The Undermining of American Charity

Our backgrounds may be relevant to the criticisms we make here of a major flaw in the financing of charities today. Lewis Cullman is a New York philanthropist who, at the age of ninety-seven, has given away over 90 percent of his wealth to charitable causes. Ray Madoff is a professor of law at Boston College and the director of a think tank on philanthropy at Boston College Law School who has written—as has Lewis Cullman—about the ways by which the tax system grants benefits to donors to private foundations without ensuring that those donations are put to charitable use.¹

We now write because we are alarmed about a major new force that has entered the field of charitable giving. It has so far been hardly noticed by the general public. But now it is threatening to undermine the American system for funding charity. This force is the commercial “donor-advised fund,” the fastest-growing, but still largely unknown, charitable vehicle.² Donor-advised funds (or DAFs) give donors all of the tax benefits of charitable giving while imposing no obligation that the money be put to active charitable use.

The rise of DAFs is a matter of grave concern because of the heavy reliance on charitable contributions in the US. In other countries it is common for universities, hospitals, art museums, symphonies, and social safety nets to be funded by governments. In the US, charitable organizations, supported by tax-favored private donations, carry out many of the same social functions. The American system depends on an adequate flow of private donations to working charities, and anything that disrupts this flow can have critical consequences for charitable organizations and the people they serve.

Here we explore the reasons for the current explosion of DAFs and its implications.

Most Americans have never heard of donor-advised funds and would be surprised to learn that, measured in donated dollars, the second-most-popular “charity” in 2015 (just behind the United Way) was not the Red Cross, the Salvation Army, or Harvard or other universities. It was Fidelity Charitable, an organization created and serviced by Fidelity Investments for the purpose of holding charitable donations. Fidelity Charitable acts as a middleman, attracting its customers’ charitable donations and managing them in separate client accounts. Money in such donor-advised funds is invested and held until the clients give instructions (“advise”) about distributions to operating charities.

Because of a 1991 IRS ruling obtained by Fidelity (and similar rulings obtained by other commercially sponsored DAFs), clients get the same tax benefits when they transfer property to their donor-advised funds that they would get by making outright contributions to a museum, soup kitchen, university, or any other federally recognized charity. But no deadline is imposed for the eventual distribution of these funds to an operating charity. If a donor fails to distribute the account during her lifetime, she can pass on the privilege of making distributions to her children or grandchildren or anyone else she chooses. The effect of these rules is that assets that have been given the tax benefits of charitable donations can be held in a DAF for decades or even centuries, all the while earning management fees for the financial institutions managing the funds, and producing no social value.

Although Fidelity was the first financial institution to create this type of charitable middleman, Schwab and Vanguard soon thereafter created Schwab Charitable and Vanguard Charitable—and together these organizations have all made it to The Chronicle of Philanthropy’s annual top ten charities in overall donations (squeezing out more traditional charities like the American Cancer Society). Goldman Sachs, T. Rowe Price, Raymond James, and many others have also created donor-advised funds, making charitable giving a growing part of the financial world’s business model for attracting and servicing its clientele.

This business plan has been highly successful. Many billions of dollars have been drawn into the orbit of charitable middlemen, and there is no end to their growth in sight. According to the National Philanthropic Trust, annual contributions to DAFs hit an all-time high of $19.66 billion in 2014. The increase in contributions, combined with a rising stock market, “drove total donor-advised fund assets above $70 billion for the first time.”³ The leader, Fidelity Charitable, has had particularly strong growth and it is widely expected that in 2016 it will surpass the United Way and receive more donations than any other charity in the country.

One of the most surprising aspects of the rise of DAFs is that donors participate in this $70 billion industry without any legal protections regarding their control over the distribution of the assets held in DAFs. When donors open donor-advised fund accounts they do so because they expect to have continuing control over their donations. This expectation is reinforced by marketing materials that allude to control. For example, one leading DAF sponsor, National Philanthropic Trust, describes DAFs as follows:

An easy way to think about a donor-advised fund is like a charitable savings account: a donor contributes to the fund as frequently as they like and then recommends grants to their favorite charity when they are ready.

Despite such references to control, legal agreements between donors and DAF sponsors in fact provide that the donor cedes all legal control over donated funds.⁴ Although a donor is given the right to make recommendations (sometimes referred to as “advisory privileges”), this is not much of a “right.” DAF sponsors are legally allowed to ignore donors’ advice about the disposition of their DAF funds.

