Cumberland Advisors Market Commentary – Time to Re-Examine Donor-Advised Fund Tax Policy
The tax treatment and rules governing donor-advised funds (DAFs) continue to garner attention nationwide. According to the National Philanthropic Trust’s 2018 DAF Report, as of FY 2017 over $110 billion was housed within 463,622 DAFs across 604 community foundations, 345 single-issue charities, and 53 national charities. Donors contributed $17.24 billion in 2013, which rose to $29.23 billion in 2017. From 2012 to 2016, the compound annual growth rate of contributions to DAFs was 15.7%.
What is a DAF, anyway? And how does it work?
A DAF is a charitable vehicle housed within a public charity, to which an individual (or corporate donor) contributes a gift of cash, appreciated securities, or even shares in a privately held business. Once the value of the gift is established, the donor realizes an immediate tax benefit. A deduction of up to 60% of adjusted gross income (AGI) applies to gifts of cash. A double tax benefit accrues to an individual contributing appreciated assets to a DAF. Once the theoretically low-cost-basis asset is transferred into the DAF and liquidated, capital gains liabilities are avoided, and a deduction of up to 30% of AGI can be realized.
Over time, the donor directs the public charity to make grants from the fund to individual nonprofits. Some donors may quickly distribute funds from their DAF, drawing it down to zero over 2–3 years. Other DAFs are permanently endowed; the principal is invested with an eye toward sustaining disbursements in perpetuity. A spending policy dictates annual grant making. Many DAF sponsors, whether they are the charitable arm of a financial services institution or a local community foundation, require a minimum annual distribution from each DAF to an operating charity.
But, technically, the law does not mandate that DAFs follow any standardized payout schedule. Unlike private foundations, which must pay out roughly 5% of their assets each year, DAFs are not bound by an annual distribution requirement.
Some legal scholars view the absence of mandatory distributions as a loophole that must be closed.
In a 2017 letter to the United States Senate Committee on Finance, Professors Ray Madoff of Boston College Law School and Roger Colinvaux of The Catholic University of America, wrote that “While some DAF sponsors have high overall distribution rates, according to the IRS, a full 25 percent of DAF sponsors distributed less than one percent of their assets in a year.” A consortium of organizations that lobby on behalf of the charitable sector challenged that statistic, claiming that the accounts referenced by Madoff and Colinvaux “… represent a very small fraction of DAF accounts or DAF assets.”
Madoff and Colinvaux’s concerns stem from what they believe to be flawed tax policy governing DAFs.
Whereas the DAF donor gains an immediate and oftentimes significant tax benefit commensurate with the dollar value of the contribution, it could be years before monies are disbursed to an operating charity. In essence, the publicly financed tax deduction that accrues to the donor may not be “recouped” by the public for years, until funds from the DAF are sent to a homeless shelter, educational institution, or hurricane relief effort.
To combat dormant DAFs, Madoff and Colinvaux proposed a 10-year payout timetable to accelerate the distribution of DAF dollars. In a 2018 opinion editorial published in the Nonprofit Quarterly, Madoff also suggested that policymakers may consider tweaking the tax code and “… tying some of the charitable benefits to the release of DAF funds. For example, Congress could enact rules that would allow donors to avoid capital gains on transfers of property into DAFs, but would delay the charitable deduction until such time as funds are distributed from the DAF to non-DAF beneficiaries.”
Temporally aligning the tax benefit with the realization of public benefit makes some sense to us.
However, we will build on Madoff and Colinvaux’s ideas and propose an alternative method to incentivize donors to balance the charitable needs of the present and the future: (1) maintain the capital gains shelter afforded to donors who elect to contribute appreciated assets, and (2) award a tax benefit only when grants from the DAFs are made to “working charities”; but here’s the kicker: (3) continue to award a tax benefit to the donor as grants are made, even if the total tax benefit is in excess of the initial gift. That way, those DAFs designed as multigenerational giving vehicles can be rewarded for prudent, long-term investing and giving.
Investment Advisor Representative
Private Wealth & Non-Profits
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*Cumberland Advisors does not give legal or tax advice. For additional information, please consult your tax or legal professional.
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