For the past 16 years, the U.S. Department of the Treasury's Office of Tax Policy and the Internal Revenue Service's joint Priority Guidance Plan has included the issuance of regulations relating to donor advised funds (DAFs) to address excises taxes, prohibited benefits and excess benefit transaction rules. In November 2023, the IRS issued a notice of proposed rulemaking to address many definitional issues related to DAFs, donors and donor-advisors in connection with the imposition of excise taxes on taxable distributions from DAFs. However, these proposed regulations did not address prohibited benefits or how the excess benefit transaction rules apply to DAFs, which are issues that are front of mind for tax advisors and sponsoring organizations pending the issuance of additional regulatory guidance. Read on for more information about the impact of these new proposed regulations.
Background
For many donors, DAFs are a popular alternative to private foundations and supporting organizations. A DAF is a type of program or fund offered by a public charity (the sponsoring organization) to facilitate charitable gifts by donors. Donors create these funds with the sponsoring organization, make irrevocable contributions to such funds and then are allowed to provide nonbinding advice or recommendations to the sponsoring organization on further distributions to qualified charities and/or investments. According to a report by the National Philanthropic Trust, over $228 billion of assets as of 2022 was held in DAFs. DAFs allow donors to receive many of the benefits associated with a family foundation without the burdensome administrative and tax obligations associated with operating a separate charitable entity.
Internal Revenue Code section 4966, which was enacted as part of the Pension Protection Act of 2006, along with section 4967, set forth the first set of statutory rules for DAFs. These Internal Revenue Code sections imposed an excise tax on taxable distributions and defined certain key terms, including taxable distributions, sponsoring organization, donor advised fund, fund manager and disqualified supporting organization.
Proposed Regulations
Seventeen years later, the Treasury issued these proposed regulations under Internal Revenue Code section 4966 to address the definition of a DAF, a donor, a donor-advisor and a distribution.
Donor. The regulations define a donor to include a person that makes a contribution to the fund unless such contributors are only public charities or governmental units. Sponsoring organizations should review their lists of donors to existing DAFs to determine if any fund would no longer be considered a DAF under these proposed regulations.
Donor-Advisor. The regulations define a donor-advisor to include (i) any person appointed or designated by the donor to have advisory privileges regarding the distribution or investment of assets in the DAF; (ii) the person that established the DAF; and (iii) personal investment advisors that manage the investment of or provide investment advice with respect to the assets of the DAF as well as the personal assets of a donor to the DAF.
The inclusion of personal investment advisors for a DAF in the definition of a donor-advisor surprised tax advisors. The consequence of such inclusion is that the payment of compensation to that personal investment advisor from a DAF is an "automatic" excess benefit transaction subject to excise taxes under Internal Revenue Code section 4958. The amount subject to tax is the amount of compensation paid for the investment management services from the DAF. For example, if the compensation is $50,000, the excise tax due would be 25% of $50,000, or $12,500. In addition, the personal investment advisor would be required to correct the excess benefit transaction by returning the compensation, with interest, to the sponsoring organization (but not to the DAF). If the transaction is not corrected, the personal investment advisor would be required to pay an additional tax of 200%, or $100,000.
Sponsoring organizations that allow a donor to recommend an investment advisor with respect to the DAF, if the investment advisor also manages personal assets of the donor, should consider the impact of this definitional change. Note that an investment advisor will not be considered a personal investment advisor, and therefore a donor-advisor, if the investment advisor is viewed as providing services to the sponsoring organization as a whole rather than providing services to a particular DAF.
The timing of this change is raising concerns for many sponsoring organizations because the proposed effective date is the tax year in which the regulations become final, which could mean that the investment management fees paid in the same tax year that the final regulations are issued (but before such regulations are issued) are automatic excess benefit transactions under Internal Revenue Code section 4958.
The definition of donor-advisor has also been broadened to cover some advisory committee members that may not have been treated as donor-advisors by the sponsoring organization in the past.
Distribution. The proposed regulations adopt an expansive definition of distributions to include disbursements or payments, not just gratuitous transfers. This broad definition could include payments for the purchase of services appropriate to carrying out charitable purposes. For example, DAFs are permitted to engage in direct charitable activities, in addition to awarding grants. In such cases, the sponsoring organization may make payments to service providers, including law firms and other vendors, for services rendered that are unrelated to investment advice. This broad definition could result in sponsoring organizations having to exercise expenditure responsibility over such payments to prevent a taxable distribution subject to excise tax.
