Once an exotic gambit known to few, donor-advised funds have been thrust to the top of the year-end tax-planning checklist.
The idiosyncrasies in the 2017 tax bill, which raised the standard deduction and stifled the deduction for state and local taxes, have combined to nullify the tax benefit of charitable giving for many.
Typically, about 30 percent of taxpayers have itemized their deductions. That number will radically decline this year, with special consequences for charitable gifts.
The other major itemized deductions – state taxes, mortgage interest, heavy medical bills – are largely fixed or inescapable. Charity, though, is voluntary. The charitable deduction has been built into societal expectations. An implicit governmental subsidy underlies the behavior of donors and development officers alike. Most givers, on making a $100 contribution, are programmed to feel as if they’ve only parted with $50 to $80, depending on their income. The rendering to God reduces what they render to Caesar, except for the value of the tote bag.
When the deduction for state taxes, a foundation of federal-state relations for a century, was capped at $10,000 in the 2017 act, and the standard deduction increased to $24,000 for married taxpayers, the law’s effect on charitable giving was as obvious as its hostility to local government.
Those who have traditionally itemized their deductions, and don’t want their charitable gifts to be stripped of their tax benefit, are turning to donor-advised funds. These are funds held by an administrator, classified as a public charity, which holds and invests the funds, and ultimately distributes them to other charities, inevitably those proposed by the donor.
These vehicles enable taxpayers with sufficient liquidity to deduct future charitable contributions before the donees receive the money. Someone who gives $500 annually to her favorite charity might give $1,500 to such a fund in a year when other circumstances would make the gift deductible, and in later years, ask the fund administrator to make her customary annual gift to the charity.
The funds represent opportunity for financial institutions. They can only be distributed to public charities, but their fund managers must be compensated, and fund administrators have related parties that can do so quite efficiently. Fidelity Charitable has passed the United Way to become the nation’s largest charity. Even before the 2017 legislation, donor-advised funds made $15 billion in grants annually, more than twice the total of 10 years earlier.
Fidelity made an early start toward becoming the industry leader in 1991, when it obtained a ruling from the IRS that treated its prototype fund as a public charity, rather than a private foundation. Congress gave recognition to donor-advised funds in 2006 by adding §§ 4966 and 4967 to the Internal Revenue Code, to impose excise taxes if funds are distributed for non-charitable purposes, or used to benefit donors and their families, but establishing few other requirements.
After receiving this administrative and legislative sanction, donor-advised funds grew – and not due to tithes from the pews. Because a donor-advised fund is considered a public charity, it can offer deductions unavailable from a private foundation, and is not subject to the transparency, distribution requirements or deductibility limits of a private foundation.
Consider a hedge fund principal who invested $50,000 in his limited partnership interest, now worth $5 million. If he were to give it to his private foundation, only the $50,000 investment could be deducted. If it were donated to a public charity – such as a donor-advised fund – its full fair market value may be deducted. Private foundations, hawked by some promoters 20 years ago as ideal giving-while-keeping-it vehicles, can start to look antiquated.
In some obvious ways, donor-advised funds resemble private foundations. They provide a deduction for the donor, whether or not any charity receives anything. The law imposes no deadline by which assets donated to a donor-advised fund must be distributed, although some financial institutions will impose such deadlines by internal policy.
In important other ways, donor-advised avoid the rules governing private foundations:
• A private foundation must distribute five percent of its assets annually. A donor-advised fund can sit inert for as long as the custodian’s policy will permit.
• Donor-advised funds must reveal where their grants go, but they don’t have to say which of their clients provided those gifts. Few funds reveal such information voluntarily. Traditional charities have long welcomed anonymous gifts, but in conjunction with modern artifices – such as charitable LLC’s of the nature pioneered by Facebook founder Marc Zuckerberg – this invisibility can increase the flow of dark money in ways more nefarious than bountiful.
• A private foundation must file an annual return, disclosing its donors and donees, one that can be examined by nosy neighbors around the world, and pay an annual excise tax. A private foundation is exempt from disclosure and excise tax.
For those who face compliance issues, many questions arise.
• Can a donor-advised fund make a distribution that enables the donor to attend a charity ball? Consider, for example, an awards banquet where the sponsor-level donation is $500, of which $80 represents the non-deductible cost of the meal and libation.
Suppose a donor were to ask the fund manager to donate $420 to the charity, while sending a separate check to the charity for the dinner portion. Would the donor receive more than an “incidental benefit” from the distribution from the donor-advised fund? If so, the consequences would not be incidental. Section 4967 of the tax code imposes an excise tax of 125 percent on a distribution that confers a prohibited benefit.
In guidance issued late last year, the Internal Revenue Service and the Department of Treasury indicated that such bifurcation is not possible for donor-advised funds. In Notice 2017-73, those agencies advised that this arrangement “can be considered a direct benefit to the donor/advisor that is more than incidental.” Since the donor couldn’t attend the charity ball by just paying $80, the action of the donor-advised fund to spring for the other $420 would be a “more than incidental benefit” in the inelegant terminology of § 4967. After all, the donor-advised funds portion “relieves the donor/advisor from the financial obligation that the donor/advisor would otherwise incur in order to receive the same benefits.”
• Can distributions from donor-advised funds be used to satisfy the donor’s pledge?
Whether or not a charitable pledge is legally enforceable is a question on which advisers and advocates will change positions, depending on whether it is a pledge by a church-going decedent for which a post-mortem deduction is being sought, or by a living donor who has changed his mind because alma mater fired his favorite coach. The answer varies by state. Guiding authority is often scant or dated.
For these reasons, Treasury and the IRS stated in the same notice that proposed regulations will provide that distributions from a donor-advised fund to a charity will not be considered to cause a prohibited benefit to the donor merely because the donor made a charitable pledge to the same charity, so long as (1) the custodian makes no reference to the pledge when making the distribution; (2) the donor receives no direct or indirect benefit as a result, and (3) the donor does not attempt to claim a charitable contribution deduction – even if the charity erroneously sends donor a written acknowledgment similar to those for standard deductible gifts.
Many more such issues will rise, as the use of donor-advised funds spreads from hedge funds to middle-class taxpayers. Donor-advised funds are poised to proliferate in every way. Regional financial institutions may choose compete with the national behemoths, after weighing the costs of compliance. Donees will have to learn not to issue their standard acknowledgment letters when receiving gifts from donor-advised funds, and instead develop a different template.