Charitable Giving with Donor Advised Funds - Part II

Charitable Giving with Donor Advised Funds - Part II

Article posted in Donor Advised Fund on 19 September 2000| comments
audience: National Publication | last updated: 15 September 2012
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Summary

Earlier this year, PGDC published Part I of this article which gave an overview of the increasingly popular donor advised funds, including what they are and how they are being used. Part II of this article gives a comprehensive analysis of the recommendations for new laws governing donor advised funds found in the President's fiscal year 2001 budget proposal. The President's proposal offers a definition of donor advised funds, applies private foundation rules to the funds and reclassifies public charities administering donor advised funds as private foundations under certain circumstances. In addition, a description of some of the alternate ideas for donor advised fund regulation put forth by other individuals and groups is provided.

by: Emanuel J. Kallina, II, Esquire & Jonathan D. Ackerman, Esquire

Click here for Part I of this article.

Introduction

Part I of this article gave an overview of donor advised funds, including what they are and how they are being used. It noted that the increased popularity of donor advised funds in recent years has also caused increased scrutiny and proposals for more regulation. As mentioned in Part I, the President's fiscal year 2001 budget proposal contains a proposal for new laws governing donor advised funds.1 This proposal attempts to define donor advised funds, apply private foundation rules to these funds and reclassify public charities administering donor advised funds as private foundations under certain circumstances.

It is not clear whether such legislation would increase the use of donor advised funds or would have a chilling effect on their use. A comprehensive analysis of this legislation follows in this second part of a two-part article. We start with a description of the President's proposal. Then, we describe some other ideas for regulation put forth by attorney Victoria Bjorklund,2 Professor Christopher Hoyt,3 the Council on Foundations4 and a group of charities.5

The Proposed Legislation

As noted above, the President's fiscal year 2001 budget proposal makes an effort to define a donor advised fund, apply private foundation rules to these funds and classify the public charity as a private foundation under certain circumstances.6 Specifically, the proposal is that a charity having the operation of donor advised funds as its primary activity could qualify as a public charity only if (i) there are no material restrictions or conditions preventing the charity from freely and effectively employing the assets held in, and income from, its donor advised funds in furtherance of the charity's exempt purposes; (ii) distributions from the donor advised funds are made only as contributions to public charities, private operating foundations and governmental entities; and (iii) at least 5% of the net fair market value of the charity's aggregate assets held in donor advised funds are distributed annually, with a 5 year carryforward for excess distributions. The operation of donor advised funds would be considered a primary activity if a charity has more than 50% of its assets in donor advised funds.7

Under the proposal, a charity would be classified as a private foundation, including application of the private foundation excise taxes, if it failed to comply with any of these requirements.8

In addition, charities operating donor advised funds but not having the operation of donor advised funds as a primary activity would be required to comply with the three requirements. However, a violation would not cause the charity to be treated as a private foundation. Instead, all of the charity's assets held in the donor advised funds would be subject to the private foundation rules and excise taxes.9 Thus, these proposed rules would apply to any charity maintaining donor advised funds.

A Statutory Definition of a Donor Advised Fund

Donor advised funds would be defined under the proposal "as any segregated fund (or account) maintained by a charity for contributions received from a particular donor (or donors) as to which there is an understanding that the donor or the donor's designee may advise the charity regarding the investment or distribution of any amounts held in the fund." The definition would not include any funds or accounts where the advice is limited to the charity's use of the funds in the account for its own operations. In addition, a donor advised fund would not include a charitable gift where the donor specifies a particular charitable recipient at the outset but maintains no ongoing ability to advise the charity.10

The terms "material restriction" would be based on the current Regulations under Code11 Section 507,12 although the proposal specifies that a material restriction would not be presumed simply because a charity follows the donor's advice. The Treasury would be given authority to issue Regulations as may be necessary or appropriate to carry out the purposes of the new laws. This would include Regulations interpreting the material restriction requirements as well as provisions outlining procedures to ensure that distributions are made only to qualifying charitable recipients.13

The proposal would revise the definition of "disqualified person" under Code Section 4958 to make it clear that a person having substantial influence with respect to any transactions involving a particular donor advised fund maintained by a public charity would include the fund's donor or other designated advisor as well as such person's family and controlled entities. The definition of disqualified person for purposes of the self dealing rules of Code Section 4941 would also be changed to include the donor or other designated advisor to a donor advised fund maintained by a private foundation as well as such person's family and controlled entities.14

Effective Dates

The proposal indicates that these new rules would become effective for tax years beginning after the Treasury issues final regulations interpreting the material restriction requirements. However, the amendments to Code Sections 4958 and 4941 would become effective for transactions on or after the date of enactment.15

