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Donor Advised Funds: New Provisions in Pension Protection Act of 2006
Among its many provisions, the Pension Protection Act of 2006 has for the first time defined donor advised funds and has placed new rules on their use. In this article, Laura Hansen Dean, J.D., from the Community Foundation of Southern Indiana, reviews the new rules and offers help to organizations that desire to communicate them to fund advisors.
Donor advised funds provide wonderful flexibility for individuals, multiple generations of families, and businesses. On May 4, 2006, The Chronicle of Philanthropy reported that assets held by the largest donor advised funds increased by more than 20% during 2005 — the largest gain since 2001, topping the 15% increase from 2003 to 2004 ("A Soaring Year," The Chronicle of Philanthropy, May 4, 2006, page 28). Total assets in donor advised funds held at the 88 reporting organizations increased to $15.5 billion from $12.7 billion in 2004.
Prior to the Pension Protection Act of 2006, signed into law by President Bush on August 17, 2006, there was no statutory definition of donor advised funds. In fact, it was only last year, in the Katrina Emergency Relief Act of 2005, that the term "donor advised fund" first appeared in federal legislation. Unfortunately, it appeared as a type of gift that did not qualify for the 100% of AGI deduction ceiling for gifts of cash made between August 28 and December 31, 2005.
Definition of Donor Advised Funds
Donor advised funds are now defined as a fund or account:
- which is separately identified through reference to the contributions of a donor or donors (by including donor names in the fund name or by tracking contributions from specific donors in the organization's financial records);
- which is owned and controlled by a sponsoring organization; and
- in which a donor or person appointed by the donor has or reasonably expects to have advisory rights with respect to investments or distributions.
Donor advised funds specifically do not include funds or accounts:
- which make distributions to only one identified organization or governmental entity (usually referred to as "designated" funds or "agency" funds when the contributed funds were assets of the entity that will benefit from the fund). The legislation exempts these types of funds from definition as donor advised funds even if a donor can provide advice on investments or the timing or amount of distributions from the fund;
- which makes travel, study, or similar grants to individuals if:
- a committee of advisors are appointed by the sponsoring organization and the committee of advisors is not controlled by the donor or persons appointed by the donor, or
- an objective and nondiscriminatory process approved in advance by the sponsoring organization's governing board and which meets the requirements for similar grants by private foundations is used to award grants from the fund; or
- exempted by the Secretary of the Treasury provided the fund is either:
- advised by a committee not controlled by the donor, or
- benefits a single charitable purpose.
Advised funds maintained by governmental entities and by private foundations are not covered by these new rules. The Council on Foundations advised in their "Summary of Charitable Provisions in H.R. 4 "that funds that make grants directly to individuals for disaster relief or emergency hardship must avoid classification as coming from donor advised funds or must obtain an exception from the IRS. However, funds that make grants to charitable organizations assisting individuals are not affected by the new rules.
Grants from Donor Advised Funds
The new legislation also provides that donor advised funds cannot make grants to individuals, to private non-operating foundations, for non charitable purposes, to type III supporting organizations except for those that are "functionally integrated," to type I or II supporting organizations if the donor or an advisor controls the supported organization, or for grants found to be inappropriate by a rule determined by the Secretary of the Treasury, and to organizations not described in Code 170(b)(1)(A) unless the sponsoring organization exercises the expenditure responsibility that has been required of private foundations making grants to such organizations.
Grants to organizations described in Code 170(b)(1)(A) (other than to type III supporting organizations and to type I and II supporting organizations if the supported organization is controlled by a donor or an advisory), to organizations not described in Code 170(b)(1)(A) when expenditure responsibility is exercised, to the sponsoring charity, and to other donor-advised funds are listed in the new legislation specifically as "permitted grants" from donor advised funds.
Penalties on Grants from Donor Advised Funds
Other provisions provide that a penalty of 125% of the value of an economic benefit, other than an incidental benefit, to a donor, advisor or related parties can be levied on the person recommending the grant (the fund advisor) or the person who received the benefit. And fund managers are subject to a penalty of 10% of the value of the economic benefit if the manager knew the distribution would result in such a benefit. Unlike other penalty taxes, these penalties are not paid to the charitable organization, instead the taxes are payable to the United States Treasury. These new taxes should significantly increase oversight by organizations that sponsor donor advised funds to prevent grants providing personal economic benefit to donors, advisors, or related parties from donor advised funds. Sponsoring organizations should notify donors, fund advisors, and related parties of the new penalty taxes for recommending grants that result in personal benefit. A sample letter to fund advisors can be found following this article.
Effective on August 18, 2006, any grants, loans, compensation, and similar payments from donor-advised funds to donors, advisors, and related parties is an excess benefit transaction subject to the penalty taxes of Code 4958, 25% of the value of the benefit and the amount involved must be repaid to the sponsoring organization but not for deposit in the donor advised fund. If the 4958 penalty applies, the 125% penalty does not apply.
If compensation paid to anyone providing investment advice with respect to advised funds ("investment advisors") is found to be excessive, the investment advisors will be subject to penalties, also effective on August 18, 2006. These penalties will apply even if the Code 4958 penalties would not apply if the investment advisor is not a person of substantial influence with respect to the sponsoring organization.
