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George F. Bearup, J.D. Senior Legal Trust Advisor

20-Aug-19

Donor Advised Funds- Proceed with Caution?

Take-Away: Recent litigation with regard to the Fidelity Donor Advised Fund should prompt donors to any donor advised fund (DAF) to add conditions to the fund.

Background: Thirteen years ago, with the Pension Protection Act, Congress required Treasury to examine concerns about possible abuses with regard to the operation of a donor advised fund (DAF.) Treasury responded in 2011 with its findings with regard to DAFs, which generalizing, did not find any abusive practices with regard to DAFs and their operation. Those key Treasury findings included: (i) donors did not control the gifted funds, despite the fact that there was a high rate of approval by the DAF of the donor’s recommendations; (ii) the lag-time between the gift to the DAF and the subsequent dispersal of funds from the DAF to charities was as no different than a direct gift to a charity when the funds were actually used or expended by the charity; and (iii) there was no need to mandate minimum annual distributions from a DAF, like there is with a private foundation, because the average payout rate from the DAF was more than 5% a year, i.e. a DAF did not act as a warehouse for charitable dollars, as the average payout rate from a DAF was about 21%. Since 2011, DAFs as a percentage of all charitable contributions has risen from 4.4% to 10.2% (as of 2017.) In short, DAFs have emerged as a commercial force in philanthropy.

DAF Investment Recommendations: The Tax Code acknowledges that a donor may make recommendations of investments of contributed funds to a DAF. [IRC 4966(d) (2).] Less clear is how much the DAF must follow those investment recommendations.

Fidelity DAF: Along with the rise of influence of DAFs in philanthropy over the past decade, Fidelity DAF has emerged as the giant in the world of philanthropy. The Fidelity Investments Charitable Gift Fund now receives more annual support than any other public charity. Currently the Fidelity DAF holds $16 billion in assets of the $85 billion DAF market as a whole. Which is why a recent lawsuit against the Fidelity DAF by donors may draw some renewed attention to the operation of DAFs by Congress.

Lawsuit: Fairbains v Fidelity DAF: A complaint was filed, and a court has denied Fidelity DAF’s motion for summary disposition. Consequently, the litigation is now headed to a jury trial.

  • Facts: The donors funded their Fidelity DAF with $100 million in publically traded stock, which they intended to use to fight Lyme disease through distributions over several years. The gift to the DAF was in the form of their publically traded company stock- Energous. The problem was that Fidelity DAF promptly sold that gifted stock, which constituted 16% of the day’s trading volume in Energous, and 35% of the total Energous trading volume over a 3-hour trading window. Needless to say, the gift, which represented 10% of all of the outstanding stock in Energous, lost significant value due to ‘blockage’ valuation discounts when the stock was ‘dumped’ by Fidelity onto the market in such a short period of time. The Fidelity DAF written policy stated that it would liquidate any non-cash gift at the earliest date possible. With the sale of the Energous stock in such a short period of time, there resulted in far less funds in the donors’ Fidelity DAF in which to carry out their charitable objectives. Mr. Fairbains claims that the Energous stock was quickly liquidated by Fidelity DAF by the end of the tax year in order to meet bonus requirements for assets under management (AUM).
  • Claims: The donors sued Fidelity DAF for misrepresentation, breach of contract and negligence. Apparently the donors made advisory recommendations on how Fidelity DAF should handle the liquidation with the intent to minimize the timing a rates at which the donated stock would be liquidated. Fidelity DAF ignored those recommendations and followed its earliest date possible

Planning for DAFs: If an individual is considering the use of a DAF, consider the following:

  • Liquidation Policies: If publically traded stock is the subject of the contribution to the DAF, a donor should initially consider the DAF’s policy, like Fidelity’s, which is to liquidate at the earliest date possible. The DAF’s policy should permit consultation with the donor with respect to the timing and rates at which the donated securities are liquidated. If the liquidation of the donated assets will have a direct impact on the amount that is ultimately available to be gifted from the donor’s DAF to fulfill philanthropic objectives, then any agreement by the DAF sponsor with regard to following the donor’s liquidation recommendations should be reduced to writing.
  • Competitive Fees: One of the claims in the Fairbains lawsuit is the competitive nature of the DAF business, especially in the advisory fees that are charged. Apparently, there could have been substantial savings in fees between competing commercially sponsored DAFs. The complaint claims that the difference between JP Morgan Chase DAF fee and Fidelity DAF fee was 0.12% annually. The claim is that the difference for Mr. Fairbains would have been about $120,000 annually over the duration of the DAF that would have been available to recommend gifts. Consequently, donors should shop for the fees that will be charged to manage their donation and balance those fees against the policies of each DAF. Mr. Fairbains opted to hire the Fidelity DAF at the lower advisory fee, which should have been balanced against the risk that Fidelity DAF would ignore his recommendations for how, and when, the donated Energous stock would be liquidated. In short, how the DAF is compensated, e.g. assets under management (AUM) might present a conflict, especially if bonuses are tied to that AUM at the end of a calendar year.

DAF v Private Foundation: A DAF provides many advantages to a donor over the creation and administration of a private foundation to carry out philanthropic objectives. Some of those DAF advantages include:

  • Deductibility: With the DAF the income tax deduction is 30% of the donor’s adjusted gross income (AGI) vs a 20% AGI income tax deduction at fair market value for contribution to  a private foundation (PF)
  • Anonymity: With a DAF, there is donor anonymity vs an annual Form 990 must be filed with the IRS (a public record) for a PF.
  • Annual Fees: With a DAF there is an annual fee for AUM, but no legal or accounting fees vs perpetual fees for both AUM as well as legal and accounting fees.
  • Control: Obviously, a private foundation is better than a DAF if the donor insists on complete control over distributions to charities, or if the donor wants to use the entity to fulfill a pledge, as DAFs cannot be used to fulfill outstanding pledges. In addition, a private foundation can ‘reverse’ the decision to fund the private foundation by the transfer of the private foundation assets to a DAF, while the assets held in a DAF cannot be transferred to a private foundation.

Conclusion: Clearly DAFs have gained tremendous popularity over the past decade as indicated by the amounts now held in DAFs nationwide. Do not be surprised, however, if Congress starts to examine the compensation and fee arrangements between the DAFs and their for-profit affiliates. The Fairbains litigation may bring new attention to DAFs, not so much as a concern as an abusive tax scam exploited by donors, as a ‘charitable monopoly’ held a handful of large for-profit financial investment firms.