Tax Rules, Investment Houses, and Donor-Advised Funds: What’s at Stake?

In November 2023, the IRS published a set of proposed regulations that would apply to donor-advised funds (DAFs), with the aim of clarifying technical tax rules governing these giving vehicles. They skirt around more contentious issues like the lack of a minimum DAF payout and limited transparency requirements. But even these mild proposals are generating a lot of heat—particularly one that would tax the fees paid from DAFs to their donors’ personal investment advisors.

This exposes one of the most dangerous aspects of DAFs. As our economy becomes more unequal, DAFs have been growing like gangbusters, with the percentage of individual giving going to DAFs rising from 4 percent in 2008 to 27 percent in 2022. And DAF administrators and asset managers have been using them to apply the machinery of the for-profit wealth defense industry to philanthropy.

How DAFs Work

Lawyers, accountants, and financial managers…have become enthusiastic promoters of DAFs for reasons that have little to do with the spirit of giving.

Many people in the United States don’t realize that DAFs exist, much less how they work. DAFs are giving accounts that are managed by tax-exempt nonprofits. Most of the money donated to DAFs goes to so-called national sponsors—with the largest of these being nonprofits that are affiliated with large investment houses like Schwab, Vanguard, and Fidelity—although community foundations (which were the original DAF account creators) still received roughly one in seven dollars contributed to a DAF ($12.03 billion out of $85.53 billion total) in 2022.

When people donate to DAFs, they get tax deductions in the year they give, since they’re technically giving to a nonprofit. The organization that manages the DAF account, which is called a sponsor, then gives the donor broad advisory privileges to direct grants to nearly whatever recipients they want, on whatever timeline they want.

The problem is that there is no rule whatsoever that says that the money has to come out. It can just sit there for years—or potentially forever. (Some fund sponsors set minimum payout rules on their own, but that’s optional.)

Members of the wealth defense industry—the lawyers, accountants, and financial managers who work to maximize assets and minimize taxes for the wealthy—have become enthusiastic promoters of DAFs for reasons that have little to do with the spirit of giving. Considerable tax advantages, a cloak of anonymity, and the lack of a payout requirement make DAFs an attractive new tool in their toolbox for tax-advantaged dynastic wealth retention, albeit through a nonprofit.

Thanks to this industry, DAFs are increasingly serving sponsor and donor interests, rather than nonprofit interests, in several ways. Donors can use DAFs to offload hard-to-value noncash assets to maximize tax deductions in a way that many smaller nonprofits are unable to process. DAF accounts’ lack of transparency allows donors to funnel money anonymously to political causes and even hate groups. Private foundation donors can get around grant disclosure and payout requirements by giving grants to DAFs. And there is a large amount of money ($2.5 billion in 2021 alone) cycling among DAF sponsors each year.

In all these examples, nonprofits—and the taxpayers that subsidize deductions—are the losers.

Proposed Regulation Highlights

The DAF-related tax code rules proposed by the IRS are many, highly detailed, and often legally arcane. They would affect one particular section of the US tax code—Section 4966—which was first codified in the Pension Protection Act of 2006. And they are likely to be obscure to people who aren’t steeped in nonprofit tax law—even those who are familiar with donor-advised funds.

Since advisors are often paid according to the assets held in a DAF, they may have an incentive to recommend that their…clients give to a DAF.

Right now, IRS regulations generally define a DAF as a financial account owned and controlled by a nonprofit sponsor. DAF donors and any donor-advisors they appoint have advisory privileges over the account’s investments, as well as over its grants, but they do not have the final legal say over either one.

In a drastically simplified nutshell, the proposed IRS rules attempt to provide some much-needed clarity to this general description.

The American Bar Association describes the changes as essentially “definitional,” meaning that they address the exact meanings behind specific DAF-related terms such as donors, donor-advisors, and distributions—rather than making significant changes in overall DAF policy. But even these relatively technical proposals are rankling the hides of DAF sponsors and the financial industry that surrounds them.

