IRS, Treasury Release Proposed Regulations on Donor-Advised Funds

The US Department of the Treasury (Treasury Department) and Internal Revenue Service (IRS) recently published proposed regulations under Section 4966 to provide additional guidance on several issues related to creating and administering a donor-advised fund (DAF). The proposed regulations provide examples and definitions of key undefined terms in Section 4966.

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Background: Definition of DAF

A DAF is a fund or account maintained by a public charity (the “sponsoring organization”) that allows donors to make a charitable contribution, receive an immediate tax benefit, and retain certain advisory privileges over the fund or account. Section 4966(d)(2)(A) defines a DAF as a fund or account (1) that is separately identified by reference to contributions of a donor or donors, (2) that is owned and controlled by a sponsoring organization, and (3) with respect to which a donor or donor-advisor has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by virtue of the donor’s status as a donor.

Section 4966 was enacted to regulate DAFs and mitigate possible abuses of DAF structures. Section 4966 imposes a 20% excise tax on a sponsoring organization that makes a taxable distribution from a DAF and a 5% excise tax on a fund manager who knowingly agrees to make a taxable distribution. The proposed regulations also address the excise taxes imposed on sponsoring organizations and fund managers under Section 4966.

Proposed Regulations

The proposed regulations attempt to help clarify Section 4966 and include proposed definitions for certain key terms, including “donor,” “donor-advisor,” and “advisory privileges.”

Separate Identification

The proposed regulations clarify that a fund or account is separately identified by reference to contributions of a donor or donors if the sponsoring organization maintains a formal record of the contributions of each donor to the fund or account. If the sponsoring organization does not maintain a formal record of contributions, the fund or account may nonetheless be separately identified by reference to the donor or donors based on the facts and circumstances. The proposed regulations list several relevant facts and circumstances to consider in making this determination, such as whether the fund account is named after the donor or whether the sponsoring organization seeks advice regarding distributions from the donor.

Advisory Privileges

The proposed regulations provide that the existence of advisory privileges (or the reasonable expectation of advisory privileges) depends on all of the facts and circumstances. However, the presence of any one of the following facts is sufficient to establish that advisory privileges exist, regardless of whether the rights are exercised: (1) the sponsoring organization permits a donor or donor-advisor to give nonbinding recommendations regarding distributions or investments; (2) a written agreement provides that the donor or donor-advisor has advisory privileges; (3) marketing materials or documents communicate that a donor or donor-advisor may provide advice; or (4) the sponsoring organization solicits advice from a donor or donor-advisor.

Advisory privileges are also deemed to exist if the sponsoring organization appoints a donor, donor-advisor, or related person to an advisory committee that advises on distributions or investments of the account funds unless (1) the appointment is based on objective criteria related to the expertise of the appointee in the particular field of interest or purpose of the fund or account; (2) the committee consists of three or more individuals, not more than one-third of whom are related persons with respect to any member of the committee; and (3) the appointee is not a significant contributor to the fund or account, taking into account contributions by related persons with respect to the appointee, at the time of appointment. An appointee can also subsequently be deemed to have advisory privileges based on changes in the facts and circumstances. If the donor is an officer, director, or employee of the sponsoring organization, advice provided solely in that capacity will not automatically deem the officer, director, or employee to have advisory privileges in their capacity as a donor unless they are the only person with advisory privileges over the fund or account.

A “related person” refers to “family members” of an individual as defined in Section 4958(f)(4), which includes an individual’s spouse, ancestors, lineal descendants, siblings, and spouses of lineal descendants and siblings. A “related person” also includes an entity owned more than 35% by the donor (or any person appointed or designated by the donor) or their family members. The proposed regulations do not define “significant contributor,” and the Treasury Department and IRS request comments on what constitutes a significant contributor for purposes of this exception.

The preamble to the proposed regulations notes that gift agreements or other enforceable gift restrictions generally do not constitute advisory privileges that would require a restricted gift to be treated as a DAF. However, a restricted gift agreement could create a DAF depending on the terms of the agreement, and restricted gifts with donor involvement could still be subject to DAF treatment.

Definition of “Donor”

The proposed regulations broadly define “donor” as any individual, trust, estate, or entity that contributes to a fund or account of a sponsoring organization, excluding public charities (other than certain supporting organizations) and governmental entities. Importantly, private foundations and certain supporting organizations are not excluded from the definition of “donor” as these organizations could utilize a DAF to bypass requirements applicable to these organizations.

