IRS Releases First Installment of Long-Awaited Donor Advised Fund Regulations | Insights

Authors:

Gil J. Ghatan , Franziska Hertel , Kendi E. Ozmon

On November 13, 2023, the Department of the Treasury and IRS released the first installment of long-awaited Proposed Regulations (REG-142338-07) providing guidance on certain tax rules relating to donor advised funds (“DAFs”). A DAF is an account that is maintained by a charitable organization (the “sponsoring organization”) and funded by contributions from donors who retain advisory privileges with respect to the distribution or investment of amounts in the fund. Because DAFs are sponsored by public charities, they have historically been able to offer many of the same benefits as private foundations without being subject to the restrictive private foundation rules.

To guard against perceived potential for abuse, Congress, as part of the Pension Protection Act of 2006 (“PPA”), added special rules enforced via excise taxes that (1) govern transactions with and benefits received by donors, donor-advisors, and certain other persons, and (2) address distributions from DAFs, including “taxable distributions.” The Proposed Regulations expand upon interim IRS notices to provide guidance on the interpretation of key definitional terms of the PPA, clarifying the scope of accounts treated as DAFs and the distributions constituting taxable distributions, and will necessarily impact the application of other rules for DAFs. Future guidance is expected to address additional rules relating to DAFs, including when distributions from a DAF provide a more than incidental benefit to a donor or donor-advisor (“prohibited benefits”) and whether a distribution from a DAF can be used to satisfy a personal pledge to make a charitable contribution by a donor (an issue addressed in IRS Notice 2017-73, which remains in effect).

Although the Proposed Regulations are not yet effective, they provide guidance that will likely affect the operations of sponsoring organizations and their DAFs that have been operating in a near-regulatory vacuum for the past 17 years.

Background

Under the statute, a DAF is defined as a fund or account (1) that is separately identified by reference to contributions of a donor or donors, (2) that is owned and controlled by a sponsoring organization, and (3) with respect to which at least one donor or donor-advisor has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor. Unless otherwise excepted, a fund or account that meets all three prongs of the definition is a DAF.

A 20% excise tax is imposed on a sponsoring organization with respect to any taxable distribution paid from a DAF and a 5% excise tax on any fund manager that knowingly agrees to a taxable distribution.

Important to navigating the application of this excise tax regime is understanding the bolded key terms above in the definition of “DAF” and “taxable distribution,” on which the Proposed Regulations shed further light.

Key Definitions from the Proposed Regulations

1. Donor Advised Fund

The Proposed Regulations clarify that a fund or account satisfies the first prong of the statutory definition of a DAF if the sponsoring organization maintains a formal record of contributions to the fund or account relating to a donor or donors. In the absence of a formal record, whether the first prong is met depends upon all of the facts and circumstances, including, among other factors, whether the fund or account is named after the donor and whether one or more donors or donor-advisors regularly receive a fund or account statement from the sponsoring organization.

2. Exceptions to the Definition of Donor Advised Fund

As important as understanding whether a fund or account meets the definition of a DAF is understanding whether it is specifically exempted from treatment as a DAF (and therefore from the complicated set of rules that apply to DAFs). The Proposed Regulations clarify and expand upon the statutory exceptions.

Key Takeaways

Multiple-Donor Funds: A multiple-donor fund or account will not be a DAF if no donor or donor-advisor has, or reasonably expects to have, “advisory privileges” (discussed further below).
Single Identified Organization: An account that is established to make distributions solely to a single public charity or to a governmental entity for public purposes is not considered a DAF. A fund seeking to fall under this statutory exception must make all distributions to the single identified organization and cannot make distributions to third parties on behalf of the identified organization. In addition, distributions to the identified organization must support activities other than administering DAFs or grantmaking. This exception does not apply if a donor, donor-advisor, or related person has or reasonably expects to have the ability to advise regarding some or all of the distributions from the identified organization to other individuals or entities (e.g., by virtue of being a director of the identified organization) or a distribution from the fund provides, directly or indirectly, a more than incidental benefit to a donor, donor-advisor, or related person with respect to the fund. Under the Proposed Regulations, private foundations, “disqualified supporting organizations” (discussed below), foreign organizations, and non-charitable organizations cannot serve as “single identified organizations” for purposes of this exception.
Scholarship Funds: In addition to a statutory exception for certain scholarship funds, under the Proposed Regulations, scholarship funds established by a broad-based section 501(c)(4) social welfare membership organization, such as a Rotary Club, are not DAFs if certain requirements are met.
Disaster Relief Funds: Consistent with earlier guidance in Notice 2006-109, the Proposed Regulations establish that disaster relief funds (within and outside of the employment context) are not DAFs, provided they comply with the tax code requirements that govern the provision of relief payments to employees to assist during qualified disasters. The Proposed Regulations decline to extend the DAF exception to emergency hardship funds outside the context of qualified disasters.

