified person immediately prior to entering into the contract. Reg. 53.4958-4(a)(3).
Taxable Distribution Rules
DAFs are subject to taxation for non-charitable distributions, which would include any distributions made to individuals. For taxable distributions, the sponsoring organization will be assessed a tax equal to 20% of the amount of the distribution. Sec. 4966(a)(1). Any fund manager who knowingly assists in a taxable distribution from a DAF will be subject to a 5% tax on the value of the distribution. Sec. 4966(a)(2).
Excess Business Holdings
After passage of the Pension Protection Act of 2006, DAFs are subject to the excess business holdings rules of Sec. 4943. This may impact some of the assets a donor gives to the DAF and how long the DAF may hold on to those assets. Gifts by disqualified persons, who together with attributed family, own 20% or more of stock or interests in the business or 35% or more of the stock or interests in a third party-controlled entity will trigger application of the excess business holdings rules. Sec. 4943(e)(2).
Generally, a transfer of business interests into DAFs will require the sale of the assets within five years. If the DAF requests approval from the state Attorney General and the IRS, the timeframe may be extended to ten years. If the assets are not liquidated from the DAF within the appropriate time frame, a tax of 10% of the value of the holdings will apply. Sec. 4943(a)(1). If, after the initial tax is levied, the holdings are not sold by the end of the taxable period, an additional tax equal to 200% of the excess business holdings will be imposed. Sec. 4943(b).
Incidental Benefits Rules
Any disqualified person with respect to the DAF who advises a distribution resulting in more than an incidental benefit to a disqualified person will be subject to an excise tax equal to 125% of the distribution. Sec. 4967(a)(1). If the fund manager knows the distribution would confer more than an incidental benefit on a disqualified person, the manager will be subject to a tax equal to 10% of the benefit of the distribution. Sec. 4967(a)(2).
IRS Notice 2017-73 provided guidance that a DAF distribution to pay for fundraiser tickets would result in more than an incidental benefit to the donor. The IRS determined that a DAF's payment of part of a ticket price for a charity event would relieve the donor of the obligation to pay the full ticket price. The guidance further noted that a distribution of this nature may also violate the Sec. 4958 "excess benefit transaction" rule.
IRS Guidance on Pledges
A pledge is an agreement between an individual and a charity whereby the individual promises to donate a specific amount of money by a specific time. Depending on the governing state law, the pledge may also be legally binding. When the donor satisfies the legal obligation by making the agreed upon donation, the pledge has been fulfilled. If the satisfaction of a legally binding pledge were an incidental benefit, then the distribution would be taxable at 125% to the donor. If the fund manager possesses awareness of the obligation, an excise tax of 10% of the distribution would be applied.
In Notice 2017-73, the IRS addressed whether a DAF distribution that satisfies a donor's legally binding pledge would violate the incidental benefits rules of Sec. 4967. The IRS took the position that the distinction between legally binding pledges and non-binding pledges would be difficult for sponsoring organizations to determine. Therefore, the IRS issued guidance under which DAF distributions may be permitted to satisfy a donor's outstanding pledge to a qualified charitable organization.
Under the proposed guidance, if a three-prong test is satisfied, the donor will not be treated as violating the incidental benefit rules. First, the distribution from the DAF sponsoring organization must not reference the existence of a pledge. Second, the donor may not receive any benefit that is more than incidental. Third, the donor must not claim a charitable deduction for the DAF distribution. If all three of the above requirements are met, a contribution made in fulfillment of a pledge will not be treated as a violation of the insubstantial benefit rules and the donor will not be subject to a 125% excise tax. Notice 2017-73 specifically permits such DAF distributions "regardless of whether the charity treats the distribution as satisfying the pledge."
Please note, Notice 2017-73 serves as merely an announcement of the IRS' intention to develop proposed regulations. The law has not changed explicitly to permit the satisfaction of pledges through a DAF distribution. It is within the IRS' discretion to rescind this guidance and revert to treating pledge satisfaction as a violation of the incidental benefit rules. Tax practitioners should proceed with caution when considering this route for their clients and be on the lookout for additional guidance regarding the proposed and eventually the final regulations on this topic.
Sponsoring charities will want to ensure there is a written agreement for the DAF with the donor. Crescendo offers a sample DAF agreement in our charitable tax law resource guide, GiftLaw Pro, in Chapter 7.1.8. It is also provided here for the reader's convenience. Sponsoring organizations may offer a DAF agreement that differs from this sample. Please note: our sample includes a restriction against using DAF distributions to satisfy pledges, but organizations' counsel may make revisions at their discretion.