Among the areas raising ire are the following:¹

• Taxing inappropriate “daisy chain” distributions: This anti-abuse provision is designed to prevent DAF donors from using “intermediary distributees” to make grants that otherwise wouldn’t be allowed.

For example, DAFs aren’t allowed to give grants to individual people. But a donor can recommend a grant from their DAF go to a nonprofit and, if that donor has enough sway at that nonprofit, can direct it to spend grant money on a specific person. If this happened under the proposed rules, sponsors and fund managers would have to pay excise taxes on the initial DAF grant.

Defenders of the status quo balk at this, saying that it’s not possible for the sponsor to know what individual DAF accounts are doing. But if that is true, it contradicts the idea that sponsors are in command of DAF funds, rather than donors. Certainly, it’s possible to imagine donors using an interconnected set of grants to funnel money to otherwise disallowed end recipients.

• Counting some single entity funds as DAFs: As with the above, here the main IRS goal is to prevent abuse by people who have influence over both DAFs and downstream recipient nonprofits.

Right now, a sponsor fund doesn’t count as a DAF if it gives all its grants to one single organization. These kinds of funds are known as single-entity funds or single-identified organization funds. The proposed regulations would make it so that these single-entity funds would indeed count as DAFs if their sole recipient charity then, in turn, uses the DAF funds to make its own grants. This can happen if, for example, a donor sets up a sponsor fund to give grants to a food security fund that, in turn, gives out grants to food banks. (Nonprofit intermediaries that regrant, such as the United Way, would not count as DAFs since for these nonprofits, unlike DAFs, donors do not retain a say in the ultimate destination of their funds.)

The proposed rules have an additional, important specification: donors won’t be allowed to donate to these single-entity DAFs if they also have a presumed advisory capacity over the grants made by the sole recipient—like if they sit on the recipient’s board.

This means, for example, that a person who sits on the board of a scholarship-granting fund won’t be allowed to donate to a DAF that is set up exclusively to give grants to that fund. Opponents of this change say that it would arguably “chill vital charitable giving” from board members.

• Taxing fees paid from DAFs to personal investment advisors: The proposed rules would clarify who counts as a donor-advisor to a DAF. On the more technical and less contentious side, the proposed rule specifies that people serving on sponsor-appointed DAF advisory committees count as donor-advisors if they meet four very specific criteria. But more importantly, and more controversially, people who serve as both an investment advisor for a donor’s personal account and their DAF would be counted as donor-advisors as well.

If a donor’s investment advisor is counted as a donor-advisor, then any compensation the DAF pays to that advisor would by definition count as an excess benefit transaction—a payment to a disqualified insider—and be subject to a hefty excise tax.

According to the tax code that covers such transactions, the sponsor would have to pay a 20 percent tax on the transaction, and any fund managers who knowingly pay this sort of compensation, whether they are employed by the sponsor or by a separate investment firm, would have to pay a 5 percent tax on it as well.

On top of that, the investment advisor would have to return the compensation, with interest, to the sponsor. And if they don’t do this in a timely manner, then they would pay an additional 200 percent tax on the payment—in effect, a treble fine.

Doth DAF Sponsors Protest Too Much?

It is this last rule—the one that would tax fees paid from DAFs to personal investment advisors—that generates the most flak. Opponents of the rule are primarily the financial and legal firms that serve DAFs and the DAF sponsors themselves.

In its introduction to the proposed regulations, the IRS explains that there are multiple reasons it wants to set guardrails around the relationship between DAFs and investment advisors. Since advisors are often paid according to the assets held in a DAF, they may have an incentive, whether conscious or not, to recommend that their charitably minded clients give to a DAF instead of giving directly to operating nonprofits, or to suggest against giving out more grants than the donor might otherwise like. Both phenomena would result in DAF assets growing, and investor fees growing accordingly, even as operating nonprofits would receive less money.