Donor Advised Fund. A DAF is defined as a fund or account (i) that is separately identified by reference to contributions of a donor or donors; (ii) that is owned and controlled by a sponsoring organization; and (iii) 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 the fund or account by reason of the donor's status as a donor.
The proposed regulations address the statutory definition of a DAF with the addition of factors related to the separately identified requirement and reliance upon facts and circumstances in the determination of whether there are advisory privileges. Advisory privileges can arise without a formal agreement through marketing materials or a list of pre-approved investment options. Sponsoring organizations should review funds that have not been treated as DAFs in the past, such as field of interest funds or fiscal sponsorship arrangements, to determine if the funds fall within the definition of a DAF under the proposed regulations. For example, a donor's service on a committee with advisory privileges regarding distributions or investments could cause a fund to be a DAF.
Exceptions to the Definition of a Donor Advised Fund. A DAF does not include (i) a fund or account that makes distributions only to a single identified organization described in Internal Revenue Code section 170(c)(2) or certain public charities; (ii) certain funds or accounts that grant scholarships; (iii) certain scholarship funds established by Internal Revenue Code section 501(c)(4) organizations; and (iv) certain disaster relief funds.
For single identified organization funds, the proposed regulations have added a requirement that a donor, donor-advisor or related person cannot have or reasonably expect to have advisory privileges with respect to distributions from that organization to individuals or other organizations. A donor, donor-advisor or related person's service on the board of directors of the single-identified organization could implicate this rule based on comments in the preamble to the proposed regulations. Further expansion of this rule could occur with respect to DAF grants where the donor, donor-advisor or related person serves on the governing body or has other roles at the grantee charity.
Taxable Distributions. A taxable distribution is any distribution from a DAF to (i) any natural person; or (ii) to any other person if (a) the distribution is for any purpose other than one specified tax-exempt purposes outlined in Internal Revenue Code section 170(c)(2)(B); or (b) the sponsoring organization does not exercise expenditure responsibility with respect to the distribution.
The proposed regulations include a concept of "deemed distributions" that is broader than the statutory provisions. This could create additional concerns around certain distributions. The anti-abuse provision heightens the risk of a taxable distribution and may require the sponsoring organization to undertake more due diligence to ensure that the grantee is not acting as an intermediary to make a grant that would otherwise be a taxable distribution if made directly from the DAF.
The proposed regulations confirm that expenditure responsibility is sufficient to allow a grant to a foreign charity, but also make it clear that the sponsoring organization can make an equivalency determination.
The proposed regulations also modify the application of the private foundation expenditure responsibility as follows with respect to distributions from a DAF subject to expenditure responsibility. The sponsoring organization is not required to make the distribution subject to a written commitment signed by an appropriate officer, director or trustee of the distributee that includes an agreement by the distributee (i) to repay any portion of the amount distributed that is not used for the purposes of the grant; (ii) to submit full and complete annual reports on the manner in which the funds are spent and the progress made in accomplishing the purposes of the grant; (iii) to maintain records of receipts and expenditures and to make its books and records available to the sponsoring organization at reasonable times; and (iv) not to use any of the funds to disseminate propaganda or otherwise attempt to influence legislation, influence the outcome of any specific election, to carry out — directly or indirectly — any voter registration drive, or to make any grant to an individual for travel, study, or similar purpose, or to an organization other than a qualifying public charity.
In lieu of these requirements, the distributee must agree not to use the funds to make any (i) grant to an organization that does not comply with the expenditure responsibilities as set forth in the proposed regulations; (ii) grant to a natural person; or (iii) grant, loan, compensation or other similar payment (as defined in the excess benefit transaction provisions of Internal Revenue Code section 4958) to a donor, donor-advisor or related person with respect to the DAF from which the distribution is made.
Effective Date
These regulations are proposed to apply in any taxable year ending after the date of publication of final regulations in the Federal Register. This could result in the regulations having retroactive application. Accordingly, sponsoring organizations should take action now to review their existing funds and consider updates to current policies and procedures.
Additionally, a taxpayer may rely on the proposed regulations for taxable years ending before the date of publication of final regulations in the Federal Register. For a tax year ending before the date of publication of the final regulations, a taxpayer may rely on the guidance provided in IRS Notice 2006-109 or, alternatively, on the proposed regulations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
