More than $110 billion that Americans have earmarked for charity are now housed in donor-advised funds. DAFs are a fundraising phenomenon that make it easy to set aside dollars for good causes and get significant tax benefits right away.
But while the dollars are flooding into DAFs, too few dollars are coming out. That is because the legal framework governing these funds is out of sync with the way tax incentives are supposed to work. The reason for tax incentives is to get people to take an action deemed good for society, in this case, to make funds available so that charities can use them in support of their mission. But with donor-advised funds, the system is backwards: the federal government provides donors huge tax subsidies upfront, handing them out when the donor sets up a fund or augments it, but there is no incentive to actually give the money away.
As legal scholars focused on public policy, we have long been concerned that the tax rules are not working as they should to get money to charities. When it comes to DAFs, we have advocated for the imposition of a payout term to ensure that DAF funds are distributed within a reasonable amount of time — say, a decade.
While a payout is one solution, as we have been studying the issue and hearing objections from sponsors of donor-advised funds, we have realized there is an even better approach that could maximize contributions, help donors save on taxes, and avoid abuses that lose money for the Treasury.
Our proposal essentially splits the tax benefit into two parts: Donors would get some financial benefits when they put money into the fund and receive additional benefits when they send money out of the fund to nonprofits they want to support.
To see why this idea makes sense, it’s important to understand how donor-advised funds work. When people put money into a donor-advised fund, whether at a community foundation or an organization like Fidelity Charitable or the National Philanthropic Trust, the donated funds are legally in the hands of the recipient organization, and the donor can never take the money back. Because of this transfer of legal title, DAF sponsors argue that transfers to DAFs should be treated the same as regular charitable donations (like an outright gift to a food bank).
However, unlike regular charitable donations, the organization holding the DAF does not expect to use DAF funds for its charitable mission but instead awaits instructions from the donor about where to send the money. DAF funds are not truly available to support a charitable mission until the donor makes an outright distribution to a nonprofit. DAF funds are held in a netherworld: The donor has given up legal title so cannot use the funds to buy a yacht or for other personal purposes. But the DAF money is not truly available for charitable use until a donor says so.
So we suggest the tax rules be changed to reflect the reality of donor-advised funds. Under our approach, just as happens today, when a donor transfers stock, real estate, or other assets that have grown in value, the donor would be able to avoid capital-gains taxes, and the property would be taken out of the estate for purposes of the estate tax. This reflects the reality that the donor can never get the property back.
But the donor wouldn’t get to take a charitable deduction just for giving to the fund. Instead, the donor would get that deduction every time dollars are sent out of the fund – and the more the donor distributes, the more valuable the deduction would be. So if the property went up in value while sitting in the fund, the deduction would reflect that increase in value.
This approach ties the charitable deduction to the behavior we all want to achieve – which is getting money to charity. Unlike current law, donors would have a clear incentive to make distributions from their accounts and to invest their DAFs in ways that achieve significant growth, both so they would have more to give to charity and so they would have access to a more sizable tax break.
Another reason this proposal is good for charities seeking donations is that it would offset the subtle incentives to hoard assets that are embedded in today’s system. DAF sponsors and donors’ financial advisers (who are often paid fees based on the amount of funds in the DAF) all profit when funds are retained in the DAF instead of being transferred to charity. That’s why you don’t often see aggressive efforts by sponsors to encourage donors to give big.
Further, there are many reasons well-meaning DAF holders may fail to make significant grants from their DAFs, including inertia and the perceived difficulties of making wise charitable decisions. In addition, behavioral economists have suggested that people often enjoy watching their accounts increase and may feel bad when their balances go down due to distributions. (This phenomenon is known as the endowment effect.) If donors could achieve bigger tax savings by sending generous donations off to their favorite charities, the incentives to hold on to assets would be greatly reduced.
Under our new system, donors would lose little that they like about donor-advised funds.
