As donor-advised funds have exploded during the past three decades, critics increasingly charge that they are little more than a tool for the wealthy to warehouse money and avoid public scrutiny. In response, congressional legislation has been proposed to address the worst DAF sins.
That legislation — the Accelerating Charitable Efforts, or ACE, Act — is a good start. But DAF reforms can and should go even further.
To understand why, let’s start by looking at what makes DAFs so popular in the first place. Four reasons are usually cited for why DAFs are often a better option for the wealthy than creating a private foundation.
First, foundation donors receive a roughly 50 percent lower tax benefit than what is typical for DAF donors. This is based on the argument that the charitable impact of foundation contributions will be delayed even though the deduction is realized immediately. DAFs, by contrast, are treated like regular nonprofits: It’s assumed that all or most of the money will be put to charitable uses in the near term.
Second, DAFs do not have a distribution requirement, while foundations must give away 5 percent of their assets each year. As a result, donors can literally stockpile their charitable money even after receiving various tax benefits.
Third, giving from a DAF does not need to be reported in any way that links a specific contribution to a specific donor. While foundations must report the size and nature of their grants, DAFs have no similar requirement.
Finally, operating a DAF is generally much less costly than operating a private foundation. Private foundations usually have staffs who oversee management, grant making, and investments. DAFs, however, don’t have their own staffs and can use resources from their sponsoring organization — often big for-profit operators such as Fidelity and Schwab. Moreover, the reporting requirements for DAFs are nonexistent, so foundations can spend less time wading through red tape.
No one questions the validity and value of DAFs as an easy, cost-effective way for wealthy people to manage their philanthropic giving. It is the other advantages of these funds that have sparked controversy, most notably the absence of a distribution requirement and the lack of transparency about how funds are spent.
Without a distribution requirement, DAF donors have no legal reason to put the funds in the hands of charities. The same is true for the primarily for-profit DAF sponsors, whose fees for management and investment services are linked to the size of the account. The result is a massive influx of money into DAFs and a comparatively paltry amount for nonprofits.
The lack of transparency has led some sponsors to tout DAFs as a means for wealthy people to give to controversial or political causes, including to 501(c)(4) organizations, without ruffling the feathers of their friends and business associates. Some foundations even transfer money to DAFs so controversial grants are not visible to the public. This is allowed under tax code rules for donor-advised funds, which state that grants to 501(c)(4)s are acceptable as long as the donation supports a charitable purpose and the sponsor adequately reports requirements regarding use of the funds — what’s known as “expenditure responsibility.” In practice, most DAF sponsors refuse to support 501(c)(4)s because of the difficulty in determining the charitable purpose and in exercising expenditure responsibility.
The secrecy enjoyed by DAFs has generated a whole lobbying movement focused on defending so-called donor privacy. But DAFs are subsidized by American taxpayers, and those fellow citizens have a right to know where the funds are going.
The ACE Act would tackle some of these problems by pushing DAFs to give more money faster. For example, DAF creators who opt for a for-profit sponsor would be required in most cases to grant funds to a nonprofit before receiving a charitable deduction. DAFs that choose a nonprofit sponsor, such as a community foundation, and have more than $1 million in assets would need to disburse at least 5 percent annually to receive a deduction. And donations of assets such as real estate would generate a deduction only when they are sold.
The legislation also addresses how private foundations can use DAFs to meet their distribution requirements. A grant to a DAF would only count toward the foundation’s payout requirement based on the amount of money given to charities by the fund in the same year.
The ACE Act, however, does not take on other critical problems. These include DAF’s lack of transparency, their use by foundations to avoid public scrutiny, and their tax advantages over private foundations. The following steps would further help level the playing field between foundations and DAFs:
Provide the same tax benefits and advantages to DAFs and foundations. Gifts to foundations receive lower tax benefits because the full charitable impact of the donation is delayed for many years. The same should hold true for DAFs. Equalizing the tax benefits would address concerns about warehousing funds and would remove a major marketing advantage of DAFs over foundations. Donors may still choose DAFs as a less time-consuming and resource-intensive alternative to starting a private foundation. But the other features that have given the funds a competitive edge — no payout requirement and total secrecy — would disappear.
Ensure DAFs are as transparent as foundations. There is no reason that DAFs today shouldn’t provide information on their grants and expenses every year. Four decades ago, this would have been viewed as overly cumbersome, but with sophisticated computer systems and smart databases, fund sponsors can easily and inexpensively comply with such a rule.
Require DAFs and foundations to distribute the same percentage of assets. It’s hard to think of a reason for not extending this requirement to DAFs — and for not raising the distribution rate to 10 percent each year for both philanthropic entities.
Public concerns about the limited grant making from foundations and DAFs has only grown since the ACE Act was proposed last year. At the same time, both have reaped substantial investment returns, making it increasingly difficult to argue that giving away more money would be a serious burden. And for-profit DAF sponsors might counteract income losses resulting from the distribution requirement by providing more extensive grant- making services — as many community foundations and other nonprofit sponsors do.
Prohibit private foundations from making grants to DAFs. Foundations that adopt this approach, whether for reasons of secrecy or because they want to stockpile resources, are clearly not doing so to advance the public good.
The practice should end, along with all transfers from private foundations and DAFs to 501(c)(4) groups. Many of the largest (c)(4)s are overtly political, supporting efforts that help a particular candidate or promote controversial legislation. Donors interested in funding such work should not receive the tax benefits and advantages that come with giving to foundations and DAFs.
These commonsense changes would not remove the appeal of DAFs as an easy and cheap way for wealthy people to give to charity. But they would help make the ACE Act a transformative piece of legislation — redeeming the legitimacy of DAFs at a time of growing criticism about how the philanthropic world operates while preserving their best features.
Note: This piece was updated on November 8, 2022.
