Do Donor-Advised Funds Need More Regulation?

Rapid Expansion of Donor-Advised Funds

Donor-advised funds (DAFs) have experienced substantial growth in recent years: 

• In 2013, there were approximately 219,000 DAF accounts — growing to almost 2 million in 2022. 
• Over the last decade, total assets in DAFs tripled from $57 billion to $229 billion.
• Contributions into DAFs also grew, from $17 billion to $86 billion — a staggering 400% surge.

This phenomenal expansion has prompted debate regarding abuses of this tax-advantaged vehicle and what policies should be adopted to close loopholes. This issue brief reviews the design of DAFs, common criticisms, recent policy developments, and opponents’ arguments against additional regulations.

What Are DAFs and Why Are They Popular?

DAFs are accounts established within a sponsoring organization, typically a nonprofit entity. The way it works is that a taxpayer makes tax-deductible charitable contributions to a DAF and the sponsoring organization that hosts the DAF subsequently distributes funds to operating charities. Once a donor makes charitable contributions, the sponsoring organization has control over the assets, although the donor retains advisory privileges as to the distribution of funds. The sponsoring organization manages and invests the funds before assets are distributed.

Sponsoring organizations are considered public charities, with the most common types being: 

• Community foundations — independent charitable entities created for the benefit of residents in a certain area. 
• National DAFs — charitable arms of large financial service firms. 
• Single-issue organizations — faith or identity-based entities that support a certain cause. 

The recent growth of DAFs has led to sponsoring organizations emerging as some of the biggest and most recognizable charities in the U.S.: In 2015, Fidelity Charitable and Schwab Charitable surpassed the Red Cross and the United Way as the largest charitable organizations in terms of funds raised.

There are three main reasons why donors use DAFs: 1) tax benefits, 2) their appeal to several types of taxpayers, and 3) restrictions on private foundations. Each of these reasons is outlined below.

1. Tax Benefits

Contributing to DAFs means donors can deduct the entire amount of their contribution in a single year, and the actual distribution of funds to charities can happen later. This could be highly appealing to taxpayers who have greatly appreciated assets and want to use charitable contribution to manage tax payments.

From a tax perspective, the popularity of DAFs reached a new height after the passage of the Tax Cuts and Jobs Act (TCJA) in late 2017, as it greatly increased the standard deduction. This led many taxpayers to employ the strategy of bunching charitable deductions and claiming the entire deduction in the year of contribution. This change also generated concerns that charitable contributions would reduce significantly.

It was no surprise that the number of taxpayers who itemized and claimed charitable deductions on their federal personal income tax returns decreased significantly as a result of the TCJA: By certain measures, itemized charitable contribution deductions decreased from 24% to 8.5% between 2017 and 2018. However, some evidence shows the actual reduction in giving may be much less than the decline in the number of itemizers. Although the level of giving was lower, the reduction was not as big as anticipated: Taxpayers still gave despite the reduced tax incentives.

2. Appeal to Several Types of Taxpayers

The front-loaded tax benefits appeal to taxpayers who have highly appreciated assets and also to donors with unconventional or in-kind assets — such as pre-IPO stock, cryptocurrencies, real estate, antiques, or art work. Typically, major DAF sponsors can sell these unique or illiquid assets, so owners can disburse the proceeds across several charities. However, some critics suggest that because these complex assets are hard to appraise, donors could significantly inflate values to increase their tax deduction.

3. Restrictions on Private Foundations

The law draws a distinction between organizations that directly perform charitable work (e.g., churches, food banks, schools, museums; commonly known as public charities) and organizations under direct donor control (commonly known as private foundations). Private foundations usually do not directly engage in charitable activities; instead, they provide funds for active charities to do the work. While both are important to nonprofit operations, the law imposes more restrictions on private foundations to ensure that funds are actually put to charitable use. These include payout limits, greater disclosure requirements, self-dealing restrictions, and anti-lobbying rules.

Payout Mandate — One major restriction is that private foundations are required to distribute 5% of fair market value of their assets each year to charities. A foundation that fails to meet the minimum distribution requirements will be subject to a 30% excise tax on the under-distributed amount. In contrast, there are currently no mandates or time limits on when DAF funds must be distributed to charities and no minimum payout requirements.

Allowable Deductions — Furthermore, donors who contribute nonpublicly traded shares to private foundations can only deduct cost basis for tax purposes, whereas donors to DAFs are allowed to deduct fair market value for most types of asset contributions. DAFs also allow higher deduction limits as a percentage of adjusted gross income (AGI) than private foundations.

