Regulating Donor Advised Funds
President Bush’s tax reduction plan is not likely to take its final form, nor be adopted, for months. It seems almost unavoidable, though, that whatever plan emerges will be controversial in one aspect or another. Still, the final product is likely to contain many provisions of secondary and uncontroversial import, which are designed merely to protect or reinforce an already agreed upon underlying tax policy. One such agreed upon policy is that charitable, tax exempt wealth be controlled and managed exclusively to benefit the public.1 Monies exempt from tax by virtue of their dedication to the public good cannot be used in a manner that conveys a private benefit.2 In general, this policy is enforced with respect to public charities via a long-standing, though not entirely clear, set of rules geared toward improper profit taking3 or excessive selectivity with respect to the persons benefited by the charity.4 With respect to private foundations, more burdensome and expensive rules seek to ensure that tax exempt wealth is and remains exclusively for, and accountable to, the public.5
Donor advised funds, though, are rather like rectangular pegs that fit neatly into neither the square nor circular holes reserved for public charities or private foundations, respectively. On the one hand, donor advised funds offer the particular advantage—control—available from private foundations. On the other, they appear to operate in a manner most like public charities, since technically such funds are controlled by fiduciaries legally independent from the funds’ primary benefactor. Because of this dual personality, the law seems ambivalent as to which regulatory form—public charity or private foundation—should apply to protect the public’s wealth held by such funds. Last year, the Clinton administration offered an uncontroversial proposal seeking to clarify the status of donor advised funds and from that clarification impose rules designed to protect the public’s vested interest in donor advised funds.6 Owing to its lack of controversy, the fact that any subsequent proposal can be cast as a revenue raiser, and that fiduciaries of donor advised funds agree to the need for clarification and modest regulation, we might expect that the Bush administration will revisit the effort to regulate donor advised funds.
Anticipating the contours of such a proposal is not terribly difficult since the most interested parties—those that maintain such funds and the Treasury Department—have agreed to and narrowed the possible legislative and regulatory approaches down to two candidates.7 The first would treat donor advised funds as public charities, while individual donors would be subject to regulation using the private foundation model.8 In essence, the fund would avoid the costly and burdensome provisions related to private foundations, while the donor would nevertheless be treated with the same sort of suspicion applied to disqualified persons under I.R.C. §4941. The second choice would regulate donor advised funds and their donors entirely under the public charity model.9 The fund would not be subject to special scrutiny, nor would the donor be forced to remain completely at arm’s length from the fund. Curiously, it is the charitable community that is advocating the more hybrid approach under which donors are treated with suspicion, while the funds themselves need not comply with the other private foundation recordkeeping and reporting requirements.10 As discussed below, this curious hybrid proposal perhaps proves something the charitable community has not previously acknowledged.
This article focuses on three aspects of the current effort to regulate donor advised funds and those who endow such funds. First, the article briefly comments on the degree of control a donor might exercise with regard to a donor advised fund without causing the fund to lose public charity status. Second, the article considers the proposed definition of donor abuse with regard to donor advised funds and the consequences that should follow upon a finding of such abuse. Finally, the article concludes by briefly questioning the motivations for the charitable community’s efforts to regulate commercially sponsored donor advised funds using the private foundation model. The first two aspects upon which this article focuses are most relevant to practitioners who advise clients seeking a better method of charitable giving. The final aspect is more broadly related to encouraging philanthropy from all sectors of the economy, rather than reserving good works to a few well established outlets.
Though they have been around for quite some time, donor advised funds have recently been touted as a vehicle for the modern, and moderate, philanthropist.11 In essence, a donor advised fund is just that. Donors are specifically recruited, or decide for their own reasons, to contribute to a fund from which grants are made to public charities. Donors are granted the explicit right to provide advice and recommendations not only as to the grant recipients, but also as to the amount and timing of the grant. And while a grant need not be made for some time after the donor actually contributes to the fund, the donor is entitled to a charitable contribution deduction immediately upon making the contribution. The fund’s fiduciaries need not follow the donor’s advice and recommendations, though as a practical matter it might be expected that they will in the normal course of events. The latter observation, that the fiduciaries normally will follow the donor’s advice and recommendation, is one source of legislative and regulatory concern addressed below. Oftentimes, too, when a grant is made upon the recommendation of a donor, the fund informs the recipient of the donor’s influence.
