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Introduction

Individuals concerned with tax planning often include charitable giving as an important element of their planning strategies. In addition to the satisfaction of knowing that they have contributed to important causes, these taxpayers may also enjoy the charitable income tax deduction that comes with a gift to charity. For many individuals, regular annual outright gifts have satisfied their goals. Under certain circumstances, taxpayers may find that their giving strategies over recent years will no longer produce their desired results. These clients may benefit from a giving strategy that allows them to make a large donation up front and the flexibility to direct the payouts over a number of years.

This article will explore the basic rules related to donor advised funds (DAFs), specifically those regarding charitable deductions and benefits to donors and their family members. It will also discuss recent developments in tax law and policy directly affecting DAFs. Finally, the article will cover scenarios in which the recent changes may encourage taxpayers to consider DAF donations.

DAF Basics

Under Sec. 4966(d)(2)(A), a donor advised fund must be (i) "separately identified by reference to contributions of a donor or donors" and (ii) "owned and controlled by a sponsoring charity." In addition, "the donor must have or reasonably expect to have advisory privileges with respect to the distribution or investment of the amounts in the account." Funds or accounts that make distributions to only a single organization are not considered donor advised funds. Sec. 4966(d)(2)(B).

For the fund to be separately identified, it is usually created in the name of a specific donor. The donor can then add to his or her own fund at any time. If a separate account is not created for each donor, then the organization should have a mechanism in place to track the contributions of each donor to the fund.

A charitable organization must have complete ownership of and control over the fund. Sec. 4966(d)(1). The owner of the fund, known as the "sponsoring organization," must be a 501(c)(3) public charity and may not be a private foundation. However, the donor must also reasonably expect to have advisory privileges regarding both investments and distributions. Therefore, a DAF must be clearly owned by a charitable organization and also allow the donor to provide input as to when and where distributions are made.

Normally, the sponsoring organization will abide by the wishes of the donor. However, the donor does relinquish title and control over the funding asset(s) on the date the DAF is funded. Therefore, the sponsoring organization is not bound to follow the donor's advice. If, for instance, the donor advises a gift that is impermissible, either under IRS rules or the sponsoring charity's mission or standards, the sponsoring charity may refuse to make the distribution. Normally, sponsoring organizations will make their best efforts to follow their donors' wishes.

Because DAFs are owned and controlled by Sec. 501(c)(3) public charities, taxpayers may deduct donations in the same way that they would for other gifts to public charities. Donors' deductions are limited to 60% of adjusted gross income (AGI) per year on gifts of cash and 30% of AGI for gifts of appreciated property held for more than one year.

The deduction is taken in the year that the DAF is funded. The donor does not have the option to delay taking a deduction until the DAF makes a distribution to charity. However, if the donor meets the deduction limits in the year the DAF is funded, he or she may carry the deduction forward for up to five additional years.

TCJA Changes and DAF Solutions

In December 2017, Congress passed the Tax Cuts and Jobs Act (TCJA). Among its many changes to U.S. tax law, the TCJA nearly doubled the standard deduction amount. For 2018, the standard deduction is $12,000 for individual taxpayers and $24,000 for married couples filing jointly. This has the likely effect of greatly curtailing the number of taxpayers who itemize their deductions. A vast number of taxpayers who previously itemized their deductions may instead be left with one option: take the standard deduction.

Example 1

Over the last five years, Darryl has given $10,000 annually to his local homeless shelter and $5,000 to his alma mater. He has a passion for helping care for the homeless and also wishes to do what he can to give back to the university he attended. He has also enjoyed the $15,000 charitable income tax deduction he has received each year. While meeting with his tax advisor regarding this year's tax situation, however, Darryl is dismayed to discover that even with his generous charitable giving, he and his wife Sue will be below the threshold for itemizing their taxes and will instead take the standard deduction for a married couple.

One potential solution to this problem is a gift to a donor advised fund. A taxpayer who might otherwise be disincentivized from making a charitable gift by the newly-doubled standard deduction may be attracted to the flexibility of donor advised fund giving. The taxpayer may find that he or she can continue to itemize by bundling several years' worth of charitable gifts into one year, exceeding the standard deduction threshold.

