Take-Away: Distributions from a donor advised fund to a private foundation can change its nature to a public charity, thus circumventing the rigorous restrictions imposed on private foundations.

Background: Over the past year comments and concerns have been raised with regard to the perceived abuse of donor advised funds (DAFs.) Most of those concerns that are raised go back to 2017 when the IRS proposed closing a perceived DAF loophole, which is that the donor to his/her donor advised fund (DAF) receives a current charitable income tax deduction, but there is no corresponding obligation to make distributions from the DAF in the same year, or for any duration for that matter, to charities. In short, a present income tax deduction is generated, but the public must wait to a later date to benefit from that incentivized income tax deduction. However,  the IRS never followed up with any proposed Regulations to close this perceived loophole in delayed distributions from a DAF, although there are those in Congress who are currently threatening such legislation to compel distributions from DAFs within a set period of time, e.g. five years.

While the timing of distributions from a DAF to charities has gained considerable attention by commentators, the IRS, and some in Congress, often overlooked is yet another potential DAF abuse, which is the way recipient ‘charities’ treat distributions from a DAF for purposes of the IRC 501(c)(3) public support test. The same 2017 IRS Notice also referenced  this other ‘problem’ and suggested its ‘solution’ that deals with the ‘distributee’ charity. The IRS’s solution would treat distributions from the DAF sponsoring organization as coming from the DAF donor rather than the DAF sponsor for purposes of the public support test for charities. But again, the IRS failed to follow through with any proposed Regulations to address the public support ‘problem.’

Example: Donna wants to give $1.0 million to a charity that she controls, The LaDonna Foundation. If Donna gives the cash directly to The LaDonna Foundation, and no one else makes a charitable gift to The LaDonna Foundation, then that charitable entity is classified as a private foundation, subject to numerous legal restrictions, limitations and reporting obligations. However, if Donna gives the cash to a DAF she maintains at Fidelity Charitable, and she then advises  Fidelity Charitable to distribute the cash to The LaDonna Foundation, then The LaDonna Foundation is a public charity under the current Tax Code. The LaDonna Foundation becomes a public charity instead of a private foundation, even though Donna controls The LaDonna Foundation, and even if The LaDonna Foundation never receives any funds from anyone other than Donna (through her DAF.) Thus, by using a DAF as an ‘intermediary,’ Donna has created an entity that provides all the benefit of a private foundation, but which is not subject to any private foundation restrictions, limitations, or reporting obligations- it is treated as a publicly supported charity.

A Perceived Abuse: From the above example, Donna has created a fully-controlled charity that avoids a private foundation status. This becomes significant for a couple of reasons.

Compensation to Family Members: Under current law, DAF sponsoring organizations e.g., Fidelity Charitable, are not allowed to pay Donna or her children any ‘compensation’ out of DAF funds. However, Donna would be able to pay herself and her children compensation just like she could if The LaDonna Foundation was a private foundation, as well as reimburse travel expenses that are associated with The LaDonna Foundation’s activities.

Expenditure Responsibility: Under current law, private foundations and DAF sponsoring organizations must exercise expenditure responsibility if they make a grant to anyone or any entity other than a public charity. Yet The LaDonna Foundation is a public charity which does not have that obligation. Expenditure responsibility is a series of actions that the federal law requires private foundations and DAF sponsors to take to make sure that their grants are used for proper charitable purposes. A public charity does not, by far, have the same expenditure responsibility.

Example: Donna wants to give funds to support a presidential candidate. Donna is not supposed to use charitable dollars (which are tax deductible by her) as a source of those political contributions. If Donna creates a private foundation, it would be prohibited from making any expenditures to support a candidate or lobbying effort, but it could probably make a grant to an IRC 501(c)(4) organization to support that organization’s charitable activities, as long as the private foundation exercised expenditure responsibility to make sure that none of the grant was used for political purposes. If, instead, Donna used a DAF as an ‘intermediary’ that permits The LaDonna Foundation to avoid private foundation status. Accordingly,  The LaDonna Foundation could then make the grant to the IRC 501(c)(4) organization without exercising any expenditure responsibility. Moreover, if Donna already had funds in a private foundation, that foundation could use the DAF as an ‘intermediary’ to move the funds to The LaDonna Foundation, which could in turn distribute the funds to the IRC 501(c)(4) organization without being bound by any expenditure responsibility.

Blocker: In short, the DAF acts as a blocker for the original foundation’s need to exercise expenditure responsibility. The fact that The LaDonna Foundation qualifies as a public charity would relieve it from the requirement to exercise any expenditure responsibility.

Delayed Distributions: When a DAF is used as an ‘intermediary’, it does not itself delay the expenditure of charitable dollars. Instead, the DAF sponsor’s statistics about expenditures would probably show distributions to the controlled charities as current expenditures of those charitable dollars from the DAF. However, once those ‘charitable’ distributions were made to the recipient foundation, in our example The LaDonna Foundation, there is no need for The LaDonna Foundation to spend them on charitable purposes on any particular timeline. In fact, The LaDonna Foundation is not even subject to the annual 5% payout requirement that is imposed on private foundations.

Example: Donna has already created a private foundation. Donna could satisfy the 5% annual payout requirement for her private foundation by using a DAF as an ‘intermediary’ to distribute funds to The LaDonna Foundation, which qualifies as a public charity. The LaDonna Foundation could then sit on those grant assets for pretty much as long as it wants, just like other public charities can hold onto their assets for long periods of time.

Conclusions: The words tax abuse are thrown around lately when it comes to DAFs sitting on tax deducted dollars for several years before ultimately being granted to benefit public charities. The fact that charities can use DAF funds as public support dollars to avoid private foundation status means that unless that rule is changes, all other rules that regulate private foundations or DAFs will be easy to avoid. If we soon see proposed legislation to mandate distributions from DAFs within a fixed period from the date the tax deduction was claimed by the taxpayer for his/her contribution to the DAF, we can probably expect yet another change that treats a distribution from a DAF as coming from the DAF’s contributor, and not the public charity sponsor of the DAF.