DAFs would still make it easy for donors to fund their charitable giving with appreciated stock and would still enable donors of complex assets (like privately traded stock and real estate) to get far better tax benefits than they would if their donation were made to a private foundation. What’s more, nothing would change about the other things that make donor-advised funds attractive. They would still offer efficiency by centralizing giving through a single account. They would still make it simple to channel sudden financial windfalls to charity, even before a donor has a philanthropic strategy set. And they still could be a strong tool for including family members in giving.
The only difference would be that DAF donors would have a continuing tax incentive to make distributions from their donor-advised fund, thus promoting more charitable activity.
Besides restoring common sense to the charitable deduction rules, our approach would also fix another problem with DAFs that ends up losing the federal Treasury a lot of money. Most donors give stock, real estate, cryptocurrency, interest in limited-liability companies, or other noncash donations to their donor-advised funds. The ability of DAF sponsors to convert these types of contributions into cash for charity — while generating significant tax breaks for donors — is a big reason many donors choose DAFs.
Unfortunately, however, the tax deduction is based on the appraised value of property at the time of contribution and not on the amount distributed to charity from the DAF account. For gifts of publicly traded stock, it’s easy to verify the price at the time it is donated. But in other cases, the value is based on appraisals paid for by donors, which can result in the federal government handing out deductions based on inflated valuations, not to mention a tax subsidy for the costs of maintaining and selling the donated property.
Our proposal to delay the charitable deduction to the time of distribution from the DAF would fix this problem, while also getting rid of the need for costly appraisals. That makes things less expensive for everyone and less prone to abuse.
Many of the organizations that sponsor DAFs say they don’t see a problem that needs to be fixed. They note that in the aggregate, donors send billions of dollars to charities from their accounts each year so today’s rules must be working fine and don’t need to change. They are right that DAFs distribute billions each year, but these distributions pale in comparison to the many billions more that are sitting in these accounts with no incentive for the money to get out the door to charity. Further, we don’t know how many of these distributions are just distributions to other DAFs, and so meaningless as a measure of charitable activity.
For example, one study conducted by the Economist magazine looked at the distributions from the three biggest DAF providers (Fidelity, Schwab and Vanguard) and found that the largest recipient of money from their DAFs was Fidelity Charitable, and the third largest recipient was the American Endowment Foundation, another DAF sponsor. In other words, a large proportion of reported DAF grants may not be not grants at all — but merely money moving from one donor-advised-fund sponsor to another.
Some DAF sponsors do want to encourage faster, more generous donations, but today they are effectively powerless to do so. If a particular DAF sponsor pushes donors to make distributions, donors can always move their money to another DAF run by a more obliging sponsor. Market forces have thus led to a DAF model that caters to donor preferences, giving donors far more control than policy makers probably ever intended.
That’s why we should use the occasion of the 50th anniversary of the Tax Reform Act of 1969, the last major legislation to set guidelines for charities and foundations, to ensure our system fairly balances public needs and donor interests. The 1969 law was formed in response to abuses of philanthropic money and put in safeguards designed to get money to working charities and out of the donor’s control.
Unfortunately, DAFs are undermining this regulatory framework by providing a way for donors to reap the benefits of contributing without making a full commitment to any particular charity.
Fixing the problem is simple and based on the bedrock principle that no charitable deduction should be available until donors give up complete control of their gift.
Suspending the income tax deduction until donors release their advisory privileges will promote more charitable activity and allow donors to continue to reap all the benefits associated with DAFs. We hope charities will join us to urge Congress to act. New legislation is the only way to guarantee that more dollars will flow more quickly to the causes that urgently need more resources to serve the public interest.
Roger Colinvaux is professor of law at Catholic University of America, where he also directs the law and public-policy program at the Columbus School of Law. He worked as a legislative counsel at Congress’s Joint Committee on Taxation from 2001 to 2008. Ray D. Madoff is a professor of law at Boston College, where she also directs the Forum on Philanthropy and the Public Good.