The IRS must introduce tax reforms to regulate donor-advised funds. Here are some proposals to consider.

by Sana Satpathy

As tax time approaches, the top one percent of US earners are meeting with their accountants to catch-up on the hottest tax shelters in the market. In accordance, they are emphatically setting up donor-advised funds in lieu of private foundations as a vehicle of charitable giving. Donor-advised funds are the fastest growing phenomenon in the philanthropic world – contributions to such funds increased 16.9 percent between 2014 and 2018, with charitable assets estimated at $121.42 billion in 2018. Donor-advised funds are also the most controversial phenomenon in the philanthropic world. Top tier donor-advised fund programs such as Fidelity Charitable, Vanguard Charitable and the infamous Silicon Valley Community Foundation have drawn unremitting criticism from academics and policymakers, mainly for hoarding assets indeterminately to maximize management fees at the cost of public expenditure and avoiding federal disclosure rules. Given this dichotomy, it is worth examining why donor-advised funds are a popular philanthropic instrument, how they influence public benefit and why they necessitate stricter regulation. 

Donor-advised funds allow donors to reserve assets (cash, real estate, stocks, etc.) for specific charities of their choice and secure an immediate and sizeable tax break on the amount reserved. To put things in perspective, in addition to receiving income tax deduction on the contribution, the donor incurs zero capital gains tax on appreciated assets and zero estate tax on inherited wealth. But here’s the kicker – unlike private foundations, donor-advised funds don’t mandate that the charitable giving actually occurs. They permit funds to remain stockpiled for an indefinite period, and be passed from generation to generation as legacy, preserving the donor’s money and political influence without spending a single dollar towards public good. Further, they can be used as dumping grounds for privately held stocks that are anticipated to depreciate in the market without any tax consequences. In other words, donor-advised funds serve as tax shelters for the wealthy that facilitate tax-free investment appreciation and disposal of bad stocks in pursuance of an uncertain, hypothetical public benefit.

The lack of a payout mandate not only deters donors from forwarding grants to charities once the tax benefits have been claimed, but also incentivizes fund managers to advertise donor-advised funds as charitable assets to be managed rather than distributed, as they earn fees for managing the assets. Further, donor-advised funds provide a safe haven for dark money by offering a veil of anonymity to donors – there are no legal provisions for tracking the original source (donor) of grants to a charity’s account. An archetypal example of billionaires relying on donor-advised funds to swindle the system is that of Nicholas Woodman, CEO of GoPro. When GoPro was at its peak in 2014 and Woodman was worth $3 billion, he parked $500 million in GoPro stock at the Silicon Valley Community Foundation. He got tax write-offs on $500 million. As GoPro became less popular and the company’s stocks depreciated, so did the value of his reserved donation.

In their current form, donor-advised funds prompt a substantial loss of efficiency by caching money that is earmarked for public good through tax expenditure and letting it sit idle in the donation warehouse. However, with improved regulation, donor-advised funds can be a viable alternative to private foundations that augment the contributions available to charities through appreciation of assets. 

The Internal Revenue Service (IRS) has done plenty to regulate donor-advised funds, as manifested by the agency’s notice vis-à-vis imposing excise taxes on certain donor-advised funds. Nonetheless, critics argue that donor-advised funds warrant stricter regulations given their rapid growth and weakly established industry standards. Dean Zerbe and Ray Madoff, amongst other academics, have analyzed the issue extensively and proposed several strict IRS laws for donor-advised funds. I recommend the following as the most effective and feasible propositions for the IRS’ consideration:

  • Delay in tax deduction benefits: Conceivably the most effective way to ensure that donor-advised funds pump money out to charities is to delay tax deductions until after the funds have been distributed. This would encourage donors to fast-track the distribution of grants, so that they can claim their tax benefits as soon as possible. It would also establish greater equity in the exchange between public benefit and tax expenditure – deductions would be applied on the true amount disbursed to charities rather than the appreciated or depreciated amount.

However, the administrative labor and costs associated with recording and tracking multiple donations for tax purposes are significantly higher than those of a single contribution to a fund. This might dissuade people from contributing to donor-advised funds as an alternative to private foundations. More importantly, delay in tax deduction benefits would defeat the purpose of a donor-advised fund by robbing it of its ability to augment the donation pool. If donors begin to fast-track grant distribution to claim tax benefits, the endowment would lose the opportunity of tax-free appreciation.

  • Mandating a minimum payout rate: Currently, the IRS requires private foundations to disburse at least 5 percent of their net assets annually to public charities, but there is no such requirement for donor-advised funds. The IRS should mandate a minimum payout rate of 15 percent given that the donation threshold for donor-advised funds is 10-20 percent more than that for private foundations and the former don’t face any excise tax under ordinary circumstances. The law should also require that funds are spent within a stipulated period of time, perhaps after the endowment has earned considerable interest and before it becomes a liability. Unlike delayed tax deductions, this would not discourage clients from contributing to donor-advised funds and ensure that fund managers are held accountable.
  • Ban donation of cryptocurrency and privately held stocks: Both cryptocurrency and stocks are malleable to market conditions and are at high risk of depreciation. Since 2015, Fidelity Charity has received $106 million in cryptocurrencies; the value of these donations in real terms is substantially lower today. To the extent possible, donations should be limited to cash and real estate, so as to ensure that the investments earn steady interest and the risk of depreciation is minimized. Because these funds are reserved for public good and not personal gain, it is prudent to be risk averse. 

In order to optimize efficiency and ensure timely distribution of donations to charities, mandating a minimum payout rate with disbursement schedules is a crucial fest step. Concurrently, specification of permissible assets for donation is essential for risk mitigation. In exceptional cases, the IRS could permit donation of cryptocurrency and privately held stocks with the condition that tax deduction benefits for volatile assets such as these be delayed until distribution. The enforcement of these laws is essential to ensure that donor-advised funds fulfill their intended purpose of serving public interests, rather than being a safehouse for the protection of private interests. 

Sana Satpathy is a first-year MPP student at the UC Berkeley Goldman School of Public Policy and Co-Editor in Chief of the Berkeley Public Policy Journal.

The views expressed in this article do not necessarily represent those of the Berkeley Public Policy Journal, the Goldman School of Public Policy, or UC Berkeley.