Commentary

The analysis of the proposal explains that this clarification would promote the continued growth of donor advised funds and ensure that funds are distributed currently for charitable purposes. On the other hand, the commentary points out that there have been no demonstrated abuses of donor advised funds necessitating new restrictions and the passage of such laws could have a chilling effect on the use of donor advised funds, particularly until such time as the Treasury issues Regulations explaining the material restriction rules. Moreover, a charity that maintains donor advised funds as a primary activity could lose its tax exempt status for a small or unintentional violation of these rules.16

The Bjorklund Proposal

Victoria Bjorklund's recent comprehensive article on donor advised funds includes her own proposal for legislative reform.17 Many of her ideas are similar to those in the President's proposal. Essentially, she believes that donor advised funds should be classified as public charities and suggests that a new provision could be added to Code Section 509(a) to specifically define donor advised funds as such. Her proposed definition would limit distributions from the funds to Code Section 509(a)(1), (a)(2) and (a)(3) public charities and private operating foundations. She states that application of the Code Section 4943 jeopardizing investment provisions and the Code Section 4944 excess business holdings provisions would not be necessary so long as the distributions were only to Code Section 509(a)(1) or (a)(2) entities or to private operating foundations, the donor cannot control investments and the donor cannot require that the assets contributed to the fund be maintained. She believes distributions to foreign charities would also be permissible if the administrator of the donor advised fund maintains appropriate discretion and control.18

Although Ms. Bjorklund's definition would cite the material restriction provisions of Treasury Regulation Section 1.507-2, she notes that it is not clear whether such Regulations should be fully applicable, given that donor advised funds do not involve separate entities for purposes of the component part test. She questions whether there is anything wrong with donor designation, rather than just donor advice, as long as the donor cannot make investment decisions and as long as distributions may be made only to public charities and private operating foundations.19

In addition, Ms. Bjorklund indicates that Code Sections 170(b)(1)(A)(vi) and 509(a)(1) might need to be amended so charities that manage donor advised funds as their primary activity would need to seek public charity status under the new provision rather than Code Section 509(a)(1). She states that the charity would still have to meet the public support tests found in Code Section 170(b)(1)(A)(vi).20

Under these new rules classifying donor advised funds as public charities, Ms. Bjorklund notes that donor advised funds would be subject to the restrictions against improper private benefits. As such, donor advised funds would have to adopt rules prohibiting donors from making recommendations for distributions that would give private benefits to the donors.21

Ms. Bjorklund's article cites Professor Hoyt's analysis of donor advised fund regulation.22 According to Ms. Bjorklund, Professor Hoyt observed in a 1997 presentation that a donor involved in an incomplete donor advised fund gift would be subject to having his or her charitable deduction delayed until the gift is complete.23 The other party to the transaction, the charity, would be subject to three possible punishments: (i) The rarely used revocation of exemption; (ii) intermediate sanctions under Code Section 4958; and (iii) treatment of the donor advised fund as a separate private foundation. As described by Ms. Bjorklund, Professor Hoyt's analysis indicates that it is unclear how the intermediate sanctions would be applied to donor advised funds and that the final punishment option would appear to apply only to community foundations operating under the component fund rules.24

With Professor Hoyt's analysis in mind, Ms. Bjorklund suggests that it might be desirable to amend Code Section 4958 and the Treasury Regulations thereunder to define the donor of a donor advised fund as a disqualified person for purposes of the intermediate sanction rules. If these amendments were not sufficient to capture potential abuses, she notes that it might also be necessary to revise the definition of excess benefit transactions to include situations where a donor makes recommendations for his or her direct or indirect personal benefit. If these changes were made, Ms. Bjorklund observes that it would be particularly important for charities to educate donors and donor advised fund managers about the intermediate sanction rules.25

The Hoyt Proposal

In a presentation given in September of 1996, Christopher Hoyt suggested that distributions from donor advised funds should be limited to public charities but noted that the Internal Revenue Service should not be concerned about whether a distribution is made to one public charity instead of some other type of public charity.26

Professor Hoyt also included a draft outline of the standards that he believed should be applied to donor advised funds. In Professor Hoyt's opinion, a donor should not directly or indirectly be allowed to control investments of his or her donor advised fund or the retention of specific contributed assets. However, it would be okay to allow the donor a one-time opportunity to select an investment option from among a set of pre-established investment options controlled by the charity. As far as the level of advice to be given by the donor, Professor Hoyt indicates that a donor should not be allowed to retain the legal right to direct distributions from the fund and that all of the charity's communications to the donor should make this clear. On the other hand, periodic non-binding recommendations are okay.27

