John R. Brooks discusses donor-advised funds in his Tax Notes Today and finds that the tax policy concerns about them may be overblown.

Read the introduction here:

The second largest charitable organization in the country in terms of annual money raised is not the Red Cross, the Salvation Army, or the YMCA — it’s Fidelity Investments. The sixth largest is Charles Schwab Corp. Vanguard Group Inc. is No, 10. Needless to say, Fidelity, Schwab, and Vanguard are not running hospitals or soup kitchens. Rather they are the three largest sponsoring organizations of donor-advised funds (DAFs)

DAFs are accounts established by contributions from charitable donors to a sponsoring organization that pools and manages many different DAFs. The DAF then makes distributions to operating charities based on the advice of the donor. Because the sponsoring organizations are, by definition, described with section 170(c), contributions by a donor into a DAF are tax deductible. Importantly, the DAF need not make any distributions immediately for the original donor to receive the deduction. Because the donation is to the sponsoring organization is a charitable organization, the original gift is fully deductible.

DAFs have grown immensely in recent years. According to the National Philanthropic Trust, there are now more than 238,000 DAFs that together hold more than $70 billion in assets. In 2014 contributions to DAF were $19.66 billion, and DAFs made $12.49 billion in distributions to operating charities. The average DAF has about $296,000 in assets, so they are sometimes described as mini-private foundations and marketed accordingly. For those without the assets or interest to set up and operate a private foundation, DAFs achieve a similar result with less cost and hassle. What’s not to love?

However, DAFs do not provide the tax benefits that are sometimes assumed. Although they are certainly more tax beneficial than private foundations, that’s a pretty low bar. In fact, in many situations DAFs impose a net tax cost on most donors relative to a direct donation. Moreover, a donor would in many cases be worse off donating today to a DAF than waiting and later donating directly to the operating charity. Taking an immediate and large deduction does not in itself create a tax benefit relative to taking a deduction later, and may even create a tax cost. As I show below, this is because of the interaction of the deduction with the ability to avoid capital gains taxation on donations of appreciated property — because the value of a future deduction can grow tax free in a donor’s personal account, donating today to a DAF to get an immediate deduction will not be beneficial. The ability to avoid capital gains taxation also means that the value of a tax-free growth in a DAF is limited to the taxes on annual income, like interest, dividends, and any net capital gain from rebalancing.

Furthermore, in the cases where there is some positive tax benefit, the additional management fees imposed by the sponsoring organizations eat away most or all of it. Fidelity, Schwab, and Vanguard charge annual fees of 0.6 percent of assets for the first $500,000 in each DAF, in addition to any investment fees charged by the underlying mutual fund or other investment vehicle.

If my claims are right, the rapid growth of DAFs is a bit of a puzzle. While some of that growth can perhaps be explained by donors who truly value the nontax benefits of a DAF, some is likely the result of a misunderstanding of the tax benefits, in part because of marketing by the sponsoring organizations. That said, DAFs provide real benefits from the simplification and centralization of giving. If the fee for those services (0.6 percent of DAF assets) is offset by any tax benefits from holding assets in a DAF, in a sense taxpayers are picking up the tab for the simplification services. Therefore, the tax benefit of a DAF isn’t missing; it’s just being soaked up by the DAF sponsoring organizations as a fee for their services.

Find the full article here (subscription for Tax Notes needed)

Posted by Pooja Shivaprasad, Associate Editor, Wealth Strategies Journal