Disclosure Requirements — Private foundations have detailed disclosure requirements, while DAFs are not obligated to disclose the annual amount they distribute or the flow of funds at the account level. The available data shows the aggregate payout rate at the level of the sponsoring organization — this means there is no way to distinguish between a DAF that has been dormant for years and another that has been distributing funds regularly.

The absence of disclosure requirements at the account level has led some observers to doubt the extent of benefits provided to the public by DAFs. The scarcity of data is a primary cause of many disputes.

Pros and Cons of DAFs

Academic research yields mixed findings regarding the effectiveness of DAFs. Some are positive: 

• These funds are helpful for donors who prefer to employ a long-term giving strategy.
• Distributions can be responsive to short-term needs — for example, distributions were higher during the pandemic to help alleviate the global health crisis. 
• Many deplete all assets within 15 years even without further regulations.
• The distribution rate has consistently exceeded 20%, which is higher than that of private foundations.

On the other hand, some researchers showed the DAF payout rate was overstated — the method commonly used by the industry could overstate the payout rate by as much as 50%. According to their calculations, the revised payout rate reduced from 22.4% to 14.7% in 2017. They also indicated one contributing factor was DAF to DAF transfers — although they were recorded as grants to charities, charitable organizations did not receive funds as a result of these transfers.

Common Abuses

Most common exploitations result from either the design of DAFs, interactions with other charitable vehicles, or a lack of clear rules. This section discusses the three most widely documented misuses and their proposed corrections.

Private Foundation to DAF Distribution

A private foundation can satisfy its payout obligation by making a grant to a DAF (known as a “qualifying distribution”), but the funds can remain in the DAF indefinitely because there is no required timeframe for distributions. The funds are also subject to the foundation’s advisory privileges.

Some practitioners believe that counting private foundation to DAF distributions as qualifying distributions has become a way for private foundations to circumvent the 5% minimum distribution requirement. Indeed, several policy initiatives have been introduced to close this loophole. President Joe Biden’s recent budgets (FY 2023, FY 2024, and FY 2025) seek to disallow such distributions being counted as qualifying distributions to satisfy the 5% payout requirement, unless the funds are distributed by the end of the following year.

Public Support

A donor can directly fund a new or existing charity, which would be classified as a private foundation and therefore subject to disclosure and distribution requirements. Alternatively, a donor can contribute funds to a DAF, which over time — with the donor’s advice — directs funds to the same charity controlled by the donor. Because the sponsoring organization is a public charity, the distribution from the DAF to the receiving charity is considered “public support.” If the recipient is funded only by one or several DAFs, then all its funds are from public charities. In substance, the two funding mechanisms reach the same recipient, in the same amount — the only difference is the flow of funds. However, using a DAF as an intermediary provides the benefits of a private foundation without its restrictions.

Political or Lobbying Activities Loophole — Some say this distinction is most relevant when it comes to political or lobbying related activities. Private foundations are not allowed to lobby, whereas publicly supported entities can spend up to $1 million per year on lobbying without penalty. If funds flow relatedly from DAFs to a variety of recipients, the donors can greatly expand the $1 million threshold. This issue was mentioned in a 2017 IRS publication (Notice 2017-73), in which the agency considered enacting rules to prevent taxpayers from using DAF to circumvent private foundation limits. Specifically, the IRS proposed to treat the distribution from DAF to the recipient charity as coming indirectly from the donor instead of the DAF sponsoring organization for the purpose of public support tests. This proposal was never finalized.

Lack of Distribution Requirement

There is currently no requirement for a DAF to distribute funds within a certain timeframe; consequently, DAFs can distribute funds at a slow pace. An article reported grants from one DAF to another DAF amounted to $2.5 billion in 2021. Some of these transfers are for legitimate reasons, such as switching sponsoring organizations for better advice or lower fees, or donors consolidating several DAFs to make one large gift. However, observers are concerned some funds are simply cycling across investment portfolios instead of benefitting charities.

Some practitioners argue the lack of a payout mandate is a fundamental design flaw of DAFs. As such, they recommend either requiring distribution of funds within a limited number of years or establishing a minimum payout rate. Others also suggest delaying part of the donor tax deduction until the funds are paid to an active charity to better match the benefits to the tax deduction.

Concerning Trends

Beyond tax revenue losses and loopholes, there are several concerning trends. 

Specifically, researchers point out that the DAFs are replacing instead of expanding overall charitable giving. Between 2007 and 2019, charitable donation levels remained unchanged as a share of household income, but contributions to DAFs rose from 4% to 13% of overall charitable giving. These researchers also found that the higher contribution to DAFs mainly displaced contributions to active operating charities instead of private foundations.

Furthermore, the accumulation of DAF assets indicates a concentration of charitable resources among a group of ultrawealthy donors. To the extent this is true, a small group of donors may have disproportional impacts on charitable giving — including the cause, timing, and amounts. Charities that do not have access to these DAFs, or do not fit into their giving priorities may be less likely to obtain funds.