He suggested that a charity should indicate to recipients of distributions from donor advised funds that the distributions are to be used for charitable purposes only and that the distributions cannot be used for the financial benefit of the funds' donors. In addition, the charity should have substantial charitable programs other than the administration of donor advised funds and it should have to publicize these other programs. The charity would need to provide substantial education to donors, perhaps on the community's charitable needs. A charity could not merely check to see if a donor's recommended recipients for distributions are qualified charities. Specifically, he is concerned that a charity not be simply a conduit for a donor's gifts.28

Finally, Professor Hoyt's suggested standards would authorize distributions from donor advised funds to Code Section 501(c)(3) entities that are public charities under Code Section 509(a)(1), (a)(2) or (a)(3) and organized under the laws of the United States or its territories. Special rules would have to be followed for distributions to non-exempt entities.29

In a recent article, Professor Hoyt addresses the President's proposal for legislation governing donor advised funds.30 He begins by emphasizing that any legislation should meet the goals stated in the President's proposal of making it easy to use donor advised funds, encouraging the growth of donor advised funds and minimizing abuses in terms of benefits for donors and their advisors. He suggests that the legislation should (i) define donor advised funds clearly so that they may be distinguished from non-advised funds; (ii) outline permissible activities of donor advised funds; (iii) describe the duties of charities administering donor advised funds; and (iv) impose penalties on donors improperly using donor advised funds for personal financial gain and on charities improperly administering the funds.31

With respect to the administration's proposed definition of donor advised funds, Professor Hoyt suggests a modified definition as follows:

any segregated fund or account maintained by a charity for contributions received from a donor as to which there is an understanding that the donor, or a disqualified person with respect to the donor, may advise the charity regarding the investment or distribution of any amounts held in the fund. For purposes of this section, a trust that is a component part of a community trust will be considered a segregated fund.

Professor Hoyt's definition then goes on to specifically delineate funds that are not donor advised funds, including funds with no donor or disqualified person involvement, funds receiving contributions from many unrelated persons, funds controlled by the governing charity and scholarship funds created by businesses for their employees and their employees' dependents. He would also include "other exemptions to be described in regulations." He notes that the exemptions for contributions limited to use within the charity and contributions earmarked at the outset as described in President's proposal would be included as well.32

He agrees that distributions from donor advised funds should be limited to "50%-type" charities including public charities and private operating foundations organized under the laws of the United States. However, he would allow distributions to certain foreign charities as well, perhaps to those that produce the Affidavit for Equivalency Determination as described in Regulation Section 53.4945-5(a)(5) and Revenue Procedure 92-94.33 Professor Hoyt suggests that the legislation should clarify that non-advised funds may make distributions to non-charities, noting that his definition of non-advised funds would include some funds with a certain level of donor involvement in the distribution-making process.34

Professor Hoyt supports the President's proposal requiring a minimum 5% aggregate payout from donor advised funds. He states that no one has problems with this minimum, noting that community foundations would easily be able to meet this based on current practices.35

The administration's proposal references the material restriction rules of the Regulations under Code Section 507 and calls for the imposition of the intermediate sanction rules on charities that violate the new donor advised fund requirements. Professor Hoyt suggests that neither of these items is appropriate. Instead, he would impose duties on charities to investigate recipients of distributions from donor advised funds and to instruct recipients that they should not cash distribution checks if there is a financial benefit to the donor or the donor's family. He advocates simpler sanctions "geared toward the grant-making characteristics of donor advised funds." He believes such sanctions would be more appropriate than those geared towards executive compensation and private foundation termination.36

Specifically, his sanctions on the charity would include sanctions similar to the "quid pro quo" disclosure sanctions found in Code Sections 6115 and 6714. If willful, repeated violations occurred, the charity's exemption could be revoked.37

Moreover, Professor Hoyt advocates repealing the favorable and unfavorable factors listed in the material restriction Regulations under Code Section 507. He believes this would make it clear that there is only one simple, unambiguous law that governs donor advised funds.38

As far as penalties for donors, Professor Hoyt suggests that donors should be subject to penalties for violation of the new rules on distributions equivalent to those penalties found in the taxable expenditure rules for private foundations.39

Professor Hoyt would include in the proposed legislation a provision making it clear that contributions to donor advised funds would be classified as public support for purposes of a charity's public support test.40