Sample Donor Advised Fund Agreement
This Donor Advised Fund Agreement ("Agreement") is made on the date specified below between Jane Donor and John Donor of Camarillo, CA (hereafter referred to as the "Donors") and the Favorite Charity of Camarillo, CA, a not-for-profit charitable organization (hereafter referred to as the "DAF Charity").
I. DAF Creation
The Donors hereby contribute to the DAF Charity the property specified in Attachment "A" as the initial contribution to the Donor Advised Fund (DAF). This value is equal to or greater than the minimum required DAF amount of [insert minimum DAF funding value]. The DAF Charity by resolution of its Board of Directors has approved the acceptance of gifts and bequests of property for the purpose of creation of DAFs. All DAFs shall be component funds and the exclusive property of the DAF Charity, subject to the control of the DAF Charity with respect to all distributions of income and principal. Funds will be named or appropriately designated as requested by the Donors.
The Donors may advise the DAF Charity in writing regarding the distribution of the fund income and principal. In addition, the Donors may designate one person to act as their spokesperson in advising the DAF Charity. The Donors may designate in writing one or more persons, usually children, to serve as DAF Advisors for a term of up to [insert number] years after the deaths of the Donors. The DAF Charity is not obligated to follow the recommendations of the Advisors, but in its sole discretion may elect to make the recommended distributions.
In the event that no written advice is received by the DAF Charity with respect to distributions of income or principal for [number of years] consecutive years, or in the event of the deaths of the Donors with no appointment of a successor Advisor for the above term of years, the DAF Charity may deem that no person has further interest in advising with respect to the fund. In this circumstance, the DAF Charity may give written notice to the last known designated Advisor or spokesperson that the right to give further advice and counsel is terminated. Any remaining DAF assets shall then be the exclusive and unrestricted property of the DAF Charity.
III. Distributions from the DAF Fund
The DAF Charity may make distributions from the fund of principal and income. The Donors shall recommend at least annually the appropriate distributions. All recommendations shall be for distributions in amounts in excess of the minimum distribution established at the discretion of the DAF Charity Distribution Subcommittee, or any minimum distribution required under current or future state or federal law. No distributions shall be made to fulfill a legally binding pledge of Donors. Distributions shall be made to qualified Sec. 501(c)(3) charities or to qualified entities that are their integrated auxiliaries. All distributions shall be to qualified exempt charities, with a minimum of [insert minimum percentage] of distributions to [a selected field of interest or area for grant].
The DAF Charity shall accept contributions and administer the fund in accordance with resolutions of the Board of Directors. These resolutions and policies may be amended as required by the Board. While the DAF is a component fund of the charity, the assets may be commingled for investment purposes and invested in units of any common investment fund of the DAF Charity. The DAF Charity shall have the right to convert any gifted property to securities or other assets of a common fund. Each fund may be assessed charges and proportionate investment costs similar to those applicable for similar funds managed by the DAF Charity.
V. DAF Remainder
This DAF is intended to be operational during the lives of the Donors. If Donors notify the DAF Charity in writing, a child or children may serve as successor Advisors for the permitted term of [insert number] years and the fund shall continue for that additional term. After the deaths of the Donors or the expiration of the term of years, as applicable, the fund shall become the exclusive and unrestricted asset of the DAF Charity. The Donors and, if selected, the child or children of the Donors, may, prior to the termination date, make recommendations for distribution of principal from the fund upon the termination date.
VI. DAF Provisions
This DAF agreement is irrevocable. Nevertheless, solely to ensure that the fund is a qualified component of the DAF Charity for Federal tax purposes, the DAF Charity, acting alone, shall have the power to modify the terms of the agreement solely to the extent required to ensure such qualification. The agreement shall be governed by the laws of the State of [insert state name].
IN WITNESS WHEREOF and in grateful appreciation, the DAF Charity and the Donors have executed this Agreement on the date specified below.
_________________________________________ Date: _________________________
_________________________________________ Date: _________________________
By __________________________________Title_________________ Date:_________
Officer of DAF Sponsoring Charity
Donor advised funds provide donors with a simplified gift model for tax planning, financial and philanthropic goals. Additionally, donor advised funds offer donors a way to instill the spirit of philanthropic giving in future generations. It is important for donors, their advisors and sponsoring charities to understand the rules surrounding permissible DAF distributions. While IRS proposed guidance has opened opportunities for giving, donors should proceed with caution and careful planning when interpretation of the rules is involved. Donor advised funds can be a tax-efficient and philanthropic solution for many charitably inclined families.