In recent years, donor advised funds have become a popular alternative to private foundations and supporting organizations for many donors. Donor advised funds allow donors to receive some of the benefits associated with a family foundation without the administrative and tax obligations associated with operating a separate charitable entity. A donor advised fund is not a separate charitable entity for federal tax purposes. It is normally a type of program or fund offered by a public charity to facilitate charitable gifts by individual donors. Although the first donor advised fund was created in the 1930s, the use of donor advised funds has grown significantly in recent years. Despite this proliferation, the term “donor advised fund” was not defined in the Internal Revenue Code (the Code) or the Treasury Regulations until 2006, when new rules addressing donor advised funds were added to the Code under the Pension Protection Act of 2006 (the 2006 Act).
Definition of “Donor Advised Fund.” The 2006 Act added a new section 4966(d)(2) to the Code defining the term “donor advised fund.” Under this definition, a donor advised fund is a fund or account that meets each of the following three requirements:
- The fund is separately identified by reference to contributions of a donor or donors (by naming the fund after a donor or otherwise attributing contributions to the donor).
- The fund is owned and controlled by a public charity (called the “sponsoring organization”).
- The donor − or any person appointed or designated by the donor (called a “donor advisor) − has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of the assets of the separately identified fund or account by reason of the donor’s status as donor.
For purposes of these rules, a “sponsoring organization” is essentially defined as any public charity that maintains one or more donor advised funds.
To be a donor advised fund, the fund or account must reference the contribution of a specific donor or donors. A general fund or account, or one that receives contributions from multiple donors whose contributions are not separately accounted for within the fund, will not be a donor advised fund. The IRS will look to the actual manner of operations of the fund in determining if it is separately identified by reference to contributions of a donor or donors.
Advisory privileges do not include enforceable rights or obligations under a gift agreement. Advisory privileges may be set forth in a written agreement, but, even in the absence of a written agreement, may be inferred from the conduct of the donor and the sponsoring organization. But, the donor does not have advisory privileges if the donor provides advice without some sort of reciprocity on the part of the sponsoring organization. It is not necessary that the donor actually provide advice, if the donor reasonably expects to have advisory privileges with respect to the fund or account and that expectation is reciprocated by some action on the part of the sponsoring organization. Advisory privileges also do not include privileges based upon the donor’s position as an officer, employee or director of the sponsoring organization in the absence of other factors, unless such position resulted from the establishment of the fund.
- that makes distributions only to a single identified organization or governmental entity;
- where the donor recommends to the sponsoring organization the selection of the committee members that will provide investment and distribution advice if the recommendations are based on objective criteria related to the expertise of the member; or
- where the donor or the donor advisor advises as to which individuals receive grants for travel, study or other similar purposes if:
- the advisory committee for such fund is composed only of members who are appointed by the sponsoring organization and is not controlled by the donor or persons appointed or designated by the donor, and
- grants are awarded on an objective and nondiscriminatory basis in accordance with procedures meeting the requirements for similar grants by private foundations and these procedures have been approved in advance by the board of the sponsoring organization.
The IRS has the authority to exempt other funds or accounts from the definition of a donor advised fund if the fund or account (i) is advised by a committee not directly or indirectly controlled by the donor or any person appointed or designated by the donor or (b) benefits a single identified charitable purpose. To date, however, the IRS has not issued any proposed or final regulations regarding the donor advised fund provisions enacted as part of the 2006 Act.
Tax on Taxable Distributions. Under the new rules enacted as part of the 2006 Act, sponsoring organizations must pay a 20 percent excise tax on each taxable distribution (as later defined) that it makes. The tax is imposed on the amount of the taxable distribution. There is also a 5 percent excise tax imposed on any fund manager of the sponsoring organization who agreed to the making of the distribution; the tax is capped at $10,000 for all fund managers for each taxable distribution. A “fund manager” is defined as an officer, director or trustee of the sponsoring organization or an individual having similar powers or responsibilities and, with respect to any act or failure to act, the employees of the sponsoring organization having authority or responsibility with respect to such act (or failure to act).
A taxable distribution is any distribution from a donor advised fund to an individual or any other person if the distribution is for other than an exempt purpose under section 170(c)(2)(B) of the Code or, if for a charitable purpose, the sponsoring organization does not exercise expenditure responsibility with respect to such distribution. Notwithstanding this broad definition, distributions to certain organizations are not taxable distributions, including distributions to a public charity (other than a Type III nonfunctionally integrated supporting organization or a Type I or II supporting organization if the donor or anyone appointed or designated by the donor for the purpose of advising the donor advised fund directly or indirectly controls the Type I or II supporting organization). Nor does a taxable distribution include a grant to the sponsoring organization or any other donor advised fund.