To date, the IRS has received 179 public comments on their proposed rules. The vast majority have been submitted by DAF sponsors, DAF advocacy groups, DAF lobbying firms, law firms, and trade associations for the investment industry, most focusing on the proposed taxation of advisor fees in particular. These groups fire a wide range of arrows against the proposal, arguing variously that it would cause “immense operational and logistical problems” for sponsors; that it is “beyond the regulatory authority delegated to the Treasury”; that “robust controls are already in place” so the new ones are not needed, and that there is actually a “public policy in favor of growing assets in DAFs for subsequent charitable distribution.”

The fervor with which DAF sponsors, investment advisors, and their advocates are protesting the idea of an advisor fee tax makes it clear that there must be a lot of this sort of payment going on, and it must be lucrative.

In fact, as Bloomberg Tax has reported, it has become “common practice” for donors to pay their personal investment advisors to advise them on their DAF accounts. And DAF industry insiders say that the rule change would “upend a widely accepted and decades-long investment management practice among DAF sponsors.” Indeed, at least one DAF sponsor, the Dayton Foundation, said in its comments to the IRS that “the majority” of its $545 million in DAF assets are managed by its donors’ personal investment advisors—presumably not for free.

If these regulations go through, investment advisors stand to lose a great deal of compensation. And sponsors, not DAF donors, would have to pay the bulk of the excise taxes on investment advisor fees—sponsors that are typically reluctant to deny anything to their often very wealthy donors. So, both parties are fighting tooth and nail to avoid having to pay those taxes—or tell their donors they can’t use the advisor they want.

Who Benefits?

If investment advisors earn fees from providing DAF investment advice, and if sponsors and fund managers stand to pay a lot in excise taxes if advisor fees are taxed, then it makes sense why they would oppose the proposed regulations.

But the rest of us must remember that all this comes at the expense of taxpayers and operating nonprofits. Donors get a couple of types of tax reductions for putting money into DAFs: they get income tax deductions on the value of their donations, and they get to avoid paying capital gains taxes on any appreciated noncash assets they donate. Those tax reductions are subsidized by other taxpayers, who ultimately must make up for the lost public revenue.

The nonprofit tax deduction that DAF donors receive is supposed to be distributed to nonprofits working for public benefit—not diverted into the pockets of investment advisors and asset managers.

A Larger Challenge

The IRS recommendations, by and large, would provide definition to sections of the tax code that very much need it. But no matter what happens with the rules, it will still be critically important to keep the pressure on DAFs to fulfill their public promises. As well-intentioned and useful as the proposed rules may be, they don’t get to the core of what makes DAFs so problematic.

Even if the IRS rules go through, DAFs will still have no payout requirement whatsoever. Individual DAF accounts will still have next to no disclosure requirements about payout and grantees, so they can still be used to anonymize giving. Private foundations will still be able to count grants to DAFs against their payout requirement. DAFs will still be able to give big grants to other DAFs. And if we’re not careful, efforts to use DAFs for impact investments could end up increasing investment advisor fees, while slowing the flow of funds to operating nonprofits.

Taxpayers subsidize donations when they go into DAFs, so the public has a vested interest in that money being distributed in a timely way for public benefit. In other words, the proposed IRS rules do not address many key policy issues. More is required. There are many policy changes that would help, including establishing a payout requirement for DAFs and demanding more transparency into how well individual DAF accounts are paying out and where their grants are going.

There is widespread support for proposals like these. DAF donors can also help by moving money out at a rapid clip to operating nonprofits, instead of paying them out as legal and investment fees. As DAFs become an ever-larger portion of the nonprofit funding system, both sponsors and donors must be held to a higher standard.

The authors would like to thank nonprofit legal expert Roger Colinvaux and nonprofit accounting expert Brian Mittendorf for their guidance on the technicalities of the proposed regulations. 

 

Note:

1. This is not an exhaustive list. As Brian Mittendorf writes in The Conversation, one other change in the regulations would ban DAF donations from being used for nonprofit lobbying.