For most donors, this will have little practical effect; donors will advise and the DAF sponsor will follow the donor’s advice. This is because the business model of commercial DAF sponsors is to profit from the fees they secure and not from appropriating donor funds. However, not all donors have been so lucky. In one case, a DAF sponsor went bankrupt and the donated funds were seized to pay its creditors. In another case, the DAF sponsor used donated funds to pay its employees large salaries, hold a celebrity golf tournament, and reimburse the cost of litigation when a dissatisfied donor sued. In both cases, courts ruled against the donors and upheld the rights of the fund sponsor to exert full legal control over DAF funds.⁵

The larger question raised by this arrangement is, why would donors and DAF sponsors enter into legal agreements that fail to reflect their expectations? Who benefits? Who is harmed?

The main beneficiaries of the arrangements for commercial DAFs are the financial industry and its wealthy clientele. The financial industry profits from commercial DAFs in several ways.

First, financial institutions profit from commercial DAFs because they are a source of investment assets. Fidelity, Schwab, Vanguard, Goldman Sachs, and other financial institutions are in the business of managing money; the more money they manage, the more profits they make. By creating charitable entities that can hold charitable dollars for investment, the associated financial institutions create an additional revenue stream that adds to their bottom line.

Second, financial institutions are able to earn fees by providing management services to the charities set up specifically to hold the DAF funds. For example, the for-profit Fidelity Management provides all management services for Fidelity Charitable. This type of arrangement also conveniently enables commercial sponsors of DAFs to avoid federal disclosure rules that otherwise require charities to disclose the salaries of their top-paid employees.⁶

Finally, commercial DAFs also provide financial benefits to individual financial advisers who can continue to receive fees for investing their clients’ charitable donations. When a client discusses charitable giving with his financial adviser, the adviser has every financial incentive to recommend that the client establish a DAF rather than make an outright gift to an operating charity. One effect of these arrangements is to add a good many members to the DAF sales force.

The financial industry has clearly had much to gain from entering into the DAF middleman business. The question is, why would donors contribute billions of dollars to DAF middlemen, preserving only the right to make nonbinding recommendations about the distribution of the funds? The answer is that DAFs help donors get maximum tax advantages for their charitable contributions. There are three main reasons for this.

First, commercial DAFs make it easy for donors to time their charitable donations in a way that produces the most tax benefits. The value of the charitable deduction is directly linked to the tax bracket of the donor. For someone taxed in the highest bracket (39.6 percent), a $100 donation produces almost $40 in tax savings. For someone taxed at a 15 percent bracket, the value of the tax deduction is only $15. And for the vast majority of Americans who don’t itemize their deductions, the charitable deduction provides no benefit at all. DAFs allow donors to maximize tax savings by making large charitable contributions to DAFs in years when they owe high taxes (maximizing the tax benefit), and then using the funds to make distributions to charities in later years.

Second, commercial DAFs make it easy for donors to make contributions of property—including shares of stock—rather than cash. These donations can save an additional 20 percent in the capital gains taxes the donor would otherwise pay. Thus, while a gift of $100 cash by a high-income taxpayer can save that taxpayer nearly $40, a gift of $100 of property can save the taxpayer close to $60 in combined income and capital gains taxes.

Finally, DAFs make it easy for donors to save on taxes by getting the maximum tax benefit for contributions of “complex assets.” For financial institutions the words “complex assets” refer to property that is not publicly traded stock. Complex assets can include such varied holdings as commercial and residential real estate, art, private business interests, and even mineral rights, yachts, and taxidermy collections. A significant part of the work of commercial DAF sponsors consists of acting as a tax-free clearinghouse for complex assets.

The ability to get this enhanced charitable deduction for donations of complex assets is particularly valuable for taxpayers who have invested in hedge funds and other business interests that are not publicly traded. If a donor were to give one of these property interests to a private foundation (the other charitable vehicle that allows a donor to have ongoing control), only the amount of the initial investment could be deducted. If the donor were to give this interest instead to a DAF, the full current value of the asset could be deducted. For example, if a donor invested $100,000 in a hedge fund, and it grew to be worth $2 million, the donor would get only a $100,000 deduction if it were given to a private foundation, but would get a $2 million deduction if it were given to a DAF. This ability to provide a larger deduction for donations of complex assets has fostered the growth of DAFs. One proponent of DAFs has referred to this ability to exploit these previously untapped resources as an opportunity for “philanthropic fracking.”

Congress specifically prohibited donations of complex assets to private foundations from being deducted at their market value because it was concerned about problems of valuation. Since there is no ready market for complex assets, the donor must get an appraisal to set the value for the donation. Appraising is not an exact science and the donor has an interest in coming up with as high a value as is legally supportable. In addition, the DAF has little incentive to challenge this valuation.