Finally, he advocates specifically clarifying issues surrounding bifurcated grants and pledges. He observes that donors to donor advised funds are often less tax-sophisticated and make smaller gifts than donors to private foundations. He notes that he commonly gets questions as to whether donor advised funds may participate with donors in buying tables at charitable events, which he refers to as bifurcated grants. That is, the donor would pay the non-deductible portion (the value of the quid pro quo received by the donor) and the donor advised fund would pay the deductible portion. In the interest of simplicity, he sees no reason why such bifurcated grants should not be permissible. Similarly, he believes the usual rules for charitable pledges should apply to the satisfaction of charitable pledges from donor advised funds. Otherwise, Professor Hoyt fears the new law would just be setting up traps for unsophisticated donors who do not word their pledges in the most tax-wise manner.41

The Council on Foundations Proposal

As part of its commentary on the President's proposal, the Council on Foundations has listed a number of provisions it believes should be included in any legislation regarding donor advised funds. It notes that its members were unable to reach a specific agreement on the level of diligence that the legislation should require charities to employ in reviewing donors' recommendations for grants. The Council suggests that any statutory provisions be enacted into the Code under the provisions for special excise taxes on public charities. It does not believe the new provisions should be included under the basic exemption provisions of Code Section 501(c)(3) or under the private foundation/public charity rules of Code Section 509.42

Recently, the United Jewish Communities indicated that it "fully endorses the comments" filed by the Council on Foundations and supports the submissions made by the Council "both in content and spirit."43

As to the definition issue, the Council on Foundations believes the legislation should define donor advised funds as follows:

A donor-advised fund should be defined as any segregated fund or account owned by a section 501(c)(3) organization, other than a private foundation, with respect to which there is an understanding between the donor and the public charity holding the fund that the public charity will take the donor's advice into consideration regarding investments and/or distributions of any amounts held in the fund. A fund would not be a donor-advised fund if the donors may give advice only with respect to how the public charity itself may use amounts in the fund for its own operations and the donor may not give advice about grants to third parties. A fund also would not be a donor-advised fund if the fund is earmarked at its creation for a specific charitable beneficiary -- such as the symphony or the zoo -- or purpose -- such as cancer research or maintaining a public park. Finally, a fund would not be a donor-advised fund if a public charity described in section 501(c)(3) or a governmental entity has the authority to appoint the majority of advisors.44

The Council recommends that the legislation include certain conditions that must be met for organizations to have donor advised funds. Noting that there is no legally binding obligation on the charity to follow a donor's advice, the Council suggests that the charity and donor be required to enter into an explicit written agreement that would alert donors to: (i) the irrevocable nature of the gift and the charity's control and discretion over the gift once it has been made; (ii) the inability of donors, advisors and members of their families to receive substantial return benefits from fund distributions; and (iii) the inability to make distributions from the fund to private non-operating foundations. The charity's ultimate control over the funds would have to be explicitly stated to potential and actual donors and advisors during the course of marketing, establishing and operating donor advised funds. In addition, the charity would be required to exercise due diligence over recommended distributions to make sure that they are used exclusively for charitable purposes.45

The Council states that the legislative history should make it clear that the operational requirements would not be violated if a charity typically follows a donor's advice on grants to public charities or governmental entities.46

As far as the aggregate 5% payout requirement contained in the President's proposal, the Council on Foundations does not believe this is the most effective response to the stated concern about indefinite accumulations. Instead, it believes charities should be able to rely upon limits on the types of advice donors may give and upon board policies to take action where no recommendations are made for a period of time. The Council notes that if a 5% payout is imposed, the rules should be similar to, but not as complex as those under, Code Section 4942. Finally, it recommends that some alternatives be included, such as provisions to take account of illiquid gifts or a grace period for new charities.47

The Council advocates a bright line test to prevent compensation, reimbursement of expenses, loans and leases for donors, advisors or their family members from donor advised funds. Certain asset sales would be allowed under narrow circumstances and exceptions would exist for transactions involving a charity's general unrestricted funds. Charities should also be allowed to charge fees for donor advised funds under standard formulas.48

Distributions to private non-operating foundations would not be allowed under the Council's proposal. Distributions could be made to foreign charities classified as private foundations under Code Section 4948(b) as long as the foreign charity is not seeking tax exempt status in the United States.49 The Council on Foundations recommends that Treasury Regulations be issued that would impose certain due diligence requirements on such grants to foreign charities, on grants to other non-public charities and on grants to individuals.50

The Council recommends that the legislation include penalties for violations of the rules on donor advised fund operations. It states as follows:

Legislation or legislative history should make clear that there are serious legal consequences for charities that have a pattern or practice of violating the operational requirements, without reasonable cause, by

(a) failing to include required language in fund agreements;

(b) including in communications with potential donors, donors or advisors explicit statements that the donor or advisor will control, direct or otherwise have the authority to cause investments or distributions to be made by the donor-advised fund;

(c) failing to perform any due diligence on a substantial number of grants to public charities or governmental entities; or

(d) failing to perform required due diligence on a substantial number of grants to individuals or non-charities.