3. Donor

The term donor is broadly defined to mean essentially any person or entity. However, the Proposed Regulations exclude public charities (other than disqualified supporting organizations – discussed further below) and governmental units from the definition of donor. The definitions of both donor and donor-advisor are important not only because they bear on whether an arrangement is a DAF and therefore subject to the complex rules applicable to DAFs, but also because the ability of DAFs to engage in transactions with, and provide benefits to, donors and donor-advisors is limited and can give rise to excise taxes (as further described below).

Key Takeaway

Non-DAFs: Any accounts that are funded solely by public charities (other than disqualified supporting organizations) and governmental units will not be DAFs. Similarly, if only public charities or government entities have advisory privileges with respect to an account, the account will not be a DAF even if there are other donors.

4. Donor-Advisor

The Proposed Regulations define donor-advisor as a person appointed or designated by a donor to have advisory privileges regarding the distribution or investment of assets held in a DAF. If a donor-advisor delegates any of the donor-advisor’s advisory privileges to another person, that person also would be a donor-advisor.

Key Takeaway

Investment Advisors: An investment advisor who serves the sponsoring organization as a whole and is recommended by a donor is not a donor-advisor. This includes, for instance, an investment advisor that contracts with a sponsoring organization and provides services and charges uniform fees to all of the organization’s DAFs. In contrast, the Proposed Regulations provide that an investment advisor that provides investment management and advice with respect to both assets maintained in a DAF and the personal assets of a donor to that DAF is a donor-advisor with respect to the DAF while serving in that dual capacity, regardless of whether the donor appointed, designated, or recommended the personal investment advisor. If finalized, this rule could have important ramifications for the fee structure used by many sponsoring organizations.

5. Advisory Privileges

The Proposed Regulations elaborate significantly on the circumstances under which a donor or donor-advisor is deemed to have advisory privileges that would give rise to DAF treatment. They generally provide that the existence of advisory privileges is based on all facts and circumstances, and they presume that advisory privileges arise from a donor’s status as a donor unless otherwise specified in the regulations. Advisory privileges may arise even if actual advice is not given. Indeed, the Proposed Regulations specify that advisory privileges exist when:

The sponsoring organization allows a donor or donor-advisor to provide nonbinding recommendations regarding distributions from, or regarding the investment of assets held in, a fund;
A written agreement states that a donor or donor-advisor has advisory privileges;
A written document or any marketing material of the sponsoring organization made available to a donor or donor-advisor indicates that a donor or donor-advisor may provide advice to the sponsoring organization regarding the distribution or investment of amounts held by a sponsoring organization; or
The sponsoring organization generally solicits advice from a donor or donor-advisor regarding the distribution or investment of amounts held in a fund.

If only one donor to a fund possesses advisory privileges, that donor will be considered to have advisory privileges because of the donor’s status as a donor. Additionally, under the Proposed Regulations, a person that establishes a fund and advises as to the distribution or investment of amounts held by the fund is considered a donor-advisor, even if the person does not contribute to the fund, making clear that the donor and donor-advisor need not be the same person in order for a fund to be considered a DAF.

Key Takeaways

Advisory Committees: Advisory privileges may arise when a donor or other individual serves on an advisory committee that advises as to the distribution of amounts from a DAF. The Proposed Regulations provide two safe harbors under which a donor’s service on an advisory committee or recommendation of an individual to serve on an advisory committee would not give rise to such advisory privileges. Charities that do not think of themselves as sponsoring organizations may need to be careful to avoid inadvertently creating a DAF when permitting a donor to participate even informally in a committee that provides advice regarding the investments and/or distributions of a fund, particularly where the distributions would constitute taxable distributions, as discussed below, if the fund were considered a DAF.
Restricted Gifts: The preamble to the Proposed Regulations notes that a donor does not have advisory privileges for purposes of the DAF rules if a gift is given with a restriction but the gift does not provide for subsequent discretion with respect to the restrictions. For example, a donor’s mere earmarking of a donation for a particular fund or program of the recipient charity at the time of donation does not create an advisory privilege that would trigger the requirement to treat the restricted gift as a DAF. However, the Proposed Regulations leave open the possibility that certain restricted gifts with donor discretion could unwittingly give rise to DAF treatment.

6. Distribution

The Proposed Regulations very broadly construe the term “distribution” to mean any grant, payment, disbursement, or transfer, whether in cash or in kind, from a DAF. Moreover, under the Proposed Regulations, any use of DAF assets that provides more than an incidental benefit to a donor, donor-advisor or related person would be deemed a distribution that would generally be considered a taxable distribution, thus incorporating into the taxable distribution regime the separate rules for prohibited benefits. It remains unclear from the Proposed Regulations how the two separate excise taxes would apply in such circumstances.