Donor advised funds look very much like a typical private foundation, though on a smaller scale.12 Like private foundations, they conduct no active charitable operations themselves, but instead fund other operating charities. They also provide a donor with an element of control similar, but not explicitly identical, to that available via a private foundation. Because that control is informal—in the sense that we might expect the fund to comply with the donor’s recommendations though it is not required to do so—donor advised funds historically have not been subject to the private foundation regulatory scheme. That scheme comprises a collection of excise taxes designed to discourage a donor from engaging in certain transactions vis-a-vis the foundation, or otherwise failing to utilize the foundation’s tax favored wealth for public purposes.13 In the absence of any other authority, the Service has applied Treas. Reg. 1.507-2(a)(8) to determine whether a donor has retained so much control that a donor advised fund should be denied public charity status and instead be subjected to the private foundation regulatory scheme. If the several factors listed in the regulation indicate too much control, the donor advised fund will be regulated as a private foundation.14
With this approach, then, the Service partly resolved the questions concerning the proper form of regulating donor advised funds. But the lack of clear legislative authority caused the Service to select one or the other options, when perhaps a hybrid approach might have been better advised. After all, a donor advised fund logically avoids private foundation status because it is not under a donor’s explicit control. But as a practical matter, a donor advised fund that ignores a donor’s wishes as often as it follows those wishes is not likely to attract very many donors. It should be expected, therefore, that despite their formal documentation to the contrary, donor advised funds necessarily concede the same sort of donor control available from private foundations. An approach that applies private foundation or public charity rules exclusively, without any middle ground, might go too far in regulating the donor advised fund (as would be the case if the fund were treated as a private foundation, despite its legal and formal independence from the donor) or not go far enough in policing the potential abuse (as would be the case if a fund were treated solely as a public charity, despite its practical relationship to a donor).
Had it been adopted, the Clinton Treasury Proposal would have imposed a pure public charity approach.15 First, the proposal codified the factors under Treas. Reg. 1.507-2(a)(8) as the proper mechanism by which to determine whether a donor advised fund should be deemed a public charity.16 One remarkable point in this regard is that a donor advised fund that “regularly” follows a donor’s advice would not have thereby jeopardized its public charity status, as might occur under the present informal approach.17 This reversal from the present approach makes good sense. It is precisely the hope of regular influence over ultimate expenditures that motivates many donor contributions to such funds. And the law should encourage as many people as possible to take a personal, individual interest in charitable endeavors. Further, donor advised funds increase the amount of wealth going to charitable causes by encouraging donors who seek a level of control but who do not have the significant assets necessary for an effective private foundation.18 In the absence of the control potential, and being unable to endow a private foundation, the smaller would-be philanthropist might not contribute at all, or may limit his or her interaction with charitable causes to the annual office donation. In the long run, charities would have less wealth to use for the public good.
The old approach whereby the regularity with which a fund followed its donors’ advice or recommendation, though, is not entirely without merit. A fund’s entirely consistent concession to a donor’s wishes does in fact suggest a concern, similar to that underlying the regulation of private foundations, that the fund is not really being operated for public benefit, but instead for the donor’s private gratification. As a result, there is basis for concern. But that concern need not be addressed by attacking the very fact that makes donor advised funds attractive— i.e., that the fund normally will follow the donor’s recommendation—so long as the public continues to benefit. The concern would be better addressed by requiring procedures that ensure the public’s benefit.
