Tuesday, June 27, 2023

Donor-Advised Funds Abuse

Everything in this post is “old news,” but last month I posted a largely positive account of donor-advised funds (DAFs).  In that post, I mentioned “specific abusive uses of DAFs,” but didn’t elaborate. So, today I want to describe one DAF “loophole” that really should be closed as soon as is practical. The Treasury proposed closing this loophole in a notice in 2017, but has never released regulations to actually do so.  I sometimes worry that efforts to prevent DAFs from delaying the use of charitable funds (which are relatively controversial) are getting in the way of acting to prevent specific abusive uses of DAFs. At the top of my list of DAF loopholes that should be closed is the way that recipient organizations treat distributions from DAFs for the purposes of the public support tests.

To understand what I mean, imagine that Mrs. Smith wants to give $1 million to a charity she controls called the Mrs. Smith Foundation. If she gives the money directly to the Foundation (and no one else does), then that charity is a private foundation, subject to a number of important legal restrictions. However, if she gives that money to a DAF and then advises the sponsoring organization to distribute the money to the Mrs. Smith Foundation, then the Foundation is a public charity under current law.  It’s a public charity instead of a private foundation even if Mrs. Smith controls the Foundation, and even if it never receives any funds from anyone but her (through her DAF). In effect, by using a DAF as an “intermediary,” Mrs. Smith has managed to create an organization that provides all the benefit of a private foundation, but which is not subject to any private foundation restrictions. Way back in 2017, the IRS pointed out this problem and announced that they “are considering” fixing the problem by requiring the “distributee charity” to treat distributions from DAF sponsoring organizations as coming from the DAF donor rather than the organization solely for the purposes of the public support tests.

Why does it matter that Mrs. Smith can create a fully-controlled charity that avoids private foundation status? First, under current law, DAF sponsoring organizations are not allowed to pay Mrs. Smith or her children “compensation” out of DAF funds, but the Mrs. Smith Foundation would be able to pay her and her children compensation (just like she could if it was a private foundation), as well as reimburse travel expenses associated with the Foundation’s activities. Second, under current law, private foundations and DAF sponsoring organizations must exercise “expenditure responsibility” if they make a grant to anyone other than a public charity. But the Mrs. Smith Foundation, as a public charity, doesn’t have that obligation. Expenditure responsibility is a series of actions that federal law requires private foundations and DAF sponsors to take to make sure that their grants are used for proper charitable purposes. Just to give one example, imagine that Mrs. Smith wanted to give funds to support a presidential candidate. She’s not supposed to use charitable dollars (which are tax deductible) to do that. If she created a private foundation, it would be prohibited from making any expenditures to support a candidate or lobby, but it could probably make a grant to a 501(c)(4) organization to support that organization’s charitable activities, as long as the private foundation exercised expenditure responsibility to make sure that none of the grant was used for political purposes. But if instead Mrs. Smith used a DAF as an intermediary to permit the Mrs. Smith Foundation to avoid private foundations status, then the Foundation could make the grant to the 501(c)(4) organization without exercising expenditure responsibility. Even better, if Mrs. Smith already had funds in a private foundation, that foundation could use the DAF as an intermediary to get the funds to the Mrs. Smith Foundation, which could in turn distribute the funds to the 501(c)(4) organization without being bound by expenditure responsibility. The DAF acts as a blocker for the original foundation’s need to exercise expenditure responsibility, and the fact that the Mrs. Smith Foundation qualifies as a public charity relieves it from the requirement to exercise expenditure responsibility. Surely that isn’t the way the law is intended to work.

Finally, here’s the irony: when DAFs are used as “intermediaries” in this way, they are not themselves delaying the expenditure of charitable dollars, which so many commentators are worried about. Instead, the DAF sponsor’s statistics about expenditures would show distributions to controlled charities as current expenditures. Once those distributions were made to the Mrs. Smith Foundation, there would be no need for the Foundation to spend them on charitable purposes on any particular timeline.  The Foundation isn’t even be subject to the 5% payout requirement of private foundations. Again, if Mrs. Smith already had a private foundation, she could satisfy the 5% payout requirement of the private foundation by using a DAF as an intermediary to distribute funds to the Mrs. Smith Foundation, which qualifies as a public charity. The Mrs. Smith Foundation could then sit on those assets for pretty much as long as it wants, just the same as other public charities. Basically, the fact that charities can use DAF funds as “public support” to avoid private foundation status means that unless that rule is changed, all other rules regulating private foundations or DAFs will be easy to avoid. The Treasury should make the change proposed in 2017 as soon as possible. 

Benjamin Leff


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Just to comment in my own post: it was pointed out to me that I failed to mention one of the most important differences between donations to private foundations and donations to public charities for Mrs. Smith. If Mrs. Smith donates appreciated property to a private foundation, she can only deduct the basis of that property and not the full fair market value (basis plus appreciation) and she can only deduct up to to 20% of her income. If she donates to a donor-advised fund sponsor, and then passes that donation through to a charity she controls, she gets to deduct the full fair market value and can deduct up to 30% of her income. This is a very significant difference, and the use of a donor advised fund as an intermediary to create a controlled charity clearly violates the spirit of the private foundation restrictions in this case.

Posted by: benjamin leff | Jun 29, 2023 6:54:43 AM

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