Definition of “Donor-Advisor”

The proposed regulations broadly define “donor-advisor” as a person appointed or designated by a donor to have advisory privileges regarding the distribution or investment of assets held in a fund or account of a sponsoring organization, including persons who have been delegated advisory privileges. Donor-advisors include a person who establishes the fund or account or advises on distributions, even if they do not actually contribute to the fund or account. This can include an investment advisor, which is defined in Section 4958(f)(8)(B) as any person (other than an employee of a sponsoring organization) who is compensated by the sponsoring organization for managing or providing investment advice over assets maintained in DAFs held by the sponsoring organization if the investment advisor is also the personal investment advisor of a donor to the DAF.

Because the proposed regulations treat a personal investment advisor as donor-advisor of the DAF, a personal investment advisor that satisfies the definition of a “donor-advisor” should not receive compensation directly from the DAF. The donor-advisor’s receipt of compensation directly from the DAF would be treated as an excess benefit transaction under Section 4958(c)(2), which would impose a tax equal to 25% of the excess benefit on the personal investment advisor based on their qualification as donor-advisor. The donor-advisor’s receipt of compensation directly from the DAF would also be treated as a taxable distribution under Section 4966, triggering a 20% excise tax on the distribution. It will be important for investment advisors and sponsoring organizations to consider whether the investment advisor is a donor-advisor and avoid allocating compensation to personal investment advisors from DAF funds, if applicable.

Similar to the definition of “advisory privileges” but with slight variations, the term “donor-advisor” also includes advisory committee members of the sponsoring organization that advise on distributions or investments of a fund or account if the member is recommended by a donor or donor-advisor. If a donor or donor-advisor recommends an individual who is appointed by the sponsoring organization to serve on an advisory committee, they are considered a donor-advisor unless (1) the recommendation is based on objective criteria related to the expertise of the member in the particular field of interest or purpose of the fund or account, (2) the committee consists of three or more individuals, and a majority of the committee is not recommended by a donor or donor-advisor, and (3) the person recommended by the donor or donor-advisor is not a related person with respect to the recommending donor or donor-advisor.

The definition of a “related person” for this purpose is the same as the definition provided under “advisory privileges.” The Treasury Department and IRS request comments on the proposed advisory committee exceptions under both the definition of “advisory privileges” and “donor-advisors,” including additional circumstances in which advisory privileges arising from advisory committees should not result in the creation of a DAF.

Exceptions to Definition of DAF

There are two statutory exceptions to the definition of a DAF under Section 4966(d)(2)(B): (1) a fund or account that makes distributions only to a single identified organization or governmental entity, and (2) a fund or account that makes grants to individuals for travel, study, or other similar purposes if the grant meets the qualifications applicable individual grants from private foundations set forth in Section 4945(g). Section 4945(g) generally requires (1) the grantee selection group to be sufficiently large to constitute a charitable class; (2) the selection committee members to receive no private benefit from potential grantees; and (3) the sponsoring organization to maintain adequate records regarding the identification and selection of grantees. The proposed regulations clarify that the exception does not apply if the selection committee is directly or indirectly controlled by one or more of the donor, donor-advisor, or any related persons. The definition of “indirect control” includes any employee or independent contractor of the donor, donor-advisor, or any related persons.

The proposed regulations provide two regulatory exceptions: (1) a fund or account which makes distributions to certain disaster relief funds or (2) a fund or account which makes distributions to certain scholarship funds whose committee is nominated by a Section 501(c)(4) organization with a “broad-based membership.”

While the proposed regulations specifically except certain scholarship funds maintained by a Section 501(c)(4) organization, other tax-exempt organizations may similarly maintain scholarship funds, particularly Section 501(c)(6) organizations (business leagues and trade associations). Comments are requested on whether this exception should be broadened to include other tax-exempt organizations that administer similar scholarship funds.

Definition of Distribution

The proposed regulations broadly define “distribution” as any grant, payment, disbursement, or transfer, whether in cash or in kind, from a DAF. The use of DAF funds that result in more than an incidental benefit to a donor, donor-advisor, or a related person will be treated as a deemed distribution. However, reasonable investments and grant-related fees would not be treated as distributions unless they result in more than an incidental benefit. Sponsoring organizations should be mindful when engaging in transactions using DAF funds to evaluate whether any transaction could be characterized as a taxable distribution considering the broad scope of this term.

