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Thursday December 2, 2021

Article of the Month

Giving Now and Later: The ACE Act's Proposed Donor Advised Fund Rules

Donor advised funds have been around for almost a century. The first donor advised fund (DAF) emerged in the early 1930s. DAFs became more popular and commercialized in the 1990's with the creation of charitable arms of large financial institutions. Tax law evolved over the years to distinguish public charities from private foundations, without codifying DAFs until 2006. Congress passed the Pension Protection Act (PPA) of 2006, which introduced DAFs formally into the tax code and defined the rules related to DAFs. Since passage of the PPA, the rules regarding DAFs have remained relatively unchanged. Over the years, there have been calls to regulate and reform DAFs.

The first article of this series discussed DAF basics, including the benefits for both donors and nonprofits, as well as some of the rules governing DAFs. This article focuses on pending legislation related to DAFs.

The Accelerating Charitable Efforts (ACE) Act


The ACE Act was introduced by Senators Angus King (I-ME) and Chuck Grassley (R-IA) on June 9, 2021. The Act would change the rules for DAFs and DAF distributions. Proponents argue that the bill will increase transparency and move existing DAF amounts faster to working charities. Opponents point to existing data that demonstrates DAFs distribute funds at higher rates than the new rules would impose and that the Act may decrease charitable giving by adding new costs and complexity for foundations and donors alike.

The ACE Act would establish three categories of DAFs, each with its own rules regarding the length of time for distribution and the deductibility of contributions. The three DAF categories would be Qualified Donor Advised Funds, Qualified Community Foundation Donor Advised Funds and Nonqualified Donor Advised Funds.

Qualified Donor Advised Funds


Under the ACE Act, a "qualified DAF" is defined as a DAF that requires any advisory privilege to end "before the last day of the 14th taxable year beginning after the taxable year in which the contribution was made." Essentially, any advisory privilege would terminate within 15 years of the contribution. In order to receive a charitable deduction, the donor must identify a preferred organization at the time of donation to a DAF. This preferred organization will receive any funds remaining in the DAF in the event the donor fails to exercise advisory privilege to distribute the full DAF amount in the allotted 15-year time frame. If a contribution has not been distributed within six months after the 15-year time frame, an excise tax of 50% of the contribution and any of its attributed earnings will be imposed on the sponsoring organization.

Deductibility

Under the current DAF rules, amounts given to DAFs often qualify for a full fair market value deduction in the year of the gift. The new rules would disallow a deduction until the sponsoring organization sells the asset, at which time the deduction would be limited to the amount of the sale proceeds. Gifts of cash or publicly traded assets would still be eligible for a deduction in the year of the gift, provided the other requirements for qualified DAFs are met.
Example

In 2019, Daniel received a large employee bonus from his pharmaceutical research company after helping develop an effective new allergy medication. He wanted to use some of his money to help those suffering from asthma and allergies, but he also wanted time to research nonprofits before giving. Daniel was looking for an immediate tax deduction to offset his income for the year. He spoke to his accountant, who recommended a DAF. Daniel could donate appreciated closely held stock to a DAF, receive an income tax deduction in the year of the gift and bypass any capital gain taxes he would have had to pay if he had sold the stock himself. Daniel could then advise distributions from the DAF to one or more nonprofits immediately or in the future.

Daniel set up the DAF with a local sponsoring nonprofit and advised a distribution of $40,000 of the funds to a pediatric allergy research nonprofit a year later. He can make more distributions as he pleases. The day Daniel donated the closely held stock to charity, it was valued at $75,000. When the nonprofit sold the stock, it was valued at $72,000. Daniel received a deduction for the stock of $75,000, the value on the date he made the gift.

In 2022, assuming the ACE Act is enacted, Daniel decides he would like to create another DAF with a different sponsoring organization. This time the DAF would be structured as a qualified DAF under the ACE Act. His advisory privileges for the DAF will expire within 15 years. At the time of his contribution, he must designate a preferred nonprofit as the beneficiary in the event he fails to direct the distribution of all the DAF funds within the time frame. He again donates closely held stock valued at $75,000 on Dec. 20, 2023. The nonprofit sells the stock on Mar. 15, 2024, when it has dropped in value to $72,000. Daniel receives a deduction in 2024 in the amount of $72,000. The acknowledgment from the nonprofit Daniel in the prior example must be provided within 30 days of the sale date on Mar. 15, 2024.
Currently, nonprofits must issue donors a contemporaneous written acknowledgment of donations for donors to substantiate their charitable deductions with the IRS. The Act would impose new requirements on the contemporaneous written acknowledgement. The new acknowledgement would report the amount of proceeds from the sale of any noncash assets donated to the DAF and inform donors that their charitable deduction must not be greater than that amount (rather than the value of the asset at the time of donation). An acknowledgment will be considered "contemporaneous" if it is provided "within 30 days of the date that the gross proceeds from the sale of the asset are credited to the account or fund of the taxpayer.

The ACE Act also requires sponsoring organizations in all categories to provide the IRS with the same information contained in the contemporaneous written acknowledgements. According to the text of the Act, "such information shall be provided at such time and in such manner as the Secretary may prescribe." This requirement may be met by the sponsoring organization filling out an IRS form which has yet to be created.

Qualified Community Foundation Donor Advised Fund


Community foundations are often defined as grantmaking public charities that work to provide charitable support to their local communities. Usually, a community foundation does not operate to provide charitable services itself but will raise money and hold funds to be used. For example, a community foundation would not act as an operating soup kitchen distributing meals, but a community foundation may make grants to the local operating soup kitchen from income produced by endowments or from outright donations.

The Act creates a category of DAFs that are owned or controlled by "qualified community foundations." These foundations are Section 501(c)(3) organizations that are "organized and operated for the purpose of understanding and serving the needs of a particular geographic community that is no larger than four states by engaging donors and pooling donations to create charitable funds in direct furtherance of those needs." Additionally, the community foundation must hold substantial total assets, at least 25% of which must be held outside of DAFs. The ACE Act does not provide a definition for "substantial assets."

Issue-based rather than geographically-based community foundations would not meet the definition of a qualified community foundation under the ACE Act, due to the four state limitation. Faith-based community foundations, university community foundations and environmental community foundations are some examples of those organizations that may not qualify, or may need to restrict their scope of operations.

In addition to the geographic service limitation and the asset requirements, a qualified community foundation DAF either 1) must have no individual who has advisory privileges over more than $1 million in total held across all DAFs at the sponsoring qualified community foundation (this amount is indexed for inflation) or 2) the DAF, by contract, must require qualifying distributions of 5% or more of the DAF's value each year. DAFs that meet these limits with qualified community foundations may have a longer operating duration.

Deductibility

As in the case of deductions for gifts to Qualified Donor Advised funds, the new rules would disallow a deduction until the sponsoring community foundation sells the non-publicly traded asset, at which time the deduction would be limited to the amount of the sale proceeds. Like the contemporaneous written acknowledgement requirement for Qualified Donor Advised funds, the acknowledgement for Qualified Community Foundation DAF contributions would report the amount of proceeds from the sale of any assets other than cash or marketable securities donated to the DAF and inform donors that their charitable deduction will equal that amount. An acknowledgment will be considered "contemporaneous" if it is provided "within 30 days of the date that the gross proceeds from the sale of the asset are credited to the account or fund of the taxpayer." A sponsoring community foundation must report the information contained in the contemporaneous written acknowledgement to the IRS as well.
Example

Rebecca is