A Qualified Defense of Donor Advised Funds

The New York Times has published a very negative article on donor advised funds (DAFs) in today’s business section. The headline characterizes DAFs as a “philanthropic loophole” that “tech billionaires” use to “hack their taxes.” The article goes on to describe DAFs as “a sort of charitable checking account with serious tax benefits and little or no accountability.” The most withering criticism of DAFs comes from the University of Southern California’s Ed Kleinbard (with whom I agree on most other tax policy questions). DAFs are “a fraud on the American taxpayer,” the article quotes Kleinbard as saying. “They’re a way for the affluent to have their cake and eat it, too.”

The remarkable rise of DAFs poses a number of interesting policy questions. But I think these questions are a lot more complicated than the Times article lets on. DAFs can serve socially useful functions, such as facilitating stock contributions to smaller 501(c)(3)s, encouraging donors to be more reflective in their philanthropic decisions, and extending the tax incentive for charitable giving beyond the very rich. It’s worth thinking about those benefits before concluding that DAFs are a “fraud.”

DAFs are section 501(c)(3) public charities that accept gifts of cash, stock, and other assets, and make grants to other 501(c)(3) public charities. The largest DAF, the Fidelity Charitable Gift Fund, also ranks number one among all 501(c)(3)s by the amount of annual contributions from private sources and number two behind the Bill & Melinda Gates Foundation by the amount of annual grants.

How do DAFs work? Let’s say you hold $10,000 in cash or stock and you’re in the 35% tax bracket. If you give it to Fidelity Charitable this year, you can claim an itemized deduction when you file your return next April that’s worth $3500 to you. That’s the same deduction you would have claimed if gave the cash or stock to the United Way — and in most cases, the same deduction you would have claimed if you gave the cash or stock to your own private foundation.

After that, there are no more tax benefits to a DAF. You still have some choice over where Fidelity Charitable invests the money, though you’re limited to a suite of Fidelity investment options. The fees on the investment options aren’t great (and certainly not as good as the zero-fee ETFs that Fidelity offers other customers), but you can park the money in a total market index fund for 15 basis points per year. You’ll pay an administrative fee of $100 or 0.6% of assets, whichever is greater. (If you only have $10,000 in there, then you’ll pay the $100.) And you can “recommend” to Fidelity Charitable that it make a grant from your account to virtually any 501(c)(3) public charity. Fidelity Charitable isn’t legally required to follow your recommendation, but it virtually always does. (For more on the tax benefits of DAFs, or lack thereof, see Jake Brooks’s excellent analysis in Tax Notes.)

Is this having your cake and eating it too? Well, it’s really more like refrigerating your slice of cake and giving it away later. You can’t withdraw the money and use it yourself. The IRS won’t allow that, and Fidelity Charitable is not going to jeopardize the tax-exempt status of its $21 billion fund by letting you use its DAF like an ATM.

Why would you want to use a DAF? Four main reasons. First, maybe you want to give stock to a small local charity that’s not well-equipped to accept stock contributions. (Full disclosure: In part to understand the DAF world better, I’ve set up a Fidelity Charitable account myself and used it for precisely this purpose.) Federal income tax law allows you to donate appreciated stock and claim a deduction for fair market value without paying capital gains tax. Larger 501(c)(3)s like the United Way will accept stock directly from you. That’s more of a hassle for smaller 501(c)(3)s, so it’s generally easier to give the stock to a DAF and then recommend that the DAF make a grant to the smaller charity. If I had my druthers, we wouldn’t allow donors to avoid capital gains taxes on gifts of appreciated stock, but if we’re going to do it for gifts to United Way, then we should do it for gifts to a local food bank or legal aid group too.

Second, maybe you’re going to be in a higher tax bracket this year than next, either because of changes in the law or fluctuations in your income. So you’d prefer to fast-forward your charitable contribution deductions to this year. But December 31 is fast approaching, and you’re not quite sure where you want to give. A DAF allows you to claim the deduction now and decide later where the money should go.

