Donor-Advised Funds.

Big bucks, few real oversights

What do you think is the most dynamic change to impact charitable giving in the last 10 years? Is it the advent of the Internet? Is it the incredible increase in wealth in our economy? Is it the impending transfer of immense amounts of wealth to future generations by the baby boomers? Or is it the dramatic increase in the donor-advised fund technique of making charitable gifts?

All of these developments may have already affected your organization. If they haven't, they probably will sometime soon. A recent private letter ruling issued by the IRS indicates that some of these developments may now be converging. The ruling was issued to Philanthropic Research, Inc., and concerns the use of the Internet to establish and operate a donor-advised fund.

Donor-advised funds have been around for many years. Community foundations, in particular, have used the technique effectively. Since 1969, when Congress created private foundations, and imposed numerous restrictions on donations to them and their operations, donors have been searching for alternatives. Donor-advised funds allow people to make a current transfer of cash or appreciated property and still retain some influence over how the funds will ultimately be used for charitable, purposes.

What is a donor-advised fund?

The term "donor-advised fund" is not defined in any statute or regulation. There are also no formal criteria for their operation. Despite these shortcomings, they have grown in popularity, as many organizations have established them in the past few years.

A donor-advised fund is an account established by a public charity. The donor transfers property to the public charity and the charity creates an account in the donor's name. The donor or designees have the privilege of making nonbinding recommendations ("advice") to the charity suggesting which charitable organizations should receive grants from their designated fund.

The charity is not required to follow the advisor's recommendations, but experience has shown that it generally will unless the proposed grant does not conform to the terms of the agreement with the donor.

Often, the sponsoring organization may insist that the grant recipients be public charities, have a specific focus or be located in the same geographic area. The donor is not allowed to receive any personal benefit from the grants made from the fund. Therefore, the fund should not purchase dinner tickets or make contributions that entitle to donor or his or her family to any consideration. The sponsoring charity will often hope to receive grants itself from the funds as well.

IRS requirements

The IRS views donor-advised funds as alternatives to private foundations. While there are no formal rules, the Service has required new funds to contain certain provisions to be recognized as public charities. The principal requirement is that the charity, in the aggregate, distribute at least 5 percent of the combined value of all funds it controls each year.

Each separate fund does not have to pay out 5 percent, but each must pay enough so that the test is met in the aggregate.

The public charity has to make clear to the donor that the charity will make the final determination on any grants from the funds. This must be spelled out in the documentation provided to the donor.

Generally, the public charity will determine the investment of the donor-advised fund principal. The donor may have the option of choosing among several funding vehicles, or the charity may retain full investment powers.

Commercial sponsors

One of the principal reasons for the dramatic growth of donor-advised funds in recent years has been the advent of commercial sponsors. Fidelity Investments was one of the earliest sponsors, creating the Fidelity Charitable Gift Fund in 1991. By 1998, it was one of the largest charities in the United States in terms of assets, and its annual receipts in 1998 were the third largest.

Fidelity advertises heavily for contributions to the Gift Fund. Investments generally are limited to Fidelity mutual funds, thereby allowing Fidelity to earn fees from this activity. Other mutual fund sponsors, such as Vanguard, have also created donor-advised fund vehicles. In addition, other financial providers, such as banks and securities firms, are starting funds.

Many public charities also will accept donor-advised fund money, in hopes that some, if not most, of the grants will be to themselves or organizations With a common purpose. Community foundations have been sponsoring donor-advised funds for many years under existing IRS regulations.

Advantages

Why do donors want to set up donor-advised funds? In many cases, donors are looking to fund several years' worth of contributions at one time. The donor may have had a windfall of income and desire to claim some tax deductions to reduce the tax bite.

A donor-advised fund allows the donor to obtain the current deduction while still having some degree of control over the ultimate distribution of the funds in the future. A private foundation would provide even more control, but the numerous restrictions and onerous reporting burdens on foundations may make it an unattractive choice.

Creation of a donor-advised fund involves a transfer to a public charity. Therefore, the tax deduction limitations are higher than those for transfers to private foundations. A donor can deduct cash contributions to a donor-advised fund up to 50 percent of the adjusted gross income. The limitation on gifts to a private foundation is 30 percent. Gifts of appreciated stock carry a 30 percent limit as opposed to 20 percent for gifts to a private foundation.

In addition, a donor can give other appreciated property to a donor-advised fund and claim a deduction for its fair market value. If the gift is to a private foundation, the deduction is limited to the donor's basis in the property.

Some donor-advised fund sponsors, particularly community foundations, may have professional staff who may help a donor choose appropriate charities to receive donations. This may be valuable to donors who may not know the community well or are unsure about how to select and evaluate charitable organizations.

Disadvantages

The principal disadvantage of a donor-advised fund is the loss of total control over the funds. The donor can only advise the charity as to appropriate gifts from the fund; in a private foundation, the foundation managers have total control.

Also, as indicated above, the donor usually will have only limited control over the investment of the assets of the fund. In a private foundation, only very limited restrictions are imposed by the code's prohibitions of excess business holdings and jeopardizing investments.

The donor-advised fund sponsor may restrict the organizations that can receive donations. The sponsoring charity may limit its activities to a certain geographic area or may only accept recommendations for gifts to organizations carrying on certain types of programs.

Gifts from the funds must conform to the sponsoring charity's exempt purpose; therefore, donors may want to choose a sponsor with broad purposes rather than one with limited purposes. The commercially-sponsored charities generally will allow donations to any other public charity.

Finally, a private foundation can carry out its charitable activities directly, rather than just through grants to other organizations. A donor-advised fund is limited to only making grants.

Recent developments

The IRS, on Aug. 2, 2000, issued a private letter ruling to Philanthropic Research, Inc. (PRI), the sponsor of the GuideStar Web site, as to whether money received from donors to its fund would count as public support. PRI released the ruling to the public through the Internet.

PRI proposes to establish a donor-advised fund as one of its programs. The fund will operate wholly on the Internet. It will only accept contributions electronically, and it will riot accept gifts other than cash or electronically transferred publicly traded stock. Donors may recommend donations only to public charities listed in the GuideStar database. Donors will access the fund through links from other charities interested in facilitating charitable giving or from the GuideStar site. PRI will also establish an undesignated fund to receive gifts that it will use for its own educational purposes.

PRI will control the investment of the funds. PRI will allocate the earnings to the individual accounts, and these earnings will be available for distributions. If an account is inactive for some period, PRI will alert the donor to make a recommendation. If none is forthcoming, PRI will transfer 5 percent of the funds in the account to its undesignated account. PRI will ensure that at least 5 percent of the aggregate value of all funds is distributed each year to public charities.

The establishment of this fund foreshadows how much future charitable giving will take place as both organizations and donors become more tied to the Internet. Congress is considering legislation that will impose some statutory restrictions on donor-advised funds, but the proposals do not appear to impose many limitations that the IRS is not now currently requiring of new sponsors.

It definitely appears that donor-advised funds are here to stay as part of the charitable landscape. If your organization does not sponsor one, or you do not work with other sponsors to encourage donations, you might want to look into this charitable vehicle.

Harvey Berger is a partner and national director of not-for-profit tax services in Alexandria, Va., for the accounting and management consulting firm Grant Thornton LLP.