Example 2

In an attempt to maximize his tax deduction this year, Darryl asks his advisor if there are any alternative giving methods available. Darryl is pleased to hear his advisor offer a potential solution. Instead of giving $15,000 each year to charity, Darryl can bundle five years' worth of charitable gifts into one year. He decides to use $75,000 of stock to set up a donor advised fund. Darryl takes a deduction up to 30% of his adjusted gross income for the year. Darryl deducts $45,000 this year and then carries forward the remaining $30,000 deduction to next year. During each of the next five years, Darryl directs annual distributions of $10,000 to the homeless shelter and $5,000 to the university.

Excess Benefits

Donor advised funds are subject to the excess benefit transactions rules of Sec. 4958. An excess benefit transaction occurs when a charity engages in any transaction with a disqualified person whereby the disqualified person receives a direct or indirect benefit from the charity for which he or she did not pay and the value of the benefit exceeds the value of the consideration received. Any grant, loan or payment of compensation to a donor, donor advisor or a relative of the donor (hereinafter referred to as a "disqualified person") is an excess benefit transaction. Sec. 4958(c)(2). The disqualified person who receives the excess benefit will be assessed a tax equal to 25% of the excess benefit. If an organization manager knowingly assists in an excess benefit transaction, the manager will be taxed at 10% of the value of the excess benefit.

Incidental Benefits

Donor advised funds are prohibited from making distributions that benefit donors, their family members or an entity of which 35% or more is controlled by these individuals. Sec. 4967. These rules are similar to the private foundation "disqualified person" rules and are designed to minimize the potential for donors to abuse the DAF structure and receive inappropriate benefits. Any disqualified person with respect to the DAF who advises a distribution resulting in more than an incidental benefit to a disqualified person will be subject to an excise tax equal to 125% of the distribution. If the fund manager makes the distribution knowing that it would confer more than an incidental benefit on a disqualified person, the manager will be subject to a tax equal to 10% of the benefit.

For many years, the consensus among practitioners has been that the "incidental benefit" rules preclude distributions from DAFs to satisfy legally-binding pledges. A pledge is an agreement between an individual and a charity whereby the individual promises to donate a specific amount of money by a specific time. If there is consideration for the promise to pay, then the pledge may be legally-binding, depending on the governing state law. Once the donor satisfies his or her obligation to make the donation, the pledge has been fulfilled, releasing the donor from a legal obligation. The common understanding among tax professionals has been that this release of a legal obligation is more than a mere incidental benefit. Under this framework, a donor's request that the sponsoring organization make a distribution to a charity with which the donor has an outstanding legally-binding pledge would be taxable at 125% to the donor. If the fund manager is aware of the obligation, he or she would be subject to a 10% tax.

Example 3

Five years ago, Erin signed a binding pledge agreement with her local hospital foundation, promising to donate $5,000 each year for 10 years. Two years ago, while looking for an additional charitable deduction during a particularly successful year for her law practice, Erin donated $10,000 to a DAF. She liked that she could take an immediate deduction now and decide which charities will receive the money at a later date. Over the past several months, Erin's law practice has recently fallen on hard times, considerably tightening up her budget for the year. She would prefer to hold onto her hard-earned cash and advise the DAF to make this year's $5,000 distribution to the hospital foundation to satisfy her pledge. When Erin met with her tax professional, however, he advised her that she would face a substantial excise tax if she advised the sponsoring organization to fulfill this year's pledge amount. Rather than saving her some cash, the distribution could cost her an additional $6,250.

Updated Guidance

In Notice 2017-73, released in December 2017, the IRS announced its intention to develop proposed regulations and requested comments on several issues pertaining to donor advised funds. The Service provided a brief history of its approach toward DAFs, including Notice 2006-109, which provided temporary guidance on certain DAF questions and Notice 2007-21, which requested comments on IRS rules related to DAFs. The Service noted that several commenters requested IRS guidance on two specific issues. First, many commenters asked whether a distribution from a DAF to pay for tickets to a charity-sponsored event, such as a fundraiser, would result in more than an insubstantial benefit to the donor under Sec. 4967.Second, commenters inquired whether a DAF distribution that satisfies a donor's pledge would violate Sec. 4967.