Is that such a bad thing? Well, if the alternative is that you rush your decision and give this year to a charity that might not make the best use of the funds, then DAFs don’t seem so terrible from a public policy perspective. If the alternative is that you don’t make the gift and don’t claim the tax deduction, then DAFs deprive the U.S. Treasury of some revenue but also reduce the amount that goes to charity. That’s the tradeoff we’ve decided to make in allowing a charitable contribution deduction. We can debate the merits of the charitable contribution deduction, but DAFs don’t really change the terms of the debate.

Third, maybe you’re a middle- or upper-middle-income couple, have paid off most or all of your mortgage, and have relatively modest charitable ambitions. With the new $10,000 SALT cap (which is the same for singles and for couples), you’re probably better off claiming the $24,000 standard deduction for married couples filing jointly rather than itemizing. Since the charitable contribution is an itemized deduction, this means you get no federal tax benefit for charitable giving. What you might do instead is open up an account at Fidelity Charitable, make a big gift once every half-decade or so, itemize your deductions that year, and claim the standard deduction the rest of the time. You can then use the funds in your Fidelity Charitable account to make annual charitable contributions like you used to. It’s a “tax hack,” yes, but for middle- and upper-middle-income married people rather than for “tech billionaires.” And it serves to transform the post-December 2017 charitable contribution deduction from a largely plutocratic tax incentive to a more participatory one.

A fourth use of DAFs is for high-net-worth individuals who might otherwise establish (or also do establish) private foundations. DAFs aren’t subject to the same excise taxes and distribution requirements as private foundations, and the limits of charitable contribution deductions for DAFs are somewhat more generous than for private foundations. Insofar as the various restrictions on private foundations are understood as safeguards against the use of foundations for the self-enrichment of their donors, then it mostly makes sense that these restrictions don’t apply to DAFs — Fidelity Charitable won’t let you use DAF money to, e.g., buy a portrait of yourself and hang it at your golf resort. [I’ll bracket the question of whether DAFs are undesirable insofar as they allow high-net-worth individuals to set up vehicles akin to private foundations without abiding by the 5% annual payout rule. The justifications for the 5% rule are, as I think Michael Klausner effectively illustrates here, sufficiently uncertain that if the biggest problem with DAFs is that they allow donors to circumvent that requirement, then the case against DAFs is pretty shaky.]

The Times also notes that some private foundations have channeled contributions through DAFs in order to avoid public transparency. While individuals don’t have to publicly disclose their charitable gifts (and charities don’t have to publicly disclose their individual donors), private foundations do have to tell us where their grants go. The Times says that “many conservative donors, including the Mercer family, have used D.A.F.s to obscure their political activity.” That does seem problematic.

But wait . . . . DAFs can’t give to political campaigns or parties, political action committees, or politically active 501(c)(4)s. And the Johnson Amendment prohibits 501(c)(3)s from participating in political campaigns. To be sure, some 501(c)(3)s are ideologically tinged. Some politically active 501(c)(4) organizations like the NRA (or, for that matter, the Sierra Club) have 501(c)(3) affiliates that carry out educational and other charitable activities. Think tanks on the right and on the left are generally 501(c)(3)s. If the Mercers want to give from their foundation to the American Enterprise Institute without having to disclose it to the public, they can potentially do so by channeling their gift through a DAF.

Perhaps there is an argument for prohibiting DAFs from accepting gifts from private foundations. But remember: the Mercers already can give directly to the American Enterprise Institute without any public disclosure; routing that gift through a private foundation and then through a DAF doesn’t accomplish anything beyond what the law already allows. Rather than a tax “hack,” it’s a tax Rube Goldberg machine.

I don’t want to portray DAFs as a philanthropic utopia. Fees are probably too high at most DAFs, though fierce competition among Fidelity, Schwab, and Vanguard has gone some way toward pushing expenses down. Silicon Valley Community Foundation, one of the largest DAFs, faces serious allegations that it allowed an abusive workplace culture to take root (ultimately resulting in the recent resignation of its CEO). But of all the tax “loopholes” to get angry about, I would rank this one quite low on my list.