The Philanthropy Project is not anti-DAF… and here's why
When people hear about the Philanthropy Project, sometimes we hear back, "But I think donor-advised funds (DAFs) can be useful."
We agree! We are not anti-DAF. We do not favor getting rid of DAFs.
We aren't anti-car, but we think there should be speed limits. We aren't anti-beer or anti-cocktail, but we support drunk-driving laws. Morphine is a crucial drug for severe pain, but we're glad it's regulated.
To be perfectly clear: we are not anti-DAF. DAF accounts can serve as efficient and generous tools to manage charitable contributions, which the world needs more of. We are, however, against the ways DAFs get used for private benefit, to support illegal activities, or when Wall Street firms manipulate tax deductions and their fees through DAFs.
"But I use my DAF responsibly and so do my friends who have DAFs!"
That's wonderful to hear. You and your friends probably also don't drive drunk. But we still need laws against drunk driving.
"If I want to put $10 million into a DAF and let my children decide after my death whether and how to give it out, I should be able to."
Yes, you should! But you shouldn't get an immediate charitable tax deduction just for socking it away now. Instead, you or your children should get a tax deduction when it is converted into an actual public benefit. That result does deserve a tax deduction.
So what do we think? The speed limits and impaired driving laws should be for donor-advised funds, private foundations and endowments. Promoting effective policies on this question is just what the Philanthropy Project is about.
When does 5% not equal 5%?
When does 5% not equal 5%?
A simple guide for the perplexed on private foundation payout
BY DAN PETEGORSKY
Super-smart researcher and analyst Dan Petegorsky explains why the "required 5% payout" for foundations isn't what it appears, in particular because their own expenses count towards the requirement.
It is common knowledge that private foundations are required to pay out 5% of their assets each year, but what does this actually mean? A short answer would be some 5% of X (defined below) must be used for expenditures for public benefit.
What tends to be less well known is how and why private foundation payout numbers just don’t seem to add up when people look at foundation tax filings.
How do we get to what’s called the payout rate? The answer is relatively straightforward (with a few wrinkles), though the terminology and the details of the precise calculations can indeed be mystifying:
- “Assets” doesn’t mean the total net assets figures that show up on Part I of the 990PF form, and
- “Payout” doesn’t mean just the amount the foundation spends in grants.
So how does the IRS determine how much a foundation is actually supposed to pay out?
Instead of “payout” the IRS uses the term “Distributable Amount” (Part X, Line 7). That amount is based not on taking 5% of all the foundation’s assets, but of what it calls the “Net value of noncharitable-use assets” (Part IX, line 5). Since assets can include things like the offices and equipment the foundation uses in furtherance of its charitable activities, we’re mainly talking about the market value of the foundation’s investments. And the foundation subtracts 1.5% to allow for cash it uses for charitable activities. The IRS calls this 5% the “Minimum investment return” (Part IX, line 6). The following examples are from the 2023 Form 990PF of the Evelyn and Walter Haas Jr Fund:
To get from there to the amount the foundation is required to distribute, the IRS deducts the 1.39% federal excise tax the foundation pays on its investment income, and certain business expenses (Part X, lines 2a-c), and then adds in things like any grants that they have counted in the past but have been returned (Part X, line 4).
So that’s how you get to what we colloquially call their payout requirement (Part X, line 7).
How does the IRS figure out if the foundation has actually distributed what it was supposed to?
As noted above, “payout” doesn’t just mean grants. The term the IRS uses is “Qualifying Distributions” (Part XI). What else goes into “qualifying distributions” besides grants? In the simplest terms, the main elements are:
• Expenses related to the grantmaking activities of the foundation, reported on Part I lines 13-23, “including necessary and reasonable administrative expenses, paid by the foundation for religious, charitable, scientific, literary, educational, or other public purposes, or for the prevention of cruelty to children or animals” (from the IRS 990PF instructions, p. 16). These can include the usual categories any nonprofit incurs: salaries and benefits, occupancy expenses, other professional fees, and travel and event expenses - e.g., for board meetings. (These qualifying distributions do not include the costs of managing investments.)
Clearly there are many judgment calls involved in foundation spending decisions, particularly deciding whether these expenses are necessary and directly “relate to activities that constitute the charitable purpose(s) of the foundation.”
