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Article of Interest: A User-Friendly Guide to Donor-Advised Funds

A Donor-Advised Fund (DAF) is, in many ways, the easy and economical version of a private foundation. There is no separate legal entity, which means there is no requirement to file for tax exemption and no requirement to file annual tax returns with the IRS. Yes, there are some restrictions on what a DAF can do; however, most people are only interested in simply providing funding to charitable entities of their choice. Fortunately for them, a DAF provides the ability to that, without the administrative burden that comes with a private foundation.

Our friends at Venable have produced a great piece introducing DAF and ’s. If you have questions about your charitable giving and think a DAF might be a good alternative for you, please reach out to Tax Principal Susan Keller at skeller@ellinandtucker.com.

The following article, “What’s the Deal with DAFS?: A User-Friendly Guide to Donor-Advised Funds” was originally published by Venable, LLP on February 20, 2019

When deciding how to achieve long-term philanthropic goals, individual donors have many options to consider. High net worth donors frequently find themselves deciding whether to establish a private foundation or a donor-advised fund, often without understanding the key differences between the two.

So, What is a Donor-Advised Fund?

A donor-advised fund, or “DAF,” is a charitable fund or account established by a donor at a public charity (called a “sponsoring organization”) over which the donor (or donor’s designee) maintains advisory privileges – in other words, the donor is able to “advise” the sponsoring organization as to which charities should receive donations from the DAF.1 Unlike a private foundation, a DAF is not a separate tax-exempt entity. A DAF must be named after its donor or otherwise separately identified by the sponsoring organization, with the donor’s contributions to the DAF (including any interest or investment income earned thereon) being separately tracked by the sponsoring organization as part of the DAF.

Who Controls the Assets of a DAF?

Assets held in a DAF are legally controlled by the sponsoring organization, with the donor or donor’s designee exercising only advisory privileges over the distribution of funds. Advisory privileges are not legal rights and recommendations are not legally binding on the sponsoring organization. In practice, however, this distinction is not very significant, as sponsoring organizations almost always honor the recommendations of the donor.

Regarding the investment of DAF funds, some sponsoring organizations will permit a donor to recommend his or her own investments and/or investment advisor, while others provide a limited menu of options. Today, many financial services firms have established nonprofit arms for the purpose of allowing clients to establish DAFs that can utilize the services of their current financial advisors.

What Are the Benefits of Contributing to a DAF?

Donors who contribute to DAFs benefit from more favorable tax treatment than donors to private foundations. Since the assets of a DAF are controlled by the sponsoring organization, and the sponsoring organization is a public charity, a donor’s contributions to a DAF are treated as contributions to a public charity. This means that donors can take advantage of higher deductibility rates than those available to donors to private foundations.

Specifically, contributions to a DAF of cash and appreciated assets are deductible up to 60% and 30%, respectively, of a donor’s adjusted gross income (“AGI”). Similar contributions to a private foundation are limited to only 30% and 20%, respectively, of a donor’s AGI. In addition, contributions of appreciated assets are also deductible at the asset’s full fair market value if contributed to a DAF, while such assets are generally limited to a donor’s basis when contributed to a private foundation. Such favorable deduction limits make DAFs an especially attractive option for donors who have accumulated highly appreciated assets.

In addition to such preferable tax treatment, DAFs also avoid the 1%–2% tax on net investment income that applies to private foundations. Thus, if a donor made a large gift to a DAF in a high income year and received a charitable deduction, the assets of the DAF could then be invested and allowed to grow tax-free, while the donor uses the DAF to make grants over time, at the donor’s leisure and without being subject to mandatory annual distributions.

Can a DAF be Handed Down to a Donor’s Descendants?

While DAFs do not provide donors with the same level of control over succession as is possible with private foundations, most sponsoring organizations allow the donor to appoint successor advisors for one to two generations. A small number even permit unlimited succession, allowing donors to pass down advisory privileges in perpetuity.