Donors Beware — Who Has Control? 

Although DAFs seem to be a flexible way for donors to bypass several restrictions, a recent court case reminds donors to be mindful about the limits of advisory privileges when interacting with sponsoring organizations.

In December 2017, two retired former hedge fund managers donated approximately 2 million shares of stock from a newly public, thinly traded company to their DAF at Fidelity Charitable as part of a larger tax planning strategy. The couple indicated that Fidelity Charitable promised to secure a $100 million tax deduction. However, they were concerned that Fidelity might sell all shares at the earliest date possible, and such large dispositions would significantly reduce the price of stock. It was argued that Fidelity agreed to keep those concerns in mind, but went ahead and sold the shares — the couple received a $52 million tax deduction, significantly less than they planned for. The average sales price per share was approximately 30% less than its closing price on the previous trading day.

The donors argued that Fidelity recklessly sold their shares without considering their advisory privileges; Fidelity disagreed. Because there was no written agreement between the donors and Fidelity regarding the disposition of the shares, Fidelity followed its stated policy. The court eventually ruled in 2021 that Fidelity was not negligent and did not violate the standard of care.

Observers believe this case shows donors that their advisory privilege and legal recourse may be more limited than they realize or expect. If the donors have specific guidance about disposition, a written liquidation plan may be a good option to ensure transparency.

Policy Developments

Proposed Legislation

The Accelerating Charitable Efforts (ACE) Act, introduced in 2022, was the most comprehensive legislative effort to reform regulation of DAFs. It incorporates many elements aimed at rectifying the misuse and shortcomings of the existing rules. The overall objective is to expedite distribution of funds to active charities. Specifically, if the contributions made to a DAF fail to be distributed within a certain number of years (ranging from 15–50 years), the undistributed funds would be subjected to a significant excise tax (50%).

Proposed Regulations

In November 2023, the Treasury released proposed regulations to give guidance on certain tax rules related to the DAFs. The proposed regulations provide definitions of key terms for stakeholders to abide by in the future; they also clarify situations under which compensation of investment advisers would be taxable, such as when donors use their personal advisers as fund advisers. This first release sets the groundwork for future rulemaking. More releases are expected in 2024.

Future guidance is expected to address issues discussed in Notice 2017-73, including questions such as:

• When would distribution from a DAF provide a more than incidental benefit to a donor-adviser? 
• Whether a distribution from a DAF can be used to satisfy a personal pledge to make a charitable contribution? 

Practitioners will also look for additional clarification on the tax treatment of grants by private foundations to DAFs, DAF to DAF distribution, and issues about public support.

Opponents to Additional Regulations 

While many agree that additional transparency and regulations would be beneficial, some observers raise concerns about these initiatives, disputing many aspects of alleged DAF abuses. For instance, they believe DAFs are “small, personal foundations for middle-class Americans” without administrative hassle, and that this mechanism not only democratizes philanthropy but also stimulates giving. Though there are multibillionaires who own DAFs with large assets, the average size of a DAF account in 2020 was about $159,000. This is evidence that average Americans are using this vehicle for their charitable giving, they contend.

Opponents of additional regulation argue that imposing minimum distribution requirements may reduce DAF payout, or worse, discourage overall giving. Their specific concern is if the law specifies a numerical payout rate — for example, 5% — donors may view that as a ceiling instead of a floor, resulting in distributions not exceeding 5%.

In addition, these observers believe that DAFs provide genuine benefits to charities in that DAFs prevent foundations from being rushed into grant making. The funds also lead to more consistent, less episodic, giving so charities can plan ahead. Another benefit they perceive is that DAF grants can at present be made anonymously, mitigating the possibility of donors being targeted over socially or politically sensitive issues.

They do not consider the scale of foundation-to-DAF distributions significant enough to raise concerns — in 2018 these distributions amounted to only $934 million out of the $36.1 billion total contributions to DAF, less than 3%. 

Conclusion

Donor-advised funds do provide benefits. They incentivize charitable giving through tax benefits, providing opportunities for donors to deliberate and make impactful contributions instead of being limited to annual giving. 

However, the legislature never intended for donors to use DAFs to bypass the existing private foundation requirements or to amass wealth. Current loopholes deprive deserving charitable organizations from receiving timely resources. Several issues around DAFs need to be addressed, including rules to establish a payout mandate, control distribution from a private foundation to a DAF, and determine what constitutes public support. In addition, further disclosure requirements are needed to bring transparency and accountability to DAFs, and ensure that both taxpayers and charitable organizations receive the full value of charitable contributions.

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.