These failures would effectively mean that the public charity was operating donor-directed funds, and strong adverse consequences should apply. First, contributions to donor-directed funds are not completed gifts and therefore are not deductible. Second, individuals and firms intentionally offering donor-directed funds and representing that donors would get tax benefits for their gifts could be liable for tax shelter promotion penalties. Third, public charities could lose their section 501(c)(3) tax exemption if they explicitly offer donor-directed funds, have pervasive and persistent instances of allowing donors to use donor-advised funds to collect substantial return benefits, or fail over an extended period of time to make adequate distributions from their donor-advised funds.51

Instead of reclassifying public charities or donor advised funds as private foundations as in the President's proposal, the Council suggests that the legislation should include a penalty excise tax system for "discrete technical violations" of the donor advised fund rules. The excise taxes would have proportionately "adverse consequences for each type of violation and an incentive to correct the errant practice." Specifically, the Council suggests the following excise taxes:

  • IF A DONOR-ADVISED FUND IS SUBJECT TO A LEGALLY BINDING OBLIGATION TO FOLLOW THE DONOR'S ADVICE, IF THE WRITTEN AGREEMENT CREATING THE FUND DOES NOT INCLUDE THE NECESSARY ELEMENTS OR IF THE FUND FAILS TO EXERCISE THE DUE DILIGENCE REQUIRED TO MEET THE OPERATIONAL TEST AND MAKES A GRANT PURSUANT TO DONOR ADVICE THAT IS NOT FOR EXCLUSIVELY CHARITABLE PURPOSES, AN EXCISE TAX WOULD BE PLACED ON THE FUND. (The tax would be the greater of 10 percent of the amount involved or $1,000.) The public charity also would be required to eliminate any binding legal obligation, correct the fund agreement, or seek recovery of the amount improperly distributed within a certain amount of time or a second higher level of tax would apply to the fund. An example of a violation might be a letter sent to a potential donor stating that the donor's advice will be followed in all cases, even though the law requires special warnings in the official documentation. In such a case, the public charity would be required to send the donor a letter retracting the first letter and restating the true legal conditions under which the fund operates.
     
  • IF THE ORGANIZATION MAINTAINING THE DONOR-ADVISED FUNDS FAILS TO MEET THE AGGREGATE 5 PERCENT PAYOUT REQUIREMENT, AN EXCISE TAX IN AN AMOUNT SUCH AS 15 PERCENT WOULD BE IMPOSED ON THE DIFFERENCE BETWEEN ACTUAL AGGREGATE PAYOUT AND THE REQUIRED 5 PERCENT PAYOUT. The public charity would have to make sufficient additional payout to meet the 5 percent requirement within a specified period of time or a second, higher level of tax would apply.
     
  • IF A PAYMENT FROM A DONOR-ADVISED FUND GOES TO A PRIVATE NON-OPERATING FOUNDATION, AN EXCISE TAX IN AN AMOUNT SUCH AS 10 PERCENT WOULD BE PLACED ON THE DISTRIBUTION, PAYABLE BY THE PUBLIC CHARITY MAKING THE DISTRIBUTION. The public charity holding the fund would be required to recover the distribution or else face a higher level of excise tax.
     
  • IF A DONOR-ADVISED FUND IS USED TO MAKE A GRANT TO, PAY FOR SERVICES FROM OR REIMBURSE EXPENSES OF A DONOR, AN ADVISOR, OR A MEMBER OF THE DONOR'S OR ADVISOR'S FAMILY, THE ENTIRE PAYMENT AUTOMATICALLY WOULD BE DEEMED AN EXCESS BENEFIT TRANSACTION. THE DONOR OR ADVISOR WOULD BE DEEMED A DISQUALIFIED PERSON AND THE INDIVIDUAL WOULD OWE THE INTERMEDIATE SANCTIONS TAXES ON THE TRANSACTION. Under intermediate sanctions, the tax would be calculated as 25 percent of the excess benefit amount. If a donor-advised fund buys or sells property to or from a donor, an advisor or a member of the donor's or advisor's family, the intermediate sanctions taxes would apply only to the extent the donor, advisor or family member received a benefit in excess of the fair market value of the property involved. For example, if a donor redeemed closely held stock from a donor-advised fund for less than what the stock was worth, the donor would be liable for the intermediate sanctions taxes on the difference between the amount paid and the fair market value of the stock. Finally, the organization manager's tax under section 4958 would apply to penalize organization managers who knowingly participate in these excess benefit transactions.52

Finally, in an effort to provide consistency and completeness, the Council suggests (i) modifying the intermediate sanction rules of Code Section 4958; (ii) holding off on modifying the supporting organization rules until more is known about potential abuses; (iii) allowing transfers among donor advised funds but not counting those towards the annual payout requirement; (iv) modifying the public support tests to cross-reference the new donor advised fund rules which would effectively eliminate the existing material restriction Regulations in most cases; and (v) applying effective date and transition rules so charities currently operating under reasonably prudent standards of due diligence would not be subject to penalties while Regulations are being written.

