34 Community Foundation leaders and other industry representatives shared why new proposed regulations would be “detrimental” to the industry.
Disclaimer: This is not a legal review or opinion, simply a recap of stories, explanations and concerns offered in public testimony to a panel of IRS representatives. Anyone who may be impacted by the proposed regulation should consult their own legal counsel and review the full proposal before making any decisions or changes to their operations.
On Monday May 6th, the Internal Revenue Service convened a public hearing to allow testimony from stakeholders in the Donor Advised Fund ecosystem to share their feedback on proposed rule changes to “Taxes on Taxable Distributions from Donor Advised Funds Under Section 4966.” There were 34 speakers in person, another 8 who spoke via phone the next day and many other organizations that submitted comments to the proposal, but did not choose to speak.
The sentiment was not subtle. Everyone speaking - from community foundation presidents, to attorneys, to industry representatives - seemed to agree that these proposed regulations, as currently drafted, would upend the Donor Advised Fund industry in the US. The most common phrase of the day was “chilling effect,” as everyone warned about the negative unintended consequences these changes would have on philanthropy and operating nonprofits.
Why now?
While DAFs were officially created by the New York Community Trust in 1931 (when Francis & William Barstow wanted to leave their funds with the community foundation, but also make grants during their lifetime), the more widespread adoption of the vehicle we’re familiar with today came after the passing of the Pension Protection Act in 2006.
Since then, DAFs have proliferated - thanks in large part to the ability for individuals or families to use their personal investment advisor to manage funds in a DAF account, even if it’s held by a sponsor like a Community Foundation, which was made possible by the PPA.
While it’s not clear exactly why this proposal came from the IRS at the end of 2023, it appears to be an effort to clarify the definitions of donor advisor, prohibited benefits and permitted distributions that came from the PPA 17 years prior.
But in those 17 years, the industry has grown to include over 1,151 DAF sponsors holding $230 billion in assets, distributing over $52 billion per year with over 3 million account holders. DAF sponsors have developed their own robust frameworks for managing these accounts to comply with the latest regulations provided in 2006 and the proposed changes were clearly untenable to everyone involved in this industry.
Key issues raised
The authority of, and the need for, the IRS to make these changes at all
Defining an Investment Advisor as a Donor Advisor (who can’t receive payment for investment management service)
Reduced DAF usage
Existing structures that already address concerns
Incentivizing private foundations
Expanding the scope of what is a DAF (to include field of interest funds, collaborative funds, fiscal sponsorships, etc.)
New restrictions on permitted expenses & distributions (Overly restrictive and impractical to manage)
The retroactive application of these rules (generating backward looking tax penalties)
1) The authority of, and the need for, the IRS to make these changes at all
Before getting into the specific problems flagged with the proposed regulations, the first order challenge many people made was whether the IRS could, or should, issue regulations at all. The key arguments made on this front were:
The IRS does not have the authority to unilaterally expand these definitions created in legislation from Congress, according to Kevin Carroll from SIFMA
The issues that the IRS appears to be trying to solve with these regulations are purely speculative and hypothetical. “There is no study or analysis backing up” these changes or issues raised in the regulation and a federal agency should not create rules “based on anecdote” according to Emanuel Kallina from Kallina & Associates, LLC.
All of the potential issues raised have existing mechanisms in place to prevent and address them. Speakers invited IRS representatives to review those mechanisms and point out any shortcomings, but the proposal completely ignores that “existing statutes already address these concerns entirely” according to David Shevlin from the American Bar Association. The existing statutes are described in more detail below.
2) Defining an Investment Advisor as a Donor Advisor
This was clearly the most problematic issue raised by nearly every single person that testified. The proposal expands the definition of a Donor Advisor to include personal investment advisors who are advising on the investments within a DAF account. If deemed a Donor Advisor, investment advisors would not be able to earn any management fees - and therefore would not engage in that service. Here are the core downstream impacts:
Reduced DAF Usage
Investment advisors recommending DAFs to their clients is a primary driver of increased philanthropic engagement and if they can’t earn a reasonable market rate on their work to manage DAF accounts, it could stifle the most promising and fastest growing vehicle for philanthropy. According to Eileen Heisman from National Philanthropic Trust, the largest independent DAF provider, 80% of their DAF account holders are referred by their personal investment advisor.
Most individuals have a close and trusted relationship with their financial advisor and if they can’t continue to work with them for their DAF, they’ll be unlikely to hold their DAF account at a community Foundation. Roxane Jerde from the Community Foundation of Sarasota County shared that their single largest DAF account holder told her explicitly that they would not hold their $30 million DAF with the foundation unless they could continue working with their financial advisory.
Community foundations in particular do not have the scale or capability to offer robust investment options on their own. Engaging a broad range of approved financial advisors helps keep them competitive with other DAF offerings, keep assets local and help fund all the activities at the foundations. Frank Fernandez from the Community Foundation for Greater Atlanta warned that this restriction would limit donor choice and threaten usage.
Existing structure addresses concerns
Because DAF sponsors are the legal owners of assets, they “thoroughly vet each investment advisor requested by DAF account holders” and hold them all to their investment policy, according to Andrea Saenz from the Chicago Community Trust. DAF sponsors regularly fire certain investment advisors who are not keeping up with benchmarks or are found to be in violation of investment policy.