Taxable Distributions

The proposed regulations incorporate the statutory definition of a taxable distribution under Section 4966(c)(1), which includes distributions to natural persons and, unless the sponsoring organization exercises expenditure responsibility, distributions to disqualified supporting organizations and organizations not described in Section 170(b)(1)(A) (i.e., noncharitable organizations). Notably, they add an “anti-abuse” rule that applies the step transaction doctrine and analyzes a series of interrelated distributions as a single distribution to confirm whether the distributions should be treated as a single taxable distribution under Section 4966.

For grants to noncharitable organizations and disqualified supporting organizations, the expenditure responsibility requirements are generally the same procedures that apply to private foundations, with certain modifications in the DAF context pertaining to permitted uses of grant funds. Specifically, the recipient of grant funds must agree not to (1) make a grant to an organization that does not comply with expenditure responsibility requirements, (2) make a grant to an individual, or (3) make a grant, loan, pay compensation, or make other similar payments to a donor, donor-advisor, or related person with respect to the DAF. A sponsoring organization may also rely on the equivalency determination procedures applicable to private foundations to make a non-taxable distribution to a qualifying foreign organization.

Excise Taxes on Taxable Distributions

The proposed regulations generally incorporate the excise taxes imposed on sponsoring organizations and fund managers under Section 4966(a). Section 4966(a) imposes a 20% excise tax on a sponsoring organization that makes a taxable distribution from a DAF and a 5% excise tax on a fund manager who knowingly agrees to make a taxable distribution. The proposed regulations add that a fund manager has “knowledge” of the taxable distribution if the fund manager is aware that the distribution is a taxable distribution or has knowledge of facts sufficient to determine the distribution would be a taxable distribution but negligently fails to make reasonable attempts to make this determination. They also add that a fund manager’s “agreement” to make a taxable distribution refers to any manifestation of approval sufficient to exercise the fund manager’s authority to approve or recommend the distribution, regardless of whether the manifestation of approval is the final approval of the sponsoring organization.

The proposed regulations also incorporate the special rules under Section 4966(b) that apply to Section 4966(a). Section 4966(b)(1) provides that if more than one fund manager is liable for making a taxable distribution, all fund managers are jointly and severally liable for the excise tax. Section 4966(b)(2) limits the excise tax imposed on fund managers to $10,000.

Effective Dates

While sponsoring organizations may rely on the proposed regulations, they are not effective until the taxable year ending after the date final regulations are published. Sponsoring organizations, donors, donor-advisors, investment advisors, and related persons should monitor the proposed regulations to ensure compliance with Section 4966. Public charities generally should also carefully consider whether a fund or account that they maintain fits within the definition of a DAF to avoid inadvertent taxable distributions and should familiarize themselves with the rules to avoid creating a DAF if they do not intend to do so.

Request for Comments

The Treasury Department and IRS request comments on several significant topics by January 16, 2024, including:

Additional factors relevant in determining whether a fund or account is separately identified by reference to contributions of a donor or donors.
Additional factors that indicate a personal investment advisor is properly viewed as providing services to the sponsoring organization as a whole, rather than providing services to the DAF.
Additional circumstances in which a personal investment advisor should not be considered a donor-advisor.
What constitutes a significant contributor for purposes of determining whether a committee has advisory privileges by reason of a donor’s status as a donor in regard to determining whether a fund or account is a DAF.
Additional circumstances in which advisory privileges arising from advisory committees should not result in the creation of a DAF.
Whether additional guidance is needed to prevent avoidance of the employer-related scholarship rules or to address any potential private benefit arising from employer-related scholarship programs.
Whether guidance is needed regarding a fund manager’s reliance on professional advice in connection with the fund manager making a taxable distribution.
Whether the scholarship fund exception for Section 501(c)(4) organizations should also apply to other organizations, such as those described in IRC Section 501(c)(5) and/or 501(c)(6).
How to identify a broad-based membership organization described in section 501(c)(4), including factors such as the organization’s number of members, criteria for selecting members, membership rights, and geographic coverage.
How to distinguish distributions from investments under Section 4966.
Whether other entities should be included in the definition of disqualified supporting organization.
The modification to the expenditure responsibility rules and whether additional guidance is needed.