The Group of Charities Proposal

The description of the legislative proposal submitted by a group of charities (including Fidelity Investments Charitable Gift Fund) notes that donor advised funds have been called "the catalyst for the democratization of philanthropy...." The group suggests that the legislation should contain simple rules "not requiring clarification or elaboration by regulation."53

The proposal suggests definitions for "Sponsoring Charity" and "Donor Advised Funds." A Sponsoring Charity would be a tax-exempt organization under Code Section 501(c)(3) that has public charity status under Code Section 509(a)(1) or (2). A donor advised fund would be any fund dedicated for charitable use by a Sponsoring Charity, if the Sponsoring Charity separately identifies and accounts for the fund, invests fund contributions, makes grants from the fund, receives contributions for the fund, and receives and retains exclusive legal control over all fund contributions and investments, grant recipients, and the amount and timing of grants. The donor or the donor's designee would have the opportunity to advise the Supporting Charity on investments, grants and the amount and timing of grants and the donor and the Sponsoring Charity would enter into a written agreement confirming the Sponsoring Charity's control over the donor advised fund and the fund's grants and investments.54

According to the charities, legislative history should make it clear that certain types of funds or gifts are not donor advised funds. These would include funds that are separately accounted for and (i) over which the donors only have the opportunity to give advice as to the Sponsoring Charity's use in carrying out its own charitable activities other than grants; (ii) to which a significant number of unrelated donors contribute for a specific charitable recipient based on solicitations to the general public; or (iii) which are established by or for public charities or governmental entities, such charities or entities may appoint a majority of the advisors to the funds and the assets of the funds may only be used for the charitable purposes of such charities or entities. In addition, gifts to a Sponsoring Charity for a specified recipient over which the donor retains no advisory opportunities (such as gifts to United Way) would not be included in the category of donor advised funds. In certain cases, the Sponsoring Charity would be allowed to elect to treat these other funds as donor advised funds.55

In addition to individuals, the charities' proposal would allow corporations, partnerships, trusts, estates and other for-profit and non-profit entities to be donors to donor advised funds. A donor would be authorized to select individuals or entities as donor advisors for the fund and successor advisors could be named. The Sponsoring Charity would have to receive legal control over donor advised fund contributions and the contributions would be treated as made to the Sponsoring Charity for all purposes.56

Certain transactions would be prohibited. With respect to a donor advised fund, the donor, the donor advisors and Code Section 267 related parties would not be allowed to (i) sell, exchange or lease real or personal property; (ii) lend money or extend credit; (iii) furnish goods, services or facilities; (iv) pay compensation or reimburse expenses; or (iv) distribute or otherwise confer a private benefit. On the other hand, a donor advised fund would be allowed to satisfy charitable pledges or tithes of donors and donor advisors and could let related parties purchase or redeem contributed business interests for cash or marketable securities equal to the fair market value of the interests.57

Transactions between the donor, donor advisor or related parties and the Sponsoring Charity would be permitted if they are for the general benefit of the Sponsoring Charity. The proposal enumerates certain permitted transactions and notes that such transactions would be subject only to Code Section 4958.58

The charities' proposal includes requirements for minimum distributions from donor advised funds. For this purpose, "Qualifying Distributions" would be described as follows (donor advised funds are referred to as "DAFs"):

grants distributed from contributions to DAFs made in prior years and the current year, including the earnings thereon. All DAFs maintained by a Sponsoring Charity shall be aggregated for purposes of this Distribution Requirement, and the test is applied by reference to grants from all aggregated DAFs. Grants from a Sponsoring Charity's unrestricted funds, and distributions from one DAF to another DAF, do not count as Qualifying Distributions for purposes of the Distribution Requirement; however, grants from a DAF to the Sponsoring Charity's unrestricted funds do count as Qualifying Distributions.59

Although there would be no annual or periodic distribution requirement for a particular donor advised fund, a Sponsoring Charity would need to make Qualifying Distributions that meet the following requirements each year:

(i) when added to Qualifying Distributions made over the preceding four years, are not less than 5% of the average market value of net assets held in the DAFs, determined on a quarterly basis, for the current year and the preceding four years; or

(ii) are equal to at least 5% of the lower of (a) the aggregate net asset value of all of the DAFs it maintains at the beginning of the year, or (b) the aggregate net asset value of all the DAFs it maintains at the end of the year, increased by any grants made from the DAFs during the year.

