| | EXECUTIVE SUMMARY
| |
 Donor-advised funds
(DAFs), as an alternative to private
foundations, have been a
popular means of charitable giving, but
fund managers, donors and their advisers
must reckon with new laws and regulations
stemming from the Pension Protection Act
of 2006. A DAF allows the donor to advise
the organization administering it on its
use to support public charities. Congress
is continuing to scrutinize issues of
possible abuse of DAFs with a study
mandated by the PPA.
Donors benefit from
fund managers’ expertise in
selecting gift recipients and especially
from the ability to deduct the fund
donation before it is disbursed to the
ultimate recipient.
The possibility of an
economic benefit to donors has
been among reasons for the scrutiny.
Others relate to donor control of
investments from the fund and the
relationship between the organization
sponsoring the fund and the one supported
by it.
Possible new
directions in regulation of DAFs
could include a minimum required
distribution of funds, since such a
requirement has been raised as a
possibility in both the study and an act
that passed the Senate in 2005 but was not
enacted into law.
Nick G. Tarlson, CPA, is
the owner of Tarlson & Associates of
San Francisco and an adjunct faculty
member in graduate programs for
accounting, finance and taxation at Golden
Gate University. His e-mail address is
ntarl@dictyon.com. |
C
ongress has shown a great deal of interest
in donor-advised funds (DAFs) in the last few
years. The Pension Protection Act of 2006
introduced several significant restrictions on
DAFs and directed the IRS to further study their
organization and operation. In complying with that
mandate, on Feb. 26 the Service issued Notice
2007-21, which raised some provocative and
potentially wide-reaching issues concerning these
funds. These issues may affect the ability of DAFs
to continue to allow donors to defer some of the
decisions relating to charitable contributions
while obtaining immediate tax benefits.
This article explores the basic structure and
characteristics of DAFs, their historic use and
changes imposed by the PPA. It also explores
issues raised by Notice 2007-21 and how future
reforms may affect the planning opportunities DAFs
offer.
ANATOMY OF A DAF
A DAF is
an account at a charitable fund or foundation that
results from a charitable contribution by a person
who has an agreement with the fund or foundation
that provides the donor the right to advise the
foundation regarding the ultimate disposition of
the gift. The gift is considered completed because
the foundation is a public charity, and under the
terms of the gift, future direction of the gift is
limited to similarly situated and qualified
charities. But the agreement provides the donor
with rights that include recommending that the
foundation make gifts to other charities from the
DAF. Although the foundation is not
obligated to follow the donor’s advice, it is
understood and accepted that its failure to do so
would be frowned upon by past and future donors. A
DAF must also be identified with the donor or
donors or a related person, usually by being named
after them [IRC section 4966(d)(2)]. It offers tax
and practical advantages for many taxpayers over
private foundations, which are subject to lower
limits on charitable deductions for donors, as
well as special regulations concerning their
operation and possible excise taxes. DAF
administrators can add significant value by
assisting donors in identifying charitable giving
opportunities consistent with their objectives.
The administrator is obligated to ensure that the
ultimate recipient of the funds is a qualified
charity and to report to the donor on the earnings
and disposition of the funds. DAF administrators
benefit from this arrangement by receiving a fee
for their services in handling and investing the
funds. Donors benefit from this
arrangement by receiving a current tax deduction
without having to decide on the ultimate recipient
of the contribution. Donors often have the right
to designate successor “advisers,” such as their
children, who can continue to advise the fund
after the donor’s death. This allows parents to
build charitable giving habits in their children.
The DAF business is booming. Ninety-nine of
the largest DAF administrators reported holdings
of $19.2 billion in tens of thousands of
individual accounts in 2006, up more than 21% from
a year earlier (see Noelle Barton and Peter
Panepento, “A Surge in Assets—Donor-Advised Funds
Are Growing Exponentially,” The Chronicle of
Philanthropy , May 3, 2007). Donors’ gifts
to the funds amounted to $6 billion, an increase
of 25% from 2005. Gifts to charities from the
funds rose 18% to $3.5 billion, amounting to about
17% of the assets held in DAFs. | |
In Congress’ Cross Hairs
Notice 2007-21 asked for
public comments on several issues relating
to DAFs:
- Advantages and disadvantages of DAFs
to the charitable sector, donors and
others, compared to other charitable
giving arrangements.