It would, therefore, be well to confirm in any legislation or rulemaking with respect to donor advised funds that it is not “control” per se that motivates the burdensome private foundation rules. Rather, it is binding and unchecked control of the type the law assumes exists with regard to private foundations. So long as the donor’s recommendation as to an ultimate recipient is first subjected to “due diligence” by an independent body,19 and compliance with the donor’s recommendation does not convey a private benefit, the regularity with which the fund follows the donor’s advice should not automatically prevent the attainment of public charity status. To require otherwise would unnecessarily attack the very factor motivating the use and creating the benefit of donor advised funds.
Hence, donors and their counsel should be happy with the apparent determination that donor advised funds are presumptively to be treated as public charities rather than private foundations. But that decision does not mean that donors should now adopt a laissez faire attitude with regard to their interactions and influence, informal though it may be, over the charitable fund. A donor must still be concerned with the precise manner in which he or she is to be viewed and regulated under the public charity rules designed to prevent the diversion of public wealth to private purpose. Public charity status, then, does not relieve the donor of the need to exercise caution when making recommendations to and otherwise interacting with the fund after the initial and any subsequent contribution.
In a curious reversal of roles, the charitable community seems ready to hold donors to a higher level of suspicion than that proposed by the Treasury Department. Indeed, while the charitable community has effectively made the case that donor advised funds should generally be regulated using the public charity model, the community nevertheless seeks to regulate donors using the private foundation model. In particular, the charitable community proposes a bright line rule that absolutely prohibits a donor from engaging in most any sort of financial transaction involving the advised fund.20 In effect, the rule applies the blanket prohibition of I.R.C. §4941, which is currently applicable to private foundations. Treasury’s proposal, on the other hand, would not prohibit transactions between the fund and its donors, but would impose sanctions only when a donor engages in a transaction unfair to the fund.21
In fact, the curiosity in the charitable community’s proposal demonstrates a subtle divergence of interests. It would appear that the charitable community prefers public charity regulation for itself, but private foundation regulation for individual donors. If such a result were to occur, the charitable community would be able and obliged to enforce a certain independence in a manner that would not necessarily alienate the donors upon whom the community depends. But if the charitable sponsors of donor advised funds really are independent and, therefore, deserving of public charity status, why would they need the reinforcement of the private foundation rules to prevent the private appropriation of the public wealth entrusted to their care?
Probably the approach most consistent with the idea of encouraging donor advised funds, preserving flexibility, and keeping administrative costs to a minimum (and thereby ultimately empowering and encouraging the smaller individual philanthropist) is to support the Treasury’s recommendation. Imposing the blanket prohibition, as suggested by the charitable community, would impose the expenses attendant to making sure that the prohibition is not inadvertently violated and thereby divert charitable resources from charitable causes.22 The blanket prohibition should be adopted, if at all, only in response to evidence that the charitable community is unable to say “no” when necessary and appropriate, and as a result charitable wealth is being used for the donor’s private enrichment or benefit. Otherwise, the law unnecessarily diverts charitable wealth from charitable causes by way of administrative transaction costs.
A final note regarding present proposals to regulate donor advised funds involves what appears like naked turf building or, more precisely, turf protection. Some in the charitable community have argued that only funds controlled by public charities should be granted the lesser regulatory burden attendant to public charity status. In doing so, they necessarily, if not implicitly, assert that funds initiated by commercial organizations should be subject to the greater regulatory burdens attendant to private foundations. The Clinton proposal adopted the charitable community’s view, thereby signaling the demise of commercially sponsored donor advised funds.23 This is unfortunate in that it unnecessarily expands the justification for and applicability of the private foundation regulatory scheme. That scheme is grounded in the notion that when there is no separation of powers between the benefactor and those who are responsible for administering charitable wealth, self dealing and other forms of abuse are very likely to occur. But just because a charitable impulse is felt by an otherwise profit-making entity does not mean that the impulse should be looked upon with suspicion, as long as the benefactor is not also the sole voice with regard to the manner in which the charitable wealth is spent. In the absence of evidence suggesting that commercially sponsored donor advised funds are subject to widespread abuse24 and result in the diversion of wealth from charitable causes, the charitable community’s proposals seem like obvious and unnecessary efforts to protect its turf from encroachment. One likely consequence, though, is that commercial organizations will not be able to offer donor advised funds, because the private foundation regulatory costs associated with those funds will make them unattractive.
