IRS donor-advised fund proposal could have 'chilling effect'

Financial advisors who already have a number of professional titles may find themselves with one more under a proposed IRS regulation: a "donor-advisor."

The IRS and the Treasury Department closed the comment period earlier this month on a proposal for donor-advised funds that experts say could be the most important regulation for the increasingly popular charitable giving vehicle in almost 20 years. One provision specifically focuses on restricting the "potential conflicts of interest" based on "the close relationship between a donor and his or her personal investment advisor" by defining that financial professional as a "donor-advisor" who may be penalized if they receive any compensation from a donor-advised fund for managing a client's assets held by the vehicle. 

That is one of the "most controversial" aspects of the proposal, according to Carolyn "Morey" Ward, a counsel in the Washington, D.C. office of law firm Ropes & Gray who works with tax-exempt organizations. Defining advisors as donor-advisors when they're hired by the funds simply for the purpose of managing their client's holdings rather than managing the vehicle's investments as a whole represents a new barrier to a "very common scenario" for reasonable compensation that's already receiving other regulatory oversight, Ward said.

"It would be subject to an excise penalty tax," she said in an interview. "It's fair to say that, if adopted in the current form, it would have a significant chilling effect on the willingness of financial advisors to recommend donor-advised funds to their clients."

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Industry concerns

Contributions to and grants from donor-advised funds have been soaring in recent years, as advisors and clients embrace a method of philanthropy that enables an immediate tax advantage upfront for the charitable deduction with ongoing control of the distribution. The donor-advised fund and philanthropic units of some of the largest asset managers — Fidelity Charitable, Vanguard Charitable and Schwab Charitable — each reported record levels of grants in 2023, to the tune of more than $20 billion between the three of them. Donor-advised funds ended the year with $228.9 billion in assets after new highs of $85.5 billion in contributions and grants of $52.2 billion in 2022, according to the National Philanthropic Trust.

The IRS and Treasury Department received more than 170 comments by the extended deadline for them of Feb. 15 after issuing the rule Nov. 14, the federal government's regulatory database showed. Representatives for the agencies didn't respond to emails seeking comment on industry criticism, which included concerns shared by the Securities Industry and Financial Markets Association and the American Institute of CPAs.

"These donor-advised fund sponsors do allow such arrangements," Christopher Anderson, a shareholder of Maloney + Novotny who's chair of the AICPA's Exempt Organizations Tax Technical Resource Panel, said in an interview. "So this would be a very big change for them and very disruptive to their operations."

While some financial firms may seek to qualify for the exception to the provision by launching their own charitable foundation or donor-advised funds if they haven't already done so, the potential impact of the proposal looks "wildly unclear," according to Andrew Grumet, a New York-based partner for the Holland & Knight law firm who works with nonprofits.

"If you look across the landscape of charities out there that sponsor programs and how many of them have this option built into it, you'll find it's pretty significant," Grumet said. "It puts a lot of financial advisors in hard situations."

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The language of the proposal

Critics question whether the funds disburse the assets to charities rather than hold them for years in a kind of tax shelter. And there have been cases in which the donors forward their money to hate groups seen as collaborating with large financial firms. In that context, experts point out the fact that IRS regulatory action indicate that this proposal for new definitions of terms like "donor-advisor," "donor-advised fund," "donor" and "taxable distributions" will lead the way for a number of possible new regulations affecting the vehicles in the future.

The new definition of donor-advisor under the proposal would be anyone providing "investment advice with respect to, both assets maintained in a DAF and the personal assets of a donor to that DAF," according to the text.

"However, recognizing that a personal investment advisor may more generally advise the sponsoring organization, the proposed regulations would provide that a personal investment advisor will not be considered a donor-advisor if the personal investment advisor is properly viewed as providing services to the sponsoring organization as a whole, rather than providing services to the DAF," the proposal said. "The Treasury Department and the IRS request comments on additional circumstances that would indicate that a personal investment advisor is properly viewed as providing services to the sponsoring organization as a whole, rather than providing services to the DAF, as well as additional circumstances in which a personal investment advisor should not be considered a donor-advisor."

In the preamble to the proposal, the agencies specifically responded to a commenter in an earlier rulemaking who cited state and federal oversight of advisors through bodies like the Securities and Exchange Commission and FINRA and argued such a definition could change any compensation from the fund into an "excess benefit transaction" that comes with excise taxes. The IRS and the Treasury answered that any grant, loan, compensation or other pay from a fund to "a personal investment advisor that is considered a donor-advisor" would indeed constitute an excess benefit transaction and trigger the penalties.

"While the commenter believes that it is unlikely that a regulated investment advisor would manipulate the assets of the DAF for personal gain, the Treasury Department and the IRS view the close relationship between a donor and his or her personal investment advisor as giving the donor influence over investment decisions with respect to assets held in the DAF comparable to that of a donor-advisor," the agencies said. "Moreover, the Treasury Department and the IRS are concerned about potential conflicts of interest."

Those possible conflicts, the preamble continued, include the promotion of a donor-advised fund over giving "directly to a public charity (other than the sponsoring organization)," a "counterincentive" against distributing the assets to charities to keep collecting fees based on the holdings under management and "another significant concern" about the donor paying a lower amount for their personal portfolio because their advisor also manages the fund assets.

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The upshot

Lawyers working with donor-advised funds and nonprofits argue those worries are misplaced, citing studies like the Philanthropic Trust's finding that payout rates from the vehicles have surpassed 20% every year that the charity and fund issuer has studied them. In contrast, private foundations must distribute only 5% of their assets each year. While not every donor-advised fund technically hires the contributor's personal advisor to manage the holdings in the vehicle, many do appoint the planner after vetting them at the request of the donor, according to Grumet.

"Clearly financial firms have the opportunity at least to take different approaches to this, but it's still going to upend the whole system, and nobody really knows what's going to happen," he said. "Donor-advised funds are a big part of the philanthropic ecosystem. Regardless of your opinion, they are. The proposed regulation really upends the ecosystem on a lot of different fronts."

Practitioners are "thrilled that the IRS is giving us guidance" for the first time in a significant way since the Pension Protection Act of 2006, Anderson said. Still, the proposal's current language "would essentially go into effect immediately" because the regulation would relate to the current tax year at the time the agencies issue the final rule, he noted. And practitioners are still wondering what form any future proposals on donor-advised funds could take.

"These would be the first in that project line, and quite honestly we believe that these are the least controversial of the proposals," Anderson said. "We don't know what's coming, and we wanted to make sure that we had comments in on these first set of regulations because we know that there are more coming."

The comments will "will provide IRS and Treasury with a lot of food for thought," Ward said.

"It's interesting to see that they want to be very thoughtful about this process," she said. "While there are some potentially dramatic proposals as part of this group of proposed regulations, I don't think that we need to assume that they're going to be finalized in this form. IRS and Treasury have indicated that this is likely to be a negotiation process."