- Propriety of deductions to DAFs when:
- Payments or other
benefits are made back to donors or
affiliates, that is, for
compensation, loans, or other
personal benefits or rights.
- The donor continues to control the
investment of the assets.
- There is an expectation that the
donor’s “advice” will be followed in
determining distributions or
investments.
- The donor has option rights (for
example, puts, calls or rights of
first refusal) with respect to the
assets.
- The transferred assets are
appreciated real, personal or
intangible property, not readily
convertible into cash.
- Expected impact of PPA provisions such
as the section 4958 excess benefit
transaction tax amendments.
- Appropriate payout requirements.
- Advantages and disadvantages of
perpetual existence of DAFs.
- Other types of giving arrangements,
which give rise to these issues.
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POTENTIAL ABUSES OF DAFs
In directing the Treasury Department to
conduct its study, Congress was clearly concerned
about several fundamental issues. One is that
donors and their relatives might receive benefits
from DAFs, such as compensation for services or
loans. It is not uncommon for a person affiliated
with a foundation to provide services and to be
reasonably compensated for them. It is less common
for a person to borrow back from a charity. Such a
transaction could raise a question about whether
the original gift was complete. In any
case, Congress’ sensitivity to such transactions
does not seem to be a serious concern to some in
the philanthropy business. According to the
Council on Foundations, “Even prior to the
enactment of the PPA, Council members did not pay
compensation to donors of donor-advised funds, nor
did they make loans to them” (see comment letter
in response to Notice 2007-21 of the Council on
Foundations, April 9, 2007). Another issue
relates to control a donor may have over a gift.
One form of control is the ability to direct the
investment of the assets. Another is the influence
a donor continues to have over the gifts to
charities under the DAF agreement. Many DAF
managers have developed procedures to prevent such
activities from providing benefits to donors.
Appreciated gifts can receive extra scrutiny,
due to the obvious potential benefits of
sheltering gain on this kind of property. DAFs
don’t necessarily bring any new issues to the
table in considering the tax effect of such
contributions. Generally, DAFs will liquidate
these investments promptly, within the bounds of
obtaining a fair price for the assets. A
good indication of how Congress might deal with
potential abuses of DAFs is S 2020, the proposed
Tax Relief Act of 2005. Although never signed into
law, S 2020 proposed a number of limitations on
DAFs that correspond with the issues under study
as a result of the PPA. They included required
distributions of 5% of the fund assets, forcing
the DAF to liquidate assets within a certain time
(see Council on Foundations, Analysis of S 2020,
The Tax Relief Act of 2005). Indeed, one
of the most significant issues relating to DAFs is
how long the assets should be “parked” in a fund
between the time the donor receives the deduction
and the ultimate charity receives the benefit.
Although DAFs as a whole seem to be distributing
more than the distribution requirement proposed by
S 2020, some individual funds may be distributing
less and would be adversely affected by such a
requirement. Donors argue that administering such
a standard would be costly and might cause
distributions to decrease (see Peter Panepento,
“Managers of Donor-Advised Funds Wary of New
Rules,” The Chronicle of Philanthropy,
May 3, 2007). S 2020 also would have
greatly expanded the definition of
disqualified persons . Under current
law, a disqualified person is one who is involved
in the management of a charity or who makes a
substantial contribution to it. An excess
benefit transaction , one that provides an
economic benefit to the disqualified person, can
require payment of a 25% excise tax by the
disqualified person on the value of the benefit
received that exceeds its consideration. If the
violation is not corrected within a specified
time, an additional tax of 200% applies. (For a
broader discussion of intermediate sanctions on
excess benefit transactions, see “
NPO Compensation in the Spotlight,”
JofA, Oct. 07, page 54.) S 2020
would have made all donors to and advisers of DAFs
disqualified persons, along with members of their
families and businesses under their control. This
would have greatly enlarged the pool of
disqualified persons by including many individuals
who lack any ability to substantially influence
the organization’s decisions. It would have posed
particular problems for charities in smaller
communities and those with large numbers of
donor-advised funds, and could have substantially
increased their operating costs. | |
How the Pension Protection Act of
2006 Affects Donor-Advised Funds
It directs the
Treasury secretary to conduct a one-year
study to determine whether charitable
contribution deductions are “appropriate”
for gifts to advised funds, whether
advised funds should be subject to a
payout requirement, whether retention of
advisory rights is consistent with the
treatment of the transfers as “completed
gifts,” and whether the preceding issues
also apply to other forms of charities or
charitable gifts.