The IRS has oversight responsibility, but it is extremely expensive for it to second-guess the appraised value of all contributions of complex assets, particularly if there is a lag between the time of contribution and the time of sale. If the property ultimately sells for less than the appraised value, that does not affect the tax status of the donor’s original charitable deduction. So in the above example, if the supposed $2 million interest was later sold for $1.5 million, the donor would still be entitled to his $2 million deduction even though only $1.5 million is ultimately made available for charity. The donor is happy; the DAF sponsor is neutral; the party that has been harmed is the taxpaying public.

Commercial DAFs have provided significant benefits for the financial services industry and for individual taxpaying donors. At the same time, the rise of DAFs has imposed costs on American taxpayers as well as operating charities and the beneficiaries they serve.

Additional tax benefits from charitable giving might be good for individual donors, but from the perspective of the public, they are an additional cost. This cost might be worthwhile if it resulted in more overall charitable giving. However, this is not the case. Charitable giving has been monitored for the past forty years and, though subject to minor fluctuations, has remained remarkably constant at 2 percent of disposable net income.⁷

In addition, the added tax benefits from contributions of appreciated property are particularly troubling because of the inequitable way that these super-benefits are allocated. The wealthiest Americans are most likely to own stock and other appreciated property and, therefore, are in the best position to take advantage of this benefit. Indeed, taxpayers with annual income over $10 million made more than 33 percent of all charitable donations of appreciated property.⁸

The benefit for contributions of appreciated property has been widely condemned by tax experts as being “inequitable,” “inefficient and unfair,” and “a clear error.”⁹ Commercial DAFs did not create this loophole—donors can also achieve this tax benefit by giving appreciated property directly to their favorite charities. But DAFs facilitate its exploitation.

Particularly troubling is the detrimental effect caused by the diversion to DAFs of funds that would otherwise have been contributed directly to operating charities. Many donors make annual contributions to their favorite charities at the end of the year in order to obtain the tax benefits of their charitable gifts. Anyone familiar with this process knows that there is often some degree of anxiety in deciding which charities to support and how much to give. DAFs relieve this anxiety by allowing taxpayers to get the tax benefits of charitable giving without having to make hard decisions about how their funds will be allocated. The problem is that once money is put into a DAF, it is likely that a significant proportion of it will stay there.

The first reason for this is inertia. Once the tax benefits of charitable giving have been claimed, there is less urgency in making decisions about distributions from the DAF. In addition, after putting charitable donations into a DAF, a more subtle transformation occurs. Instead of the donor thinking of this transfer as a charitable gift that has been made (the way one would feel about an outright transfer to a museum, for example), the donor now thinks of the DAF as a charitable asset in which he has a continuing interest. To the extent that donors think of DAFs this way, they are less likely to spend DAF funds. Behavioral economists refer to this desire to keep property in which one feels one has ownership interest as the “endowment effect.”¹⁰

DAF sponsors encourage the endowment effect by building up the donors’ sense of ownership in the DAF. They do this by granting the donors the ability to manage the investment and by providing regular statements about how their investment is doing. Donors are also encouraged to pass these accounts on to their children and grandchildren, creating a “charitable legacy.” The combined effect is to subtly encourage donors to hoard, rather than distribute, their DAF funds. Of course, this approach benefits the financial companies representing the DAF as well; the longer the property is held in the DAF, the greater the management fees.

This tendency to hoard rather than spend DAF funds is borne out by the most recently available statistics from the IRS, which show that the median annual payout rate from all DAFs was 7.2 percent, while nearly 22 percent of all DAF sponsors reported no grants at all.¹¹ (Some commercial DAF sponsors claim payout rates that are significantly higher than 7.2 percent; but they do not generally calculate their payout rates using the same method as IRS statisticians.)¹²

Finally, DAFs are also detrimental because they disrupt the flow of money from private foundations to operating charities. Private foundations are required to distribute 5 percent of their assets each year and these distributions typically go to operating charities. However, according to current tax rules, contributions to donor-advised funds qualify as required distributions for private foundations. This means that a private foundation can meet its payout requirement by giving funds to a DAF, which itself has no payout requirement.

Donor-advised funds have been a bad deal for American society. They have produced too many private benefits for the financial services industry, at too great a cost to the taxpaying public, and they have provided too few benefits for society at large. When we consider their overall effect, we see that rather than supporting working charities and the beneficiaries they serve, they have undermined them. Congress should enact a rule requiring that donor-advised funds be distributed to operating charities within a reasonable period of time in order to assure a regular flow of money to working charities. In addition, private foundations should not be allowed to satisfy their payout rules by making contributions to donor-advised funds.

Congress should revise the tax incentives for charitable giving so that they more clearly work in the public interest. If it fails to do so it will deprive charitable organizations of the funds they need to make their essential contributions to American society.