Taxes on Prohibited Benefits. The 2006 Act also enacted a new section 4967 of the Code, which imposes significant excise taxes on certain transactions that result in prohibited benefits. This new provision imposes a 125 percent excise tax if any donor, donor advisor or related person provides advice to a sponsoring organization that causes a distribution from a donor advised fund resulting in that person or any other donor, donor advisor or related person receiving, directly or indirectly, more than an “incidental benefit.” The tax is imposed on any such person who advises as to the distribution or who receives a benefit as a result of the distribution. Any fund manager who agrees to the making of the distribution, knowing that it would confer a prohibited benefit, is also subject to a 10 percent excise tax (with a cap on the total tax for fund managers of $10,000).
A “more than incidental benefit” is any benefit that would have resulted in a reduction of the income tax charitable deduction had the person made a direct contribution to the charitable recipient. These taxes do not apply if the transaction results in a tax under the excess benefit transaction rules of section 4958 of the Code (discussed below).
Application of Excess Benefit Transaction Rules to Donor Advised Funds. The 2006 Act also modified the excess benefit transaction rules of section 4958 of the Code to treat donors, donor advisors, and investment advisors to donor advised funds and family members of such persons or entities 35 percent controlled by them or family members as disqualified person with respect to the sponsoring organization for purposes of the excess benefit transaction rules. An investment advisor is any person compensated by the sponsoring organization for managing the investment of, or providing investment advice with respect to, assets maintained in donor advised funds owned by the sponsoring organization.
The new rules treat any grant, loan, compensation or other similar payment, such as an expense reimbursement, distributed to a donor, donor advisor, or person related to a donor or donor advisor, as an automatic excess benefit transaction. The entire amount distributed to such person is treated as an excess benefit for purposes of section 4958 of the Code. Any correction amount cannot be held in or credited to the donor advised fund.
Amounts paid under a bona fide sale or lease of property are not subject to this special rule, but will instead be subject to the general excess-benefit transaction provisions of section 4958 of the Code, with the special disqualified-person definition described above applicable. The technical explanation of the 2006 Act makes it clear that a substance-over-form analysis will apply to determine whether a purchase is made from a donor advised fund (in which case the full amount involved will be deemed the excess benefit) or from the sponsoring organization (in which case an arm’s-length standard will apply).
Application of Excess Business Holdings Rules to Donor Advised Funds. The 2006 Act applies the private-foundation excess business holdings rules of section 4943 of the Code to donor advised funds. The private-foundation excess business holdings rules provide that the amount of holdings of the organization in a business enterprise, when combined with the holdings of disqualified persons, cannot exceed 20 percent. Any holdings in excess of this amount are subject to an excise tax. A disqualified person includes any person who is a disqualified person for purposes of the new rules imposing an excise tax on prohibited distributions from a donor advised fund, as well as family members of such individuals and 35 percent controlled entities.
Substantiation of Charitable Contributions to Donor Advised Funds. The written acknowledgement or receipt provided by the sponsoring organization to a donor for a gift to a donor advised fund must meet certain requirements. No deduction is allowed for a contribution to a donor advised fund unless the donor obtains a contemporaneous written acknowledgement from the sponsoring organization meeting the normal requirements but also stating that the sponsoring organization has exclusive legal control over the assets contributed.
Annual Returns for Sponsoring Organizations. A sponsoring organization is required to include certain information on its Form 990. This information includes the total number of donor advised funds owned by it at the end of the taxable year, the aggregate value of assets held in such funds at the end of the taxable year, and the aggregate contributions to and grants made from such funds during the taxable year. This information is reported in Part I of Schedule D to the Form 990.
Possible Tax Law Changes Affecting Donor Advised Funds. Under current law, donor advised funds do not have payout requirements and a donor may claim a deduction for a contribution to a donor advised fund in the year the contribution is made. The IRS and lawmakers have been concerned about the abuses inherent in the immediacy of the deduction, the donor’s retention of advisory privileges and the delayed distribution of the funds for actual use in the charitable sector. These concerns were the genesis of the provisions of the 2006 Act. But there appear to be continuing concerns as highlighted by recent proposals. In February 2014, Rep. Dave Camp (R-MI), as then-chairman of the U.S. House of Representatives’ Ways and Means Committee, released a discussion draft of the “Tax Reform Act of 2014,” which included a proposal to amend the current law applicable to donor advised funds. The proposed changes would impose new distribution requirements on donor advised funds. Specifically, under the proposed rules, donor advised funds would be required to distribute contributions within five years of receipt or pay an excise tax equal to 20 percent of any undistributed contribution in the sixth year. Qualifying distributions would be those made by the donor advised funds to public charities under section 509(a)(1) or (2) of the Code. Distributions to private foundations, supporting organizations or other donor advised funds would not qualify. Since the release of these proposals, there have been indications from staff members of the House Ways and Means Committee that this five-year spend-down provision might be eliminated in future drafts, although there continue to be policy concerns about the timing of the deduction and the spending of the contributed funds.
Conclusion. Establishing donor advised funds allows donors to make tax-deductible donations with less paperwork and fewer administrative burdens than those associated with creating a private foundation or sponsoring organization. Nevertheless, donors and supporting organizations should be aware of the rules enacted as part of the Pension Protection Act of 2006 that apply to donor advised funds and continue to monitor possible tax reforms that would affect donor advised funds.