This is the first of a two-part blog series on Donor-Advised Funds (DAFs). In this segment, we delve into the history and fundamentals of DAFs, and part two will explore how nonprofits can access DAFs.
DAFs are the fastest growing vehicle for charitable giving in the U.S. The 2023 DAF Report by National Philanthropic Trust reported that there were close to 2 million DAF accounts in 2022 that received about $86 billion in contributions, distributed about $52 billion in grants, and ended the year with about $229 billion in assets.
What exactly is a DAF?
A DAF serves as a charitable giving vehicle designed to manage donations on behalf of organizations, families, or individuals. Administered by a public charity, a DAF operates by individuals or organizations opening accounts and depositing cash, securities, or other financial instruments. In doing so, they relinquish ownership of the contributed assets while retaining advisory privileges over how their account is invested, and how it distributes money to charities.
Where do DAFs come from?
The concept of DAFs traces back to 1931 when William and Françoise Barstow established the first fund at the New York Community Trust, offering an alternative to the intricate process of creating a private foundation. However, it wasn't until a pivotal legal battle in 1987 that the landscape of DAFs began to shift. The IRS filed a lawsuit against the National Foundation, Inc., an organization managing DAFs, asserting that the FoundationI failed to meet the criteria of an IRC 501(c)(3) organization. This was due to its failure to exclusively serve exempt purposes, its focus on serving the private interests of donors, and its net earnings benefiting private individuals.
The court ruled in favor of National Foundation Inc. In the decision, they also set guidelines for DAF’s charitable giving:
That it be consistent with the charitable purposes specified in section 501(c)(3);
That it has a reasonable budget;
That it be adequately funded;
That it be staffed by competent and well-trained personnel; and
And, that it be capable of effective monitoring and supervision.
The outcome of this case opened the door for many other providers to launch donor-advised fund programs.
Why are DAFs popular?
DAFs provide a flexible way for donors to pass money through to charities—an alternative to direct giving or creating a private foundation. The sponsoring organization does the paperwork after the initial donation, and the donor receives cost savings and tax advantages by conducting their grantmaking through the fund. This makes them easy and efficient. The buy-in can be as low as $10,000 (the average is $25,000) and there is no requirement to give the money away until the term ends, which is often when the donor or their heirs pass away.
How does a DAF differ from a Foundation?
There are several significant differences:
The founders/board of a private foundation have complete control over where its giving goes within broad legal bounds. In a DAF, the donor only advises the sponsoring organization where the money should go. While rare, a sponsoring organization could conceivably ignore the donor's intent.
DAFs can only give to IRS-certified 501(c)(3) organizations or their foreign equivalents. This excludes donations to individuals, scholarships, and political donations.
DAFs provide a significant cost advantage with a one-time tax deduction when money is contributed, so the amount grows tax-free.
Because a public charity houses the DAF, donors receive the maximum tax deduction available, avoid excise taxes and costs to establish and administer a private foundation, and have no staffing and legal fees.
How are DAFs currently regulated, what legislative measures could potentially impact them, and what is the current buzz surrounding upcoming regulatory changes from the IRS?
Unlike private foundations, the only existing regulation for DAFs is the limited guidance on DAF structure and operations provided by the 2006 Pension Protection Act. Thus, DAFs have been operating in a near-regulatory vacuum for the past 17 years.
In recent years, legislation has been proposed regarding DAFs to address perceived loopholes in the tax code, focusing on two main concerns:
The mismatch in timing between when a donor-advisor receives a tax deduction for a contribution to their DAF and when a charity receives those funds
And, limiting perceived endless donor control.
The Accelerating Charitable Efforts (ACE) Act, introduced to Congress in 2021, remains the most comprehensive legislation under consideration for mitigating these concerns, proposing the following significant changes:
Donor-advisors contributing noncash property to their DAFs would not qualify for a charitable deduction until the property is sold for cash by the sponsoring organization.
Similarly, deductions for both cash and noncash contributions would be contingent upon the sponsoring organization distributing the funds to charitable organizations, aligning the deduction with when philanthropic entities receive the funds rather than when contributed to the DAF.
Under current law, DAF contributions can remain undistributed indefinitely, with donors retaining advisory privileges. The ACE Act mandates that contributions be distributed within a specified timeframe, ranging from 15 to 50 years depending on the sponsoring organization, or face a significant excise tax. Failure to distribute within this period incurs a 50% tax on undistributed donations.
The fate of the ACE Act remains uncertain, as it has yet to be introduced in the current Congressional session as of February 2024. However, the potential for new legislation looms, particularly in response to the IRS’ Proposed Treasury Regulations (REG-142338-07). While these regulations do not address payout requirements, the public support test, or uses by private foundations covered in the ACE Act, they have sparked significant concern within the philanthropic community. Various worries have been raised, including confusion over specific arrangements being classified as DAFs and potential negative impacts on charitable giving. With over 100 public comments expressing concerns about potential redefinitions of DAFs and their impact on charitable giving, the IRS is expected to review feedback and determine the necessity of revisions to the proposed regulations.
The regulatory landscape surrounding DAFs is on the brink of potential transformation, driven by both legislative proposals and IRS regulatory actions. The outcome of these developments will undoubtedly shape the future of charitable giving and donor-advised fund management.