The laudable consequence of the sudden expansion of donor advised funds is that more wealth is being directed toward public benefit, as opposed to private indulgences. The effort to regulate donor advised funds in response calls to mind the old adage that we ought to leave well enough alone. There haven’t been any real cases of abuse that cannot be addressed by present law and, therefore, require additional government intervention and regulation. In fact, the motivating factor behind the growth of donor advised funds is perhaps an overreaction to the regulation of charitable endeavors in which benefactors continue to play an active role managing the wealth they seek to convey to charitable causes.25 The private foundation rules prevent all but the wealthiest benefactors—those who do not mind and can afford to divert part of their endowment to administrative red tape—from adopting them. The current call to regulate donor advised funds, if it must be heeded, should be careful not to impose those burdens to a form of charitable giving that increases charitable wealth and which has not shown itself to be the subject of widespread abuse. Thus, donor advised funds should be regulated using the public charity model and that model should not be denied to those profit-seeking entities that pause to give heed to their charitable impulses merely for the sake of turf protection.
1 See generally I.R.C. §501(c)(3) (1986) (all references to tax statutes pertain to the 1986 code as amended).
2 See, e.g., Treas. Reg. 1.501(c)(3)-1(d)(1)(ii).
3 I.R.C. §501(c)(3) (regarding the prohibition against private inurement). The prohibition against private inurement was the only one of the requirements for tax exemption (the others being the prohibition against campaign intervention, private benefit, and substantial lobbying) that was included in the original statutory recognition of tax exemption. See Darryll K. Jones, The Scintilla of Individual Profit: In Search of Private Inurement and Excess Benefit, 19 Va. Tax Rev. 575 (2000). It has recently been subject to an effort at legislative and regulatory clarification. See I.R.C. §4958 (enacting “intermediate sanctions); Treas. Reg. 53.4958-0T – 53.4958-8T.
4 Treas. Reg. 1.501(c)(3)-1(d)(1)(ii). For a discussion of the private benefit prohibition, see Darryll K. Jones, Private Benefit and The Unanswered Questions From Redlands, 89 Tax Notes 121 (2000).
5 Private foundations are subject to a whole series of excise taxes all designed to curb the potential for abuse thought to arise from the fact that the foundation’s small number of benefactors also control the foundation’s operations. See I.R.C. §4940 (excise tax on net investment income, originally enacted to pay the administrative costs of monitoring private foundations); I.R.C. §4941 (excise tax on self-dealing, designed to apply whenever “disqualified persons” engage in certain transactions with their private foundation, regardless of how fair the terms might be); I.R.C. §4942 (excise tax on failure to distribute income); I.R.C. §4943 (excise tax on excess business holdings); I.R.C. §4944 (excise tax on investments that jeopardize the charitable purpose); I.R.C. §4945 (excise tax on certain improper expenditures, such as lobbying and campaign expenditures). As a general proposition, these excise taxes make the private foundation vehicle a much more expensive method of pursuing good causes than the public charity vehicle. See generally Victoria B. Bjorklund, Charitable Giving to a Private Foundation: The Alternatives, The Supporting Organization, and The Donor-Advised Fund, 27 Exempt Org. Tax Rev. 107 (2000).
6 Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2001 Revenue Proposals, at 105-107 (2000) (hereinafter “Clinton Treasury Proposal”).