In addition, if there are no contributions to or distributions from a particular donor advised fund for seven years, the advisory opportunities for that fund would be lost and the fund's assets would escheat to the Sponsoring Charity's unrestricted funds unless the Sponsoring Charity believes the donor advisor intends to exercise its advisory privileges within a reasonable period of time.60

The proposal indicates that Qualifying Distributions for all purposes should include grants to Code Section 170(b)(1)(A) entities, if the donee agrees to certain conditions in writing. The conditions are that the donee will use the grant solely and exclusively for its exempt purposes, the donee will not provide any consideration for grants received and the donee will communicate to the donor or donor advisor that grants to the donee are not tax deductible by the donor or the donor advisor. Grants to foreign charities would be allowed if the Sponsoring Charity "exercises control and discretion and maintains records establishing that the grant will be used exclusively for charitable purposes..." as would grants to other entities eligible to receive charitable contributions under Code Section 170(c) so long as the entities are not private foundations.61

In addition, individuals could receive grants from donor advised funds if "(i) the grant is to a designated class of persons in a manner that serves a charitable purpose (e.g., scholarship beneficiaries, disaster victims or low-income individuals), (ii) the donor, Donor Advisor, and persons related to the donor and Donor Advisor (as defined in Section 267) are not permitted recipients, and (iii) the donor and Donor Advisor are not consulted in determining which individual members of the class receive grants."62

Donor advised fund could make distributions to other donor advised funds under the proposal but, as indicated in the definition of Qualifying Distributions cited above, such distributions would not be Qualifying Distributions for purposes of meeting the distribution requirements.63

Electronic records, electronic signatures and other electronic means could be used for all notices, acknowledgments, confirmations and other communications referenced under the proposal.64

Finally, the proposal includes sanctions for failures to meet the minimum distribution requirements and for prohibited transactions. If the distribution requirements are not met in any year prior to the first day of the second taxable year thereafter, the Sponsoring Charity would be subject to a penalty tax equal to 5% of the amount of the "under-distribution." If the under-distribution is not corrected within a reasonable time, the Sponsoring Charity would be subject to a second tier penalty tax. If there is a prohibited transaction with a donor advised fund, the donor, donor advisor or related person would be subject to a penalty tax equal to 5% of the amount involved. If the prohibited transaction is not corrected within a reasonable time, second tier penalty taxes would apply. If the Sponsoring Charity knowingly permits the prohibited transaction, the Sponsoring Charity would be subject to a penalty tax equal to 5% of the amount involved. The penalty taxes on prohibited transactions are in addition to other sanctions that might apply under current law and they may be abated for reasonable cause.65

As part of the sanctions provisions, the definition of disqualified persons found in Code Section 4958(f) would be amended to include donors and donor advisors. The proposal would also make it clear that the sanctions described, including those otherwise applicable under current law, would be the only sanctions to be imposed "in those cases in which the prohibited behavior does not rise to a level where it calls into question whether, on the whole, the Sponsoring Charity functions as a charitable tax-exempt organization." The proposal would provide for revocation of tax-exempt status for a Sponsoring Charity that "exhibits a consistent pattern of repeated, willful and intentional violations of these rules...."66

Discussion

With the significant growth in donor advised funds in recent years and the increased attention focused on them, it appears inevitable that some abuses will arise. Clarification of the rules applicable to them is appropriate. More certainty about the operation of donor advised funds will likely increase their use as more and more charities and donors gain confidence about the risks and rewards involved. As noted in Part I of this article, donors appreciate the many advantages of donor advised funds, including immediate charitable deductions, favorable percentage limitations for contributions, name recognition, the ability to make recommendations for distributions and ease of use.

The excellent analyses of possible regulation of donor advised funds provided by Ms. Bjorklund, Professor Hoyt, the Council on Foundations and the group of charities cited above all contain similarities to the President's recent budget proposal. Ms. Bjorklund's article was published before the President's proposal came out so her article does not specifically comment on the administration's proposal. Having the opportunity to consider all of the issues raised in these proposals, a workable framework for donor advised fund legislation is probable. However, it is interesting to note some of the differences. Is it likely that Congress would permit a donor directed fund? While the 5% distribution requirement is generally viewed favorably, the nature of the penalties for noncompliance and some of the critical definitions do differ. If the legislation is properly drafted, will it be necessary to cloud the clarity with the imposition of the favorable and unfavorable factors, material restrictions standard under the 507 Regulations? With proper due diligence, grants to individuals and foreign charities should be permitted.