Investments and reasonable investment and grant-related fees that provide only incidental benefits are generally not considered distributions. However, any expense charged solely to a particular DAF that is paid, directly or indirectly, to a donor, donor-advisor, or related person with respect to the DAF is treated as a distribution. The preamble to the Proposed Regulations notes that while a determination of whether fees are reasonable will be based on all facts and circumstances, an expense charged ratably across all DAFs would generally be considered reasonable.

Key Takeaway

Compensation of Investment Advisors: Many sponsoring organizations compensate outside investment advisors who manage the assets of, or provide advice with respect to, assets in a DAF. Since the Proposed Regulations provide that such advisors will be donor-advisors if they also provide advice with respect to the donor’s personal assets, the payment of compensation using DAF assets to such personal investment advisors who serve in this dual role would constitute a distribution that would generally be a taxable distribution (and could also be a prohibited benefit).

7. Taxable Distributions

A taxable distribution includes any distribution from a DAF that is made to an individual or is made for non-charitable purposes. In addition, payments to (i) organizations not described in section 170(b)(1)(A) (primarily, private non-operating foundations and non-charitable entities) and (ii) “disqualified supporting organizations” are treated as taxable distributions unless the sponsoring organization exercises expenditure responsibility.

Consistent with the statute, the Proposed Regulations treat as “disqualified supporting organizations” any Type III non-functionally integrated supporting organization and any supporting organization that supports an organization that is directly or indirectly controlled by a donor or donor-advisor of the DAF (or any related parties).

The Proposed Regulations clarify that a non-taxable distribution may be made to any organization, even if it is not a charity described in section 170(b)(1)(A), so long as the distribution is used for charitable purposes and not for activities that could cause a section 501(c)(3) organization to lose its exemption, and “expenditure responsibility” is exercised. A recipient organization that is not exempt under section 501(c)(3) must separately account for the grant funds. The Proposed Regulations generally incorporate the expenditure responsibility rules applicable to grants by private foundations with slight modifications. The expenditure responsibility rules generally require pre-grant diligence, a written grant agreement that contains specific elements, and ongoing grantee reporting.

Key Takeaways

Purchase of Goods and Services by a DAF: A sponsoring organization that permits a DAF to purchase goods and services from non-charitable vendors for charitable programs or fundraising purposes would need to exercise expenditure responsibility with respect to such payments.
Grants for Lobbying: Because lobbying constitutes a non-charitable activity, a distribution used for lobbying would be a taxable distribution even though public charities are permitted to engage in a limited amount of lobbying.
Grants to Intermediary Organizations: The Proposed Regulations set forth an anti-abuse rule providing that a planned series of distributions to intermediary recipients that would be considered a taxable distribution if made directly to the final recipient will be treated as a single taxable distribution.
Distributions to Foreign Charities: Distributions made to qualifying foreign organizations are not considered taxable distributions. The Proposed Regulations clarify that for purposes of determining whether a foreign organization is the equivalent of a U.S. public charity, DAFs may rely on the same procedures private foundations use to make “equivalency determinations” with respect to foreign grantees. A sponsoring organization therefore does not need to exercise expenditure responsibility with respect to a foreign organization that the sponsoring organization determines in good faith is a public charity described in sections 501(c)(3) and 170(b)(1)(A), applying the principles of the equivalency determination rules, which generally require written advice of a qualified practitioner.

8. Knowing Approval by Fund Manager

A fund manager of a sponsoring organization who knowingly agrees to make a taxable distribution must pay an excise tax of 5% of the taxable distribution, capped at $10,000 per distribution. The Proposed Regulations clarify that whether a fund manager has knowingly agreed to make such a distribution is interpreted broadly. The IRS will deem the fund manager to have knowingly approved a distribution if the manager is aware that the distribution is taxable or has knowledge sufficient to determine that the distribution would be a taxable distribution and fails to make reasonable attempts to determine whether the distribution is a taxable distribution.

Key Takeaway

Binding Decision Not Required: A fund manager is deemed to agree to a distribution through any manifestation of approval of the distribution that constitutes an exercise of the fund manager’s authority to approve the distribution, regardless of whether the approval is a final or decisive act on behalf of the sponsoring organization.

Effective Dates

The Proposed Regulations are effective for taxable years ending after the date on which final regulations are published in the Federal Register. An organization may rely on the Proposed Regulations for taxable years ending before the date the Proposed Regulations are finalized. With respect to disaster relief funds, organizations may rely on either Notice 2006-109 or the Proposed Regulations for taxable years ending before final regulations are published.

If you have any questions about the Proposed Regulations or the DAF rules, please contact Gil Ghatan, Franziska Hertel, or Kendi Ozmon.