Regarding the first question, the Service noted that commenters suggested that if a DAF distribution paid for only the deductible portion of the ticket, then an excess benefit has not occurred. Under this theory, if a DAF pays for only the fair market value portion of the ticket and the donor covers the excess cost, the donor's benefit is insubstantial.

Nevertheless, the Service disagreed with this theory and determined that a DAF's payment of part of the ticket price would relieve the donor of the obligation to pay the full ticket price. Thus, the IRS stated that the proposed regulations would conclude that a DAF distribution to pay for fundraiser tickets would result in more than an insubstantial benefit to the donor. The Service further noted that the distribution may violate both the Sec. 4967 "incidental benefit" rule and the Sec. 4958 "excess benefit transaction" rule.

The Service next addressed the question of whether DAF contributions can be used to satisfy donors' pledges. The Service began by pointing out that several commenters likened the Service's approach to DAF distributions to the Sec. 4941 prohibition against private foundations making grants to fulfill the legal obligations of disqualified persons. The Service then noted that with regard to pledges, the distinctions between legally-binding pledges and non-binding pledges (which it labeled "merely an indication of charitable intent") are often difficult for sponsoring organizations to determine. Therefore, the Service suggested a framework under which DAF distributions may be allowable to charitable organizations with which the donor has an outstanding pledge.

If the following three-prong test is satisfied, the donor will not be treated as having received more than an incidental benefit. First, the distribution from the sponsoring organization must make no reference to the existence of a pledge. Second, the donor may not receive any other benefit that is more than incidental. Third, the donor must not attempt to claim a charitable deduction for the distribution. If all three of the above requirements are met, a contribution made in fulfillment of the pledge will not be treated as more than an insubstantial benefit to the donor and will not subject the donor to a 125% excise tax.

Example 4

After doing some research, Erin's tax professional informs her that the IRS has proposed new guidance which may enable her to advise a distribution from the DAF to the hospital foundation in satisfaction of her pledge. He informs her that she can safely advise the distribution so long as the distribution is done without any reference to the existence of a pledge, she receives no additional benefits from the distribution and she does not try to claim a charitable deduction. Erin decides to move forward and contacts the sponsoring organization to initiate the process. The hospital foundation gladly receives the distribution from the DAF and credits it toward Erin's $5,000 pledge for this year. Erin has been able to accomplish her goal of fulfilling her pledge obligation and holding onto her $5,000 of savings.

It is important to note the Service's rationale with regard to legally-binding pledges. On the one hand, the Service appears to tacitly acknowledge that the contribution from a DAF to satisfy a legally-binding pledge may, in fact, be more than an insubstantial benefit to the donor, when it states, "The Treasury Department and the IRS currently agree with those commenters who suggest that it is difficult for sponsoring organizations to differentiate between a legally enforceable pledge by an individual to a third-party charity and a mere expression of charitable intent." On the other hand, the notice specifically permits such distributions "regardless of whether the charity treats the distribution as satisfying the pledge."

A prudent tax professional should bear in mind that in Notice 2017-73, the Service merely announced its intention to develop proposed regulations. While the Service has announced its position regarding DAF distributions to satisfy legally-binding pledges, there has been no actual change in the law. At best, this notice merely represents a change in posture by the IRS. While a distribution to satisfy a legally-binding pledge may currently carry low risk, a number of circumstances could cause the Service to revert to its former position on the subject. Should the Service fail to propose and enact the announced regulations, legally-binding pledges could once again be off-limits for DAFs. Therefore, ample caution is warranted for practitioners considering this route for their clients.

Conclusion

Donor advised funds can be an excellent way for individuals to effectuate their tax planning goals. Savvy advisors can counsel their clients to use DAFs to continue to make their charitable gifts without sacrificing their deductions. Nevertheless, individuals should exercise caution and understand the rules surrounding permissible DAF distributions in order to avoid the traps that can cause the donor to pay hefty excise taxes. With proper guidance and planning, however, many taxpayers will find DAF gifts to be a tax-efficient and philanthropic solution.