Conclusion

This second part of a two-part article describes some proposals for legislation governing donor advised funds. Part I attempted to explain what donor advised funds are and how they are being used. Clearly, there is confusion on the "what they are" question. As with any type of planning technique, increased use almost inevitably leads to abuses or at least IRS fear of abuses. Increased use also leads to increased scrutiny. As a result of these factors, new legislation is being considered.

As noted above, it is not clear whether such legislation would result in the increased use of donor advised funds or would put a damper on their use. However, if the legislation is properly drafted, it would be more likely to increase the use of donor advised funds by providing donors and charities with more confidence and certainty as to the operation of donor advised funds.


Footnotes


  1. Joint Committee on Taxation's Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal.back

  2. Victoria B. Bjorklund, "Charitable Giving to a Private Foundation: The Alternatives, The Supporting Organization, and The Donor-Advised Fund," 27 The Exempt Organization Tax Review 107 (2000).back

  3. Christopher R. Hoyt's outline, "Donor Advised Funds: Legal Focus," a presentation given at the Twelfth Annual Conference for Community Foundations Council on Foundations in San Diego, California (Sept. 11, 1996) and Christopher R. Hoyt, "Framework for Donor Advised Fund Legislation," Charitable Gift Planning News, March 2000, at 5.back

  4. 2000 TNT 97-25 (May 11, 2000).back

  5. 2000 TNT 106-16 (May 17, 2000) (the cover letter submitting the group's proposal to the Department of Treasury is signed by American Guaranty Fund, Wilmington, Delaware; The Ayco Charitable Foundation, Albany, New York; The U.S. Charitable Gift Fund, Boston, Massachusetts; Fidelity Investments Charitable Gift Fund, Boston, Massachusetts; National Philanthropic Trust, Jenkintown, Pennsylvania; The Fund for Charitable Giving, Boston, Massachusetts; Raymond James Trust Co., St. Petersburg, Florida; Schwab Fund for Charitable Giving, San Francisco, California; and Vanguard Charitable Endowment Program, Malvern, Pennsylvania).back

  6. Joint Committee on Taxation's Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal.back

  7. Id.back

  8. Id.back

  9. Id.back

  10. Id.back

  11. All references to the Code are to the Internal Revenue Code of 1986, as amended from time to time.back

  12. See Part I of this article for a description of the material restriction provisions.back

  13. Joint Committee on Taxation's Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal.back

  14. Id.back

  15. Id.back

  16. Id.back

  17. Victoria B. Bjorklund, "Charitable Giving to a Private Foundation: The Alternatives, The Supporting Organization, and The Donor-Advised Fund," 27 The Exempt Organization Tax Review 107 (2000).back

  18. Id at 124.back

  19. Id.back

  20. Id.back

  21. Id.back

  22. Id at 120-21.back

  23. Id, citing Christopher R. Hoyt's presentation, "Legal Issues: Parameters in Fund Development" (Nov. 1997).back

  24. Id.back

  25. Id at 125.back

  26. See Christopher R. Hoyt's outline, "Donor Advised Funds: Legal Focus," a presentation given at the Twelfth Annual Conference for Community Foundations Council on Foundations in San Diego, California (Sept. 11, 1996).back

  27. Id.back

  28. Id.back

  29. Id.back

  30. Christopher R. Hoyt, "Framework for Donor Advised Fund Legislation," Charitable Gift Planning News, March 2000, at 5.back

  31. Id at 5-6.back

  32. Id at 7.back

  33. 1992-2 C.B. 507.back

  34. Christopher R. Hoyt, "Framework for Donor Advised Fund Legislation," Charitable Gift Planning News, March 2000, at 7.back

  35. Id at 8.back

  36. Id at 6 and 8.back

  37. Id at 8.back

  38. Id at 6 and 10.back

  39. Id at 6 and 8.back

  40. Id at 6 and 9.back

  41. Id at 9-10.back

  42. 2000 TNT 97-25 (May 11, 2000).back

  43. 2000 TNT 155-20 (June 29, 2000).back

  44. Id.back

  45. Id.back

  46. Id.back

  47. Id.back

  48. Id.back

  49. Id.back

  50. Id.back

  51. Id.back

  52. Id.back

  53. 2000 TNT 106-16 (May 17, 2000).back

  54. Id.back

  55. Id.back

  56. Id.back

  57. Id.back

  58. Id.back

  59. Id.back

  60. Id.back

  61. Id.back

  62. Id.back

  63. Id.back

  64. Id.back

  65. Id.back

  66. Id.back

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