Defines donor-advised
fund as any fund or account that is
separately identified by reference to the
contributions of a donor or donors, owned
and controlled by the sponsoring
organization; and with respect to which a
donor or person appointed by the donor has
or reasonably expects to have advisory
rights with respect to investments or
distributions.
Identifies prohibited
grants —grants to individuals or
any entity if the payment is not for a
charitable purpose—as taxable
distributions, subject to a 20% excise tax
on the recipient and 5% excise tax on the
manager of the sponsoring organization who
knowingly makes the distribution.
Denies
deductibility for contributions to certain
sponsoring organizations, including
certain veterans and fraternal
organizations and cemetery companies.
Requires donors to obtain a
contemporaneous written acknowledgment
from the sponsoring organization providing
that the organization has exclusive legal
control over the assets contributed.
Requires sponsoring
organizations to exercise “expenditure
responsibility” over certain grants.
Provides for penalties of:
- 125% of the amount of any
prohibited benefits —more
than incidental benefits from a
donor-advised grant to the donor,
adviser or related parties. The penalty
can be imposed on the person who
recommended the grant or the person who
received the benefit.
- 10% for fund managers who knowingly
approve prohibited benefit grants.
- 25% of excess benefits
—grants, loans, compensation and
similar payments from donor-advised
funds to donors, advisers and related
parties—and requires that the amount
involved be repaid. Also included are
any excessive payments to investment
advisers.
Applies the excess
business holdings rule to assets held by
donor-advised funds.
Requires charities
to disclose: - How they will
maintain such funds (on Form 1023,
Application for Recognition of
Exemption ).
- The number of donor-advised funds,
aggregate assets held, contributions to
and distributions by those funds (on
their annual Form 990, Return of
Organization Exempt From Income Tax
).
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PLANNING ISSUES AND OPPORTUNITIES
In changes that took effect Feb.
13, 2007, the PPA eliminated income tax
deductibility for DAF contributions to certain
types of organizations, specifically war veterans
and cemetery organizations and domestic fraternal
lodges. It also specified how organizations that
sponsor DAFs for the support of other
organizations must be related to the supported
organizations and increased requirements for
substantiating contributions. These restrictions
may seem relatively benign, but they portend
greater challenges ahead. In advising clients as
to the benefits of DAFs, CPAs should ensure that
they explain the issues and possible future
constraints. For example, the client should be
willing to accept the responsibility of
recommending a significant amount of the fund
assets be paid out to charities each year in the
future, even though this is not currently
required. A client in a small community should
consider how stricter definitions of disqualified
persons might affect the structure of the
nonprofit organization and its cost of doing
business. 
| | AICPA
RESOURCES
JofA articles
“
Monthly Checklist: Tune Up for
High-Performance Wealth,” July 07,
page 25
“The
Right Philanthropic Vehicle,” July
01, page 22
Conference
Advanced Personal Financial
Planning, Jan. 20—23, Las Vegas
For more information or to register, go
to www.cpa2biz.com,
or call the Institute at 888-777-7077.
OTHER RESOURCES
Web sites
Council on Foundations, www.cof.org
IRS Notice 2007-21, www.irs.gov/irb/2007-09_IRB/ar11.html | |
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