Excess Business Holdings Rule and Penalty Now Applies to Donor Advised Funds
Effective 180 days after August 17, 2006, the very complicated excess business holdings rule of Code 4943, which generally requires divestiture of new gifts of equity ownership in business entities that amount to 20% or more of the voting control of the business within five years from the date of the gift, will now apply to gifts to donor advised funds.
Gifts to Advised Funds Held by Some Supporting Organizations Not Deductible
Gifts to advised funds held by type III supporting organizations (unless functionally integrated) and to type I and II supporting organizations where a donor or advisor controls the supported organizations will not be deductible as charitable contributions. The new law also requires gift acknowledgements to affirm explicitly that the organization sponsoring the donor advised fund has exclusive legal control over the contributed assets.
New Information Required on Form 990 of Organizations Sponsoring Donor Advised Funds
The Form 990 filed by sponsoring organizations holding donor advised funds, starting on August 18, 2006, must include the total number of donor advised funds, the aggregate assets held by donor advised funds, the aggregate contributions to donor advised funds, and the aggregate distributions by donor advised funds.
Congress Concerned about Whether Contributions to Donor Advised Funds Should Qualify for Charitable Contribution Deductions
Clearly, Congress has qualms about extending any new tax incentives to contributions to donor advised funds. The Katrina Emergency Relief Act of 2005 excluded gifts to donor advised funds and to supporting organizations from the provision allowing cash contributions to charities made between August 28 and December 31, 2005 to be deductible up to 100% of AGI. The Pension Protection Act of 2006 continued this exclusionary theme when it excluded gifts to donor advised funds and to supporting organizations from the provision allowing individuals age 70½ and older to make outright charitable contributions of up to $100,000 in each of 2006 and 2007 in tax-free rollovers from Individual Retirement Accounts. Several national organizations are working to address this most recent over reaction to concerns about donor advised funds and supporting organizations.
Could there come a time when contributions to donor advised funds don't qualify as charitable contributions? In the Pension Protection Act of 2006, Congress directed the Secretary of the Treasury to conduct a one-year study to determine whether charitable contribution deductions are "appropriate" for contributions to donor advised funds, whether donor advised funds should be subject to minimum payout requirements, whether the right to advise as to distributions impacts whether contributions are "completed gifts," and whether these issues also arise with other forms of charities or charitable gifts. The report is due on August 17, 2007.
In the author's opinion, it would be unfortunate indeed if Congress determined that contributions to donor advised funds are not charitable contributions, so long as donor advised funds are administered to provide that only grants for legitimate charitable purposes are made from such funds. The Chronicle of Philanthropy study on activity in donor advised funds in 2005 reported that $3.3 billion in grants were awarded from the 88 entities included in the study — an increase of nearly 21% over 2004. Clearly, individuals, families, and businesses find donor advised funds to be a donor-friendly, flexible way to make critically important grants to charitable organizations and causes. Surely, enforcement of the rules already in place can prevent abuse of this important tool in years to come.
Exhibit: Sample Memo to Donor Advised Fund Advisors Regarding New Restrictions Under the Pension Protection Act of 2006
To: Fund Advisors
RE: Pension Protection Act of 2006:
New Penalty Taxes on Grants from Donor Advised Funds
Which Result in an Economic Benefit to a Donor, Fund
Advisor or Related Parties
As a Fund Advisor for a donor advised fund held at the NAME OF SPONSORING ORGANIZATION, we want to inform you of a provision in the Pension Protection Act of 2006 that imposes a new and significant penalty tax when a donor, a fund advisor, or related party receives an economic benefit, other than an incidental benefit, from a donor advised fund.
One of the basic requirements of administering donor advised funds has long been that grants cannot be made from donor advised funds which confer an economic benefit, other than an incidental benefit, to a donor or related party. Examples of non-incidental benefits include the payment of pledges the donor has made to make charitable contributions and reservations to participate in fund raising events where a non-incidental economic benefit, such as a meal, a sporting event, etc. is part of the value of the reservation paid.
Congress is concerned that grants from donor advised funds are being made which confer non-incidental economic benefits to donors, fund advisors and related parties. To emphasize the seriousness of this concern, effective on DATE (Note: can't be later than the first day of the sponsoring organization's fiscal year that starts after August 17, 2006) a penalty of 125% of the value of the non-incidental economic benefit can be levied against the fund advisor who recommended the grant or against the person who received the non-incidental economic benefit. And, a 10% penalty of the value of the non-incidental economic benefit can be levied against our organization if our staff member knew the grant would result in such a benefit when the recommended grant was approved.
Our organization is committed to administering donor advised funds as required by the Internal Revenue Code and the regulations thereunder. Please help us do so by understanding the limitations on the types of grants that can be made from donor advised funds. We may ask you for additional information when a grant recommendation is made to be sure we are in compliance. We don't want our donors or fund advisors or related parties to be subject to this substantial penalty and we will do everything we can to avoid the 10% penalty tax that can be levied on our organization.