Donor advised funds, originally created by community foundations to allow living donors to suggest the most appropriate distributions from charitable funds, have been growing in popularity. They are the primary attraction of gift funds such as the Fidelity Charitable Gift Fund, Vanguard Charitable Endowment or the National Philanthropic Trust.
More recently, they have become an attraction for major operating charities such as colleges and hospitals. Some charities not only allow the donor to suggest which program to support within the charity, but also allow the donor to use a part of the fund for distributions to totally independent organizations. Donor advised funds, however, have also become somewhat controversial and subject to misunderstanding.
There is no definition in the Tax Code or the Treasury Regulations of a donor advised fund. The “commonly accepted definition,” according to one commentator, is a fund held by a public charity for which the donor, or a committee established by the donor, may recommend to the charity where to make grants from the fund. The charity must retain the right to make the ultimate decision on distributions.
“Poor Donor’s Foundation”
For a potential donor, donor advised funds are often marketed as “the poor donor’s private foundation.” In some ways they provide more benefits than a private foundation. Since gifts to donor advised funds are gifts to a public charity, they may be deductible in greater amounts than the same gifts to a private foundation.
Since the holder of the fund is a public charity, the funds are not subject to private foundation excise taxes on their income, or to self-dealing, excess business holdings, or other limitations imposed on private foundations. And since the funds are administered as part of a larger charity, they generally have lower administrative costs and do not have to file separate tax returns or other reports.
At the same time, however, the donor gives up ultimate control over the investment and distribution of the funds. While the charity which holds the funds may be generally responsive to the wishes of the donor-advisors, the charity cannot be legally obligated to do as the donors request.
Small Foundations Expensive
Most commentators recommend against the creation of a private foundation unless the foundation will be worth more than $2 or $3 million. With anything less, the administrative costs eat up a substantial portion of the money available for distribution.
With donor advised funds, the donor can usually achieve the same practical result, since most charities holding donor advised funds do what they can to follow the donor’s wishes. Many will also allow the donor to name at least one more generation of advisers, thus including children within the advisory scheme when the parents are no longer interested or able to recommend. Some community foundations are willing to accept multiple generations of advisers.
Some donors may nevertheless create a private foundation if they want to retain full control over the investment and distribution of the funds or if they wish to guarantee that their family members will be able to continue the foundation after the donors are gone. They may deem the security of full control worth the higher administrative cost and greater regulation.
For those intending to establish a donor advised fund, they must be sure that they do not subject the fund to “material restrictions” which might either prevent the gift from being completed (and therefore not deductible) or would cause the fund to be treated as a separate private foundation.
Material Restrictions
A material restriction, according to the Treasury Regulations, is a restriction or condition which prevents the charity from “freely and effectively employing the transferred assets, or the income derived therefrom, in furtherance of its exempt purpose.” Although these rules are technically written for a different situation, they are commonly applied to donor advised funds.
Some restrictions or conditions are clearly permissible. The donor may name the fund and may establish a field of interest, such as the arts, or geographical area, such as a specific city, for distributions. (A donor may even, at the time the fund is created, designate the recipient of distributions, although the fund then is a donor-designated fund and not a donor advised fund.)
The donor may not retain control, directly or indirectly, however, over selection of recipients after the initial agreement is reached, timing of distributions, or investments or selection of investment managers.
The IRS has the power to examine the administration of donor advised funds to see if the public charity is actually exercising its discretion and authority in making grants and administering the fund.
Among those factors listed as favorable in showing that donor control does not exist are the fact that the charity conducts an independent investigation of potential grantees, that it has promulgated guidelines of community need for its grantmaking, that it has an educational program for donor advisors on specific charitable needs, that it makes similar grants from other funds, and that its solicitations make clear that it retains ultimate control and is not bound by the advice of the donors.
Many community foundations market donor advised funds as a way to obtain professional help in evaluating and selecting potential recipients of grants.
Adverse factors include solicitations that imply that the charity will follow the donor’s advice, only the donor’s advice is considered with regard to distributions from the donor advised fund, and the charity follows donors’ advice substantially all of the time.
Donors also need to recognize that the fund cannot be used as an extension of themselves. It cannot be used to fulfill pledges of the donor, to buy tickets for the donor to attend fundraising events, or to pay tuition for the children’s schooling. Most donor advised fund agreements make these limitations clear.
Donor advised funds have been criticized for some perceived abuses, including the payment of pledges and grants to a donor’s own public charity (to assure public support) or to private foundations (to obtain higher deductions or provide funds for the foundation to make its required 5% distribution).
Most of the gift funds have voluntarily adopted policies, stemming in part from IRS scrutiny of the Fidelity Fund, to require at least a 5% annual payout from the donor advised funds, and prohibiting grants to private foundations or foreign charities and fundraising events.
Treasury Proposes New Rules
The Treasury Department has proposed legislation which would provide that a charity whose primary activity is operating donor advised funds would be considered a public charity only if it avoids material restrictions on its funds, makes grants only to public charities, private operating foundation or governmental entities, and distributes at least 5% of its aggregate investment assets annually. The proposed rule would prohibit distributions to foreign entities. In addition, donor advisers would be treated as persons “having substantial influence” for purposes of the excess benefits tax rules.
If less than 50% of a charity’s assets were donor advised funds, failure to meet the requirements would not jeopardize the charity’s public charity status, but the funds would be subject to private foundation rules and taxes.
You Need to Know
With more donors apparently seeking a greater perception of control over their gifts, donor advised funds are growing in popularity. Both donors and charities must understand the rules if the donor advised funds are to be effective and satisfactory.
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