7 See, e.g., Council Suggests Areas to Include in Donor-Advised Funds Legislation, 29 Exempt Org. Tax Rev. 208 (2000) (letter to the Treasury Department offering broad suggestions pertaining to proposed legislation regarding donor advised funds); Charities Suggest Areas to Include in Donor Advised Funds Legislation, 29 Exempt Org. Tax Rev. 213 (2000) (letter to Treasury Department from several large charitable foundations—including the Raymond James Foundation in St. Petersburg, Florida—offering detailed legislative proposal regarding regulation of donor advised funds) (hereinafter “Charity’s Legislative Proposal”).
9 See supra note 6.
10 Charity’s Legislative Proposal, supra note 7.
11 Gene Steuerle, Charitable Endowments, Advised Funds & The Mutual Fund Industry, 23 Exempt Org. Tax Rev. 299 (1999).
12 Id. (“In many respects, donor-advised funds can look, taste, and feel like nonoperating foundations.”)
13 Supra note 5.
14 “Some of the more significant facts and circumstances to be considered in making such a determination are:
“(A) Whether the public charity (including a participating trustee, custodian, or agent in the case of a community trust) is the owner in fee of the assets it receives from the private foundation;
“(B) Whether such assets are to be held and administered by the public charity in a manner consistent with one or more of its exempt purposes;
“(C) Whether the governing body of the public charity has the ultimate authority and control over such assets, and the income derived therefrom; and
“(D) Whether, and to what extent, the governing body of the public charity is organized and operated so as to be independent from the transferor.”
Treas. Reg. 1.507-2(a)(8). The regulations go on to list several other factors which affect the determination.
15 Clinton Treasury Proposal, supra note 6, at 106.
17 Id. (“It is intended that the definition of ‘material restriction’ generally will be based on current-law regulations under section 507, but that the existence of a material restriction will not be presumed from [the] fact that a charity regularly follows a donor’s advice.”)
18 Steuerle, supra note 11.
19 That is, the fiduciaries follow procedures that ensure a donor’s recommended recipient is one that can be expected to properly and exclusively convey a public benefit. See, e.g., Letter from Robert C. Harper, Manager, IRS Exempt Organizations, Technical Group 3 to Philanthropic Research, Inc. (unpublished private letter ruling issued to Philanthropic Research, Inc., available at http://www.guidestar.org/ruling.htm (visited March 8, 2001)).
20 In essence, the charitable community would impose I.R.C. §4941 on donors. Charity’s Legislative Proposal, supra note 7.
21 Treasury’s proposal would classify donors as “disqualified persons” for purposes of I.R.C. §4958 (and only with respect to the fund, not the sponsoring charity) and thereby make donors applicable to excise taxes only if they enter into an unfair transaction with the fund. Clinton Treasury Proposal, supra note 6, at 107.
22 “Nonoperating foundations. . . are regarded by most individuals, rightly or wrongly, as vehicles only for those with substantial wealth. That view is supported by enough complexity in dealing with the IRS that for decades advisers have recommended against forming foundations unless the amount of giving is substantial. One hurdle is the cost of the advice, including legal and accounting fees, which potentially could eat away at the charitable activities of the foundation.” Steuerle, supra note 11.
23 Under the Clinton proposal, only donor advised funds maintained by public charities would enjoy the presumption of public charity status. Clinton Treasury Proposal, supra note 6, at 107.
24 Admittedly, there are isolated cases of reported abuse. See Reed Abelson, Serving Self While Serving Others, N.Y. Times, May 8, 2000, at A16 (discussing alleged abuses of donor advised funds by one particular promoter); Monica Langley, Efforts of Biggest Charities to Limit Popular Tax Break Gain Momentum, May 5, 2000, at B8 (discussing alleged abuses of donor advised funds by same promoter).
25 Steuerle, supra note 11.
Darryll K. Jonesis an assistant professor of law at the University of Pittsburgh School of Law. He teaches federal income tax, partnership tax, and corporate tax. His research interests are focused primarily on tax exempt organizations. He is a 1994 graduate of the University of Florida Graduate Tax Program.
This column is submitted on behalf of the Tax Section, Marvin C. Gutter, chair, and Michael D. Miller and Lester B. Law, editors.