Colorado Probate Blog - Wade Ash Woods Hill & Farley, P.C.

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What’s So Bad About Donor-Advised Funds?

Last Friday, the New York Times published a very negative article about donor-advised funds (DAFs), calling them a “Philanthropic Loophole” in its headline and quoting a tax professor at the University of Southern California as calling DAFs “a fraud on the American taxpayer.” What, exactly, is a DAF, and are DAFs really so bad?

Suppose you have $25,000 in cash or appreciated stock that you want to give to charity. You can make the gift to a public charity, such as the Red Cross, and take an itemized charitable deduction on your income-tax return. If you make the gift in the form of appreciated stock, you not only don’t have to pay capital gains tax on the appreciation, you may deduct the full value of the stock.

If you haven’t yet decided which charity you want to benefit, you can make the gift to a DAF. A DAF is a public charity, so the deduction rules are the same as if you made the gift to the Red Cross. But with a DAF, the DAF keeps track of the money you gave it and you may make recommendations to the DAF about when and to which other charities it should distribute the money in your account. The DAF is not legally required to follow your recommendations, but so long as you are recommending distributions to legitimate tax-qualified charities, the DAF will almost certainly do what you ask. So a DAF allows you to make a gift to charity now but defer the decision about when and to which public charities the money should go.

DAFs have proliferated in recent years. Some are huge, such as the Fidelity Charitable Gift Fund, which is the largest, with more than $5.5 billion in assets. Other large investment firms also have DAFs. The Schwab and Vanguard DAFs are numbers two and three in size. But many much smaller local community foundations also offer DAFs.

What did the New York Times find offensive about DAFs? It seems to come down to two things. First, DAFs are not subject to annual minimum distribution rules. (Unlike private foundations, which must distribute at least 5% of their assets each year.) Consequently, the money you donate to the DAF may remain in the DAF for a long time before it is distributed to an operating charity and applied to charitable purposes. Second, DAFs don’t have to disclose when and to which charities they make distributions.

The mismatch between the time when the donor gets the income-tax deduction and when the money is actually put to work for charitable purposes, coupled with the media’s inability to know who gets the money and when, seems to be what riled the Times. The Times article focused on a $500 million dollar gift made by tech billionaire Nicholas Woodman (founder and CEO of GoPro) to a DAF at the Silicon Valley Community Foundation just after GoPro went public. The Times was frustrated by its inability to discover how much of the $500 million had been distributed to which charities and when. The Times characterized DAFs as “a sort of charitable checking account with serious tax benefits and little or no accountability.”

In response to the Times article, Daniel Hemel, a professor at the University of Chicago Law School wrote “A Qualified Defense of Donor Advised Funds.” Professor Hemel’s response is, in my opinion, much more balanced than the Times article. Professor Hemel summarizes four reasons why you might want to use a DAF. First, you might want to give stock to a small charity, but small charities may be ill-equipped to deal with receiving a gift of stock. So instead, you can give the stock to a DAF, which will sell it, and you can then recommend that the DAF make a distribution to the small charity. Hemel points out that the public policy of allowing a deduction for the full value of a gift of appreciated stock is debatable, but if you can do it with a gift to the Red Cross, why shouldn’t you be able to achieve the same thing with a gift to a DAF that then finds its way to a small charity?

Second, if you want to make a charitable gift and take an income-tax deduction but you are not quite sure which charity or charitable purpose you want to benefit, you can make a deductible gift to a DAF in the current year and then take your time to decide about the recommendations you want to make to the DAF for how it distributes the money. That doesn’t seem to be so bad, and in fact may lead to more thoughtful selection of the charities that will ultimately benefit.

Third, you may use a DAF to manage your income-tax deductions over time. With the increase of the standard deduction to $24,000 under the new tax law, fewer people will itemize their deductions. Because the charitable deduction is an itemized deduction, people who give to charity in a year in which they take the standard deduction will get no income-tax benefit from the charitable gift. So a person in that situation may want to make large contributions to a DAF every few years and itemize deductions in those years. In the intervening years, the person can take the standard deduction. The donor can make distribution recommendations to the DAF in any year. Again, this doesn’t seem to be such a bad thing, and this technique makes the charitable deduction available to middle-income taxpayers who might otherwise get no charitable deduction under the new tax law.

The fourth reason for using a DAF is for more wealthy clients who might otherwise have considered creating their own private foundation. Private foundations are subject to the 5% distribution rule as well as a number of excise taxes that don’t apply to DAFs, because DAFs are public charities. In addition, as public charities, DAFs do not have to disclose to whom they make distributions, but a private foundation does. Thus, a wealthy donor who does not want her charitable gifts disclosed may use a DAF to avoid the disclosure, minimum distribution, and excise tax rules that apply to private foundations and still retain some degree of control. While this is a technique for the wealthy, it doesn’t seem outrageous.

You can read the New York Times article here and Professor Hemel’s response here.

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