If, however, the donor dies and no successor advisors have been appointed, or the fund has otherwise remained inactive for a set number of years, most sponsoring organizations provide in their agreements that the assets in the DAF will pass automatically to the sponsoring organization’s general fund to be distributed to charities selected by the sponsoring organization. By contrast, most private foundations have self-perpetuating boards, which lessens the likelihood of gaps in the succession plan.

To Which Organizations Can a DAF Make Distributions?

As the legal owner of a DAF’s assets, the sponsoring organization has the final say on where and when a DAF makes distributions. However, as long as the recipients recommended by the donor are tax-exempt public charities (or, when allowed by the sponsoring organization, the foreign equivalent), the donor’s advice is typically followed.

Some sponsoring organizations may also allow a DAF to make distributions to private foundations and certain supporting organizations by exercising what is called “expenditure responsibility.” Expenditure responsibility is a procedure that allows DAFs and private foundations to make grants to organizations that are not U.S. public charities without being subject to excise tax. Satisfaction of expenditure responsibility requires that the DAF exert all reasonable efforts and establish adequate procedures (i) to see that the grant is spent only for the purpose for which it is made, (ii) to obtain full and complete reports from the grantee organization on how the grant funds are spent, and (iii) to make full and detailed reports on the expenditures to the IRS.

Unlike with a private foundation, the burden of exercising expenditure responsibility for a DAF would fall on the sponsoring organization, rather than the managers of the individual donor’s private foundation (who are often the donor and/or the donor’s family).

Are DAFs Required to Make Annual Distributions?

Unlike private foundations, DAFs are not required to meet annual distribution requirements. In order to avoid excise taxes, a private foundation is required to make minimum distributions each year, equal to approximately 5% of the fair market value of its assets. DAFs, on the other hand, have no such requirements. However, it is worth noting that some sponsoring organizations may require a DAF to make certain minimal distributions every several years in order to keep the fund active. Such requirements vary among sponsoring organizations and are generally much less onerous than those imposed on private foundations. Moreover, failure to meet the distribution requirements imposed by a sponsoring organization will not subject the DAF (or the donor) to federal excise tax as they would for a private foundation.

Can a DAF be Used to Fulfill a Donor’s Pledge?

Yes. Unlike distributions from a private foundation, recent guidance provides that distributions from a DAF can be used to fulfill a donor’s pre-existing pledge to another charity. However, certain criteria must be met to ensure that the distribution does not subject the sponsoring organization or the donor to excise taxes. In order to avoid excise taxes: (i) the sponsoring organization must not reference the existing pledge when making the distribution; (ii) the donor must not receive any other impermissible benefit (such as tickets to a fundraising dinner2) as a result of the distribution; and (iii) the donor must not attempt to claim a charitable deduction for the distribution from the DAF, even if the donor erroneously receives a receipt for the distribution from the recipient charity. While these rules were announced in IRS temporary guidance, the IRS has indicated that donors may rely on such rules until more permanent guidance is issued in the future.

What’s the Administrative Burden?

Since a DAF is simply a fund established at an existing public charity, rather than a separate, standalone organization, it does not require its own board of directors or governing documents. This keeps the start-up and overhead costs to a minimum and means that no separate state or federal filings are required. All necessary filings happen at, and are handled by, the sponsoring organization, making the administration of a DAF much less burdensome than that of a private foundation.

Given the variety of options and myriad of factors to consider when planning to achieve philanthropic goals, it is generally in the donor’s best interest to consult with legal counsel to assist in planning.

[1] Note, however, that funds or accounts that make distributions only to a single identified organization or governmental entity are not DAFs.  For example, an endowment fund created by a donor at a university for the benefit of that university is not a DAF, even if the fund is named after the donor and the donor has advisory privileges regarding the distribution or investment of amounts in the fund.  Such single-beneficiary funds are expressly excluded from the definition of DAFs under the Internal Revenue Code.

[2] Unlike private foundations, which could receive an event ticket in connection with a donation and allow the donor to attend as a representative of the foundation, a donor of a DAF is prohibited from using a ticket purchased by the donor’s DAF.

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