Donor-advised funds reeled in a record-breaking $29 billion in contributions last year, and with new wealth comes heightened scrutiny. Critics charge that DAFs are warehousing philanthropic dollars, with contributions pouring in but only trickling out. The warehousing phenomenon is all the more objectionable, say critics, because DAF donors can claim tax deductions when contributions go in even though years may pass before any money reaches active charities.
The latest proposal for DAF reform comes from Roger Colinvaux and Ray Madoff, law professors at Catholic University of America and Boston College, respectively. Colinvaux and Madoff are thoughtful and accomplished scholars of nonprofit law whose ideas attract wide attention — and rightly so. Their suggested reform — under the headline “A Donor-Advised Fund Proposal That Would Work for Everyone” — would deny DAF donors a charitable-contribution deduction until money is distributed from their accounts to an active charity. At the time of distribution, under Colinvaux and Madoff’s proposal, donors would be able to deduct the amount paid out to charity (which may be more than donors put in if their DAF investments appreciated in the interim). This, the authors argue, would encourage DAF donors to put their charitable funds to use quickly rather than allowing dollars to languish in DAFs for lengthy periods.
Colinvaux and Madoff’s idea is, in some respects, a “light touch” approach to DAF reform. Contrast their proposal with alternatives that would require DAFs to distribute funds within a short timeframe (e.g., five years) or to pay out a certain fraction of their assets annually (e.g., 7 percent). Colinvaux and Madoff would not require anyone to do anything; they would instead delay (but not deny) tax benefits. Theirs is a nudge rather than a hammer.
Nonetheless, the Colinvaux-Madoff proposal would have wide-ranging ramifications for DAFs and their donors. It would stymie taxpayers who seek to use DAFs to spread philanthropic activity across the life cycle. It would dramatically reduce the tax benefits of DAFs for middle-income donors. And it raises the potential for unintended and unwanted consequences.
Timing the Incentive to Donate
Start with the implications for life-cycle giving. The charitable-contribution deduction — being a deduction, rather than a credit — is most valuable for high-bracket taxpayers. It’s also capped as a percentage of adjusted gross income so taxpayers can claim larger (and more valuable) deductions in their peak income-earning years. As a result, individuals have an incentive to donate when their take-home pay is highest, which — not coincidentally — is also when they are busiest.
DAFs allow taxpayers to claim charitable-contribution deductions when those deductions are most valuable and then distribute funds to charities when they have time to do so thoughtfully. (Private foundations serve the same purpose but with higher start-up and maintenance costs.) Colinvaux and Madoff’s proposal would undo that benefit. If taxpayers cannot claim deductions until DAF dollars are distributed, then taxpayers will again face a stark choice between rushing their donation decisions or forgoing maximum federal tax benefits. It’s hard to see why, from a societal perspective, that’s an attractive result.
The life-cycle giving function of DAFs is all the more significant in the wake of the December 2017 tax law, which nearly doubled the standard deduction and thus reduced the number of taxpayers who will itemize deductions on their returns. Some taxpayers have responded to this change by “bunching” their charitable contributions into a single year. For example, instead of making $10,000 of charitable contributions (well below the $24,400 standard deduction for couples) for five years and receiving no federal tax benefit as a result, a couple might donate $50,000 to a DAF one year and nothing for the next four. The taxpayer will itemize deductions in the bunched year and claim the standard deduction in others.
Colinvaux and Madoff would not outlaw bunching, but they would make it much more difficult. Not only would donors have to bunch their contributions into a single year, but they would have to bunch all of their distributions into that year too. This raises the same concern as above about rushed decision making. It pushes philanthropy to operate on federal tax law’s timetable.
Bunching, to be sure, is only necessary because of the way Congress has chosen to structure charitable tax benefits. As Colinvaux and Madoff (and others) have argued, a better approach would be a charitable credit available on equal terms to all taxpayers — regardless of their tax bracket and whether or not they itemize deductions on their returns. While a well-designed charitable credit would obviate the need for bunching, enacting the Colinvaux-Madoff proposal piecemeal without a broader reform of charitable tax incentives would eliminate an imperfect fix without solving the underlying problem.
A Boomerang Effect
Beyond the implications for life-cycle giving and bunching, Colinvaux and Madoff’s proposal has the potential to boomerang — to make DAFs more attractive and to encourage taxpayers to delay donations even longer. The reason is simple: Funds inside a DAF grow tax-free while funds outside a DAF don’t. Under Colinvaux and Madoff’s proposal, then, donating to a DAF and keeping the money there would be like investing your charitable contribution deduction in a Roth IRA or any other tax-exempt account.
To make the math straightforward, imagine that the tax rate is 40 percent and that investments double over a decade. A taxpayer who gives $1 million to charity today will receive a charitable-contribution deduction worth $400,000. If she reinvests those funds, her $400,000 will become $800,000 pre-tax — or $640,000 after-tax — 10 years from now. If instead she puts $1 million in a DAF today, leaves it there for a decade, and then distributes the resulting $2 million to charity, she will be able to claim a deduction worth $800,000 then. Bottom line: She ends up with $640,000 after-tax without a DAF and $800,000 after-tax if she uses a DAF. The benefit is larger the longer she delays distributions.
There are a number of additional complications that Colinvaux and Madoff’s proposal would raise. One involves inherited DAFs. If a DAF donor dies and names her child as a successor, will the child be able to claim a charitable-contribution deduction when funds from the DAF are paid out? There is no obviously right answer to this question. Denying the deduction would put pressure on late-in-life donors to accelerate gifts lest their families lose the tax benefit for good. Allowing the deduction would open up the possibility that DAFs could be used as a tool for estate-tax avoidance.
Another wrinkle involves sponsor supervision of DAFs. Under current law, a DAF-sponsoring organization can refuse to honor a donor’s grant recommendation (e.g., if the donor recommends a grant to a tax-exempt hate group). If the donor retains an entitlement to a tax deduction when DAF dollars are distributed to an active charity, will it be harder for DAF sponsors to refuse grants to groups whose missions are antithetical to the sponsoring organization’s own values?
These concerns aside, Colinvaux and Madoff’s proposal advances an important discussion about DAF reform. Some current uses of DAFs should raise consternation even among DAF defenders. It’s hard to argue, for example, that private foundations should be permitted to use DAFs to satisfy payout mandates or skirt disclosure requirements. Our current regulatory regime for DAFs is certainly not perfect, and Colinvaux and Madoff are much-needed voices in a worthwhile debate.
But delaying deductions for DAF donors is no place to start. Not only would it undermine the utility of DAFs to life-cycle givers and small-dollar donors but it also could cause high-bracket taxpayers to hold money in DAFs even longer. Rather than the win-win that the authors describe, this is a DAF reform that should please no one.
Kate Harris is a second-year student at the University of Chicago Law School. Daniel Hemel is an assistant professor at the University of Chicago Law School and a visiting professor at Harvard Law School.