The DAF sponsor also retains all grant-making authority and signs off on every single grant request made, not investment advisors.
“Federal statutory limitations on investment advisors should already handle what the Treasury is trying to address here. They already require a duty of care, a duty of loyalty and a duty of fiduciary responsibility that prevent harm and conflicts of interest,” According to Kevin Carroll from SIFMA.
There is no evidence to support the concern that Investment Advisors discourage grant making to keep funds in the account. Several DAF sponsors shared specific data on how outside managed accounts are in-line with or even outperforming their overall payout ratio. The Chicago Community Foundation, which has 2/3 of its DAF accounts managed by outside Investment Advisors, has seen a 69% payout rate for DAF accounts held by individuals with their own Investment Advisor.
Incentivizing Private Foundations
This restriction is likely to drive more donors to utilize private foundations for philanthropy, which would result in:
Greater cost and admin burden for each donor, reducing total philanthropy. Richard Mills from the American Bar Association pointed out that “Private foundations are expensive and complex, while DAFs make philanthropy more democratic.”
Less real-time oversight, increasing the risks the IRS appears to be trying to address. DAF sponsors are enforcing IRS restrictions on tax-exempt grantmaking for each distribution in real time. With private foundations, the IRS has to review their activity 1 by 1 retroactively when reviewing their tax filings.
Drastically lower payout rates to nonprofits. Rachel Schnoll from the Jewish Communal Fund pointed out that “JCF’s payout rate in 2023 was 32% and the industry overall has had payout rates above 20% for 15+ years. While private foundations hold $1.1 trillion in assets, their payout rate last year was only 11.6%”
3) Expanding the scope of what is a DAF
The new regulations would cause many other types of funds managed by Community Foundations to be designated as DAFs, restricting the way those vehicles are funded and managed. That includes fiscal sponsorship programs, field of interest funds, giving collaboratives and giving circles. If deemed a DAF, these programs would:
Not be able to receive IRA distributions
Not be able to make direct cash payments to non 501(c)3 entities, like fiscally sponsored initiatives or families affected by crises. Amy Freitag from the New York Community Trust shared how their funds are currently directing funds toward the 180,000 migrants that have come to the NY area in the past 2 years which would be disallowed under the regulation.
Not be able to engage donors in the grant making process, a core tenant of collaborative giving that deeply engages donors in philanthropy.
4) New restrictions on permitted expenses & distributions
The regulations provide much stricter guidance on what is a permissible expense incurred by a DAF sponsor, which only includes investment management and grant making costs. DAFs regularly receive contributions in the form of illiquid or complex assets - real estate, art or stakes in private businesses - that require expensive professional services to properly appraise and liquidate.
It’s a significant benefit of DAFs that they can handle these complex processes centrally and many organizations can benefit from that gift in the form of cash DAF distributions. Anna Maria Chavez from the Arizona Community Foundation highlighted the benefit to “smaller charities in our communities that are able to receive the benefit of non-cash & complex asset donations.”
These new definitions also present new restrictions on DAF distributions that sponsors felt were both unclear and untenable to practically manage. It would require DAF sponsors to monitor the specific end use of each dollar at a 501(c)3, and Alexander Reid from TEGE Exempt Organizations Council stated that DAFs should instead “simply be held to the same restrictions as private foundations when it comes to permitted distributions.”
Dr. Mark Lail from Church of the Nazarene Foundation highlighted how DAFs already proactive mitigate potential abuses in grant requests, regularly denying DAF accounts recommendations when they are impermissible under existing regulations.
"We would much rather have unhappy donors over unhappy IRS officials”
5) The retroactive application of these rules
The timing of these rules being effective retroactively if adopted was clearly the most practically difficult element of the entire proposal. Everyone highlighted how operationally burdensome it would be to implement and comply with a new set of regulations as disruptive as these. It would take years to adjust current procedures and the new rules would generate a tidal wave of excise taxes from historical and near term violations until sponsors can come into compliance. No matter the final decision, everyone stressed the importance of a reasonable multi-year timeline for application.
Requests & Next Steps
All of those testifying requested that the Treasury either work with stakeholders to redraft new regulations or withdraw this current proposal entirely and start again from scratch. Some warned that the current proposal would assuredly be litigated, according to Alexander Reid from TEGE Exempt Organizations Council, causing even further delay and confusion for everyone.
The members of the panel were clearly engaged and attentive. They were regularly nodding along to people’s points and taking extensive notes on the testimonies. Their body language would suggest that they’re genuinely interested in engaging and incorporating feedback, but they did not give any verbal reaction to any testimony - other than a few chuckles at some moments of levity.
The only thing that’s certain, is that this is going to be a drawn out process. It doesn’t sound like any DAF sponsors or investment advisors are going to make any changes to their operations until there is more clarity from the IRS. That means DAFs are likely to continue expanding and nonprofit fundraisers should be increasingly proactive in their engagement with DAF donors.
While we are waiting on further clarity, you can sign up for updates on the first-ever nonprofit DAF benchmark study that’s underway and review your own DAF strategy to keep up with the fastest growing vehicle in philanthropy.
If you’d be interested in an educational presentation or moderated discussion on DAFs for nonprofit fundraisers, please reach out: mitch@givechariot.com