These expenses are called “Distributions for charitable purposes,” and are detailed on the first page of the 990PF, in Part I, column (d), lines 13-26, with the total carried over to in Part XI, line 1(a).
• Program related investments. This is a larger topic, but basically these are investments that align with the foundation’s purpose and that generate below market returns. They are allowed to be counted just like grants, and are summarized in Part XI line 1(b), with details on Part VIII-B.
The IRS form does not itself report what the foundation’s actual “payout rate” would be. Instead, Part XII reports how much the foundation’s Qualifying Distributions have either exceeded or fallen short of the Distributable Amount. In a nutshell:
- If they’ve given out more than the minimum, they’re allowed to carry over that amount into the next years (for as long as 5 years) in case they fall short in the future (Line 9).
Since the Haas, Jr. Fund consistently distributes more than the required amount, this amount grows from year to year. - By contrast, if the foundation has fallen short of the requirement, then Line 6(f) shows the amount of “undistributed income” they’re required to make up in the following year. If they then fail to distribute that amount they’re required to pay a 30% excise tax on the amount they fall short, which then gets even steeper if they still fail to pay up. (More about the surprising dollar totals in “undistributed income” to come – a critical compliance matter and trapped value problem – ripe for a future examination.) The following example is from the 2023 Form 990PF of the Lilly Endowment.
First, Part XII, line 1(d) shows the amount the foundation is required to distribute in 2023. Note, however, that Line 2(c) shows that in 2022 they had fallen some $1.4 billion short of meeting that year’s requirement:
So before applying any of their 2023 qualifying distributions (Line 4) to meet the 2023 requirement, the foundation first needs to make up for the 2022 that shortfall, leaving just $125.5 million to meet the 2023 requirement:
The result is that the foundation carried forward an even greater amount of undistributed income - $2.1 billion – that it needs to make up in 2024 (Line 6f):
That’s the fine print. And what about the payout rate? Using IRS terminology, it equals Qualifying Distributions divided by Net value of noncharitable use assets. So for our two examples:
| Year | Net value of Year noncharitable use assets | Distributable Amount | Qualifying Distributions | Payout Rate | |
|---|---|---|---|---|---|
| (Part IX line 5) | (Part X line 7) | (Part XI line 4) | |||
| Evelyn And Walter Haas Jr Fund | 2023 | 453,710,585 | 22,473,663 | 29,523,422 | 6.5% |
| Lilly Endowment Inc | 2023 | 45,493,346,401 | 2,247,414,647 | 1,548,655,658 | 3.4% |
ABOUT THE AUTHOR: Dan Petegorsky is a consultant to the Institute for Policy Studies and other infrastructure leaders. He is formerly the policy director for the National Council for Responsive Philanthropy. You can read more of his writing here: https://ips-dc.org/ips_author/dan-petegorsky/
A CPA Speaks Out: Why DAF Rules Annoy Me So Much
Hilary Crosby's CPA firm, Crosby & Kaneda, has audited and helped countless nonprofits and foundations in California and beyond. She is also a volunteer for many important community causes. But at the beginning of her career, she owned a hot dog restaurant that was named "Best Hot Dog in Boston." As a nonprofit auditor (and former hot dog maven), here are some of her thoughts on donor-advised fund (DAF) donations:
One of my early jobs was working as a bookkeeper for the ACLU. There I saw people working hard and with so much smarts and big hearts to help people and seek justice. I realized that I couldn't do what they did, but I could support their work through bookkeeping. They also encouraged me to get my CPA, which I did. I hated to see nonprofits spend too much of their charitable dollars on audits. Throughout my career, I've been proud to support so many people and causes through affordable audits and by basing our work on the values we share with our clients.
So it makes me angry to see charitable dollars going to waste.
Philanthropy Project readers probably already know that the Internal Revenue Code Section 501(c) describes 24 different types of nonprofits such as Black Lung Benefit Trusts, Cemetery Companies and Homeowner Associations. But I just want to talk here about 501(c)(3) organizations that are religious, educational, charitable, scientific or literary organizations that do nice things for people. These organizations help people, often by doing the things the government should be doing, or doing things to alleviate harm caused by big business. Such organizations aren’t just exempt from income tax themselves, but their donors don’t have to pay income tax on the money they give to them.
That feature was added to the tax code during World War I to encourage people to donate to help each other out because at that time the government was spending a lot of money to fight a war to end all wars. (It didn’t turn out that way, but you already knew that.)
I'm not talking about the couple bucks you toss into a guitar case of a street musician, or the money you give through a Facebook request. That’s pretty standard behavior and is included in the “standard” deduction that most people take on the annual tax filing. In 2019, over 86% of tax filers just took the standard deduction.(1)
Only 14% of taxpayers can now use the charitable tax deduction
That means that only 14% of people were able to take the financial tax advantage of making donations to nonprofits. They can give regular money or appreciated stocks and other investment products to a favorite charity. (Obviously not folks living paycheck-to-paycheck or only on social security income.)
Donors with extra cash (and a desire for an immediate tax deduction) can establish a donor-advised fund (DAF) inside a DAF sponsor (often a community foundation or financial investment firm). There are usually minimums to establish such a fund, which can be $5,000 or more. (Obviously not folks who are using their “excess” cash to pay for braces or tires or home care for an infirm parent.)
If such a donor has a family foundation (think Uihlein or Coors), they can shield up to 50% of their adjusted gross income from income tax by giving to their private family foundation, where they maintain control of when and where it goes to nonprofits.
Donor Advised Funds Sitting around
Donor-advised funds sit around waiting for the donors to advise the other charities where to give them. Private foundations have to pay out 5% of their equity each year, but that payout can include the foundation's rent, salaries, family travel expenses and so forth. In both cases, funds can sit in investment accounts for decades with the donors maintaining control.
And when they do make grants, donor-advised funds do not have to report where they made those grants. (These grants from DAF funds end up listed undesignated in the midst of a lengthy 990 report of their DAF sponsor.) They might designate their grants to charities they believe are doing good. Or they can make them to a university their children are applying to. Or to think tanks that develop legal arguments to support the donor's family business or financial interests.
Should wealthy individuals and families be able to get immediate tax deductions, then still control those funds—including deciding to give none or less than 5% out?
If I could vote on this, I’d vote NO.
A Fundraiser Speaks Out About DAFs
Nonprofit voices are crucial to the dialog about philanthropic reform. Thank you Victoria Williams – a real life fundraiser! – for sharing your perspective:
Data shows that donor-advised funds (DAFs) have exploded in popularity, and, as a fundraiser for New York City-based nonprofits, I've felt that first-hand over the past decade. At first, this news sounds positive because more money to DAFs means more money to charitable causes, but that’s not been my experience.
Most DAF donations I’ve processed are from donors who already knew my organization. From what I could tell, having a DAF did not signal that they were more generous or thoughtful in their giving than a donor who did not.
Tax years and human nature
What I do know though, is that these donors, like most major donors, are taking into consideration what tax year their gift will be made in. After all, if a specific tax year isn’t an incentive, there’s little reason to go through the extra steps of creating and funding a DAF instead of simply using a credit card to make an online gift the moment you feel compelled to give. The tax benefit drives a sense of urgency for most donors to make a gift now (instead of delaying it indefinitely).
If DAFs become even more widespread among everyday donors, I’m concerned the urgency to give to a nonprofit in a certain year to receive a tax benefit will essentially disappear. Without that urgency, I see donations going down from individual donors to operating nonprofits like the children and youth organizations I’ve fundraised for. Not because DAF donors don’t want to be generous or are bad actors, it’s simply human nature to let the funds linger if you get busy or are undecided about what donation to make
And from the DAF sponsors' perspective, having funds sit there a little longer benefits them. That money can be invested, and they get a fee for doing so — typically a percentage of the assets under management. It’s a perfect setup for everyone. . . except operating nonprofits and the people and causes they serve. Without a mandatory pay-out rate or sunset date for DAFs, charitable assets are getting stuck for an indeterminate amount of time before ever making a positive impact.
Being on the inside of nonprofits with a range of mission areas from supporting youth in foster care to small businesses, I know first-hand that securing reliable funding is a continual challenge that’s only getting worse with the reduction of federal funding. It’s very frustrating as a fundraiser to know there are hundreds of billions of dollars in DAFs waiting to be directed to charitable causes. Those funds are not helping communities until they’re disbursed.
So what can we do about it? Lots!
I agree with the four public policy areas that the Philanthropy Project is focusing on. But I want to add a fifth one: I see an issue with financial institutions hosting DAFs through associated nonprofits. Logically, it sets a clear incentive for them to grow and maintain funds held in their coffers. To further emphasize this point, I saw a job posting recently from a bank-associated DAF for essentially a major gifts officer focused on new high-capacity donors. They didn’t have their own grantmaking fund to raise money for, they simply wanted more funds to manage in their DAFs because, clearly, it’s a revenue stream for the bank.
Until DAFs provide meaningful charitable advising that connects clients with organizations and, very importantly, incentives for actually distributing funds, the uptick in DAFs is akin to taking funding away from operating nonprofits that are urgently in need of resources today.
Ideally, DAFs bring more funding into the nonprofit sector but that’s only meaningful if the money actually goes to operating nonprofits in a timely manner. Funds sitting in a DAF account connected to a big bank and creating revenue for these banks isn’t cutting it. This chokehold on funding is hurting authentic, operating nonprofits – and thereby the people we serve – and we need change.
—
Victoria Shadle Williams is a career nonprofit fundraiser and has served as the chief fundraiser at two NYC-based nonprofits with budgets of approximately $4M. Her varied professional experience has included being a development associate at an arts nonprofit with a $3M budget and a development officer at a $100M+ education and social services nonprofit. In addition to her practical experience in the field, Victoria earned her Master’s in Nonprofit Management from Columbia University and has returned as an associate instructor since 2020. She was a founding board member of a grassroots nonprofit, NACHMO, and is currently the nonprofit liaison for Lancaster County Women for Good (a local giving circle) and an active Association of Fundraising Professionals member.
The Wink-Wink Organizations
An obscure American sub-genre is that of products that proclaim to be useful in a certain way, but nobody – I mean nobody – uses it for that. Example: Q-tips. Their ads show women gently stroking their cheeks with Q-tips, but everyone buys them to clean out their ears. But Q-tips can’t say that.
Another example is vibrators – according to ads, used to relax arm and back muscles. At least that’s how I use mine! Sexual use goes unmentioned by either the seller or the buyer.
These are wink-wink products. The ads wink at the buyers, who wink knowingly back. The unspoken business driver hides behind a wink.
What are the wink-winks in the nonprofit community?
The most obvious: donor-advised funds (DAFs). Advertised and promoted as a way for people to make donations to nonprofits conveniently and “strategically,” but behind the wink is their real purpose, performing as a tax avoidance mechanism.
On paper, the person gives the money to a financial institution such as a Wall Street investment firm or a community foundation, which then assumes legal control of the funds – immediately making the transfer a tax-deductible contribution. Technically the donor – now a donor-advised fund account holder – “recommends grants from the DAF sponsor to chosen nonprofits.” But the business model relies on a wink – the investment firm will follow the account holder’s instructions. Only in a rare set of circumstances (when the recipient is not an eligible tax-exempt organization) does the sponsor exercise real control and decline the disbursement.
In fact, donor-advised funds are increasingly discussed – and used – just like any other financial asset. Individuals feel that they have a house, a checking account, an investment account and a DAF in their overall portfolio. They are encouraged to leave their DAF to their children – technically naming the children as "successor advisors," but in reality deeding control as part of their generational wealth game plan. Wink wink.
For wealthy individuals, donor-advised funds come up first as a tax strategy. A former development officer for a large community foundation told me that in every single instance, they were approached first by a wealth advisor exploring tax benefits, who would then raise the idea with their clients.
A nice side benefit: with large donor-advised fund accounts, the individuals' wealth advisor or wealth manager can continue to "recommend" the buying and selling of investments. The wink? The DAF sponsor is the legal wealth manager, but they accept the direction of the donor's wealth manager, who often continues to earn fees based on the asset size of the DAF.
The business incentive for DAF sponsors and wealth advisors is to keep DAF monies in the DAF. "We're a smart way to give" is the pitch. Wink wink.
There are other wink wink nonprofit endeavors, including Type III Supporting Organizations, neutral voter registration, non-cash donations, and others. Some wink wink efforts slide right into fraud. As with DAFs, there are honest people doing honest things with wink winks, but the business model relies on a very big wink.
