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Taxing donor-advised funds

Congress should extend two taxes to donor-advised funds which currently apply to private foundations. First, Congress should apply to donor-advised funds the federal tax on private foundations’ net investment incomes. Second, Congress should extend to donor-advised funds the federal penalty tax imposed upon a private foundation if it fails to pay out annually an amount of at least equal to five percent of its assets.

By some measures, donor-advised funds are the fastest growing form of charity in the US. Recent reports about the travails of the Silicon Valley Community Foundation have highlighted the increasing use of donor-advised funds by charitable donors in general, and by very affluent donors in particular.

In the Tax Reform Act of 1969, Congress divided charitable organizations into private foundations and public charities. In the former category are entities established by one donor or a relative handful of donors. The latter category includes more broadly-supported institutions, such as schools, hospitals, and community foundations.

Congress perceived private foundations as potentially subject to abuse. Congress was concerned that such foundations, while nominally committed to philanthropic purposes, could be used by their donors to accumulate and control tax-favored wealth with no substantial philanthropic benefit. Consequently, Congress in 1969 imposed upon private foundations (but not public charities) a series of regulatory taxes to prevent, inter alia, insiders from abusing the assets of such foundations. Among these regulatory taxes, Congress required grant-making private foundations to pay out annually for charitable purposes an amount equal to at least five percent of the foundations’ assets.

 Donor-advised funds thus straddle the line between heavily-regulated private foundations and less regulated public charities.

Congress further decreed that private foundations must pay the federal Treasury a tax of 1% or 2% of their net investment incomes. This tax recognizes the public services which protect the assets of such foundations.

Donor-advised funds often operate like donor-controlled private foundations without being subject to the same strictures. A donor-advised fund is located in a public charity such as a community foundation or a public charity established by a commercial vendor such as Fidelity or Vanguard. Since the donor-advised fund is part of a public charity, it is not subject to the full network of taxes applicable to private foundations. However, in practice, a donor-advised fund usually operates like a private foundation as the “advice” advanced by those who establish the fund is generally followed by the public charity at which the fund is located.

Donor-advised funds thus straddle the line between heavily-regulated private foundations and less regulated public charities. In recent years, Congress has recognized the often close resemblance between a donor-advised fund and a donor-controlled private foundation, but has not gone all the way. Congress has extended to donor-advised funds rules designed to prevent insiders from misusing such funds’ assets. But Congress has not applied to donor-advised funds the same minimum payout requirements that apply to private foundations. Congress has also not subjected donor-advised funds to the tax on their net investment incomes which private foundations must pay to offset the public services from which such foundations benefit.

In light of the close resemblance between the two, Congress should now extend these two taxes to donor-advised funds. Donor-advised funds, like the private foundations they emulate, can be used to accumulate funds income tax-free without bona fide philanthropy receiving much (or any) of that income. Donor-advised funds, again like private foundations, use public services.

It is now time for Congress to follow its initial steps recognizing that private foundations and donor-advised funds are in practice typically indistinguishable. Similar entities should be taxed and regulated in the same way. Donor-advised funds should be subject to the same minimum distribution requirements as are private foundations, as well as the tax on net investment incomes.

Featured image credit: Tax pen writing by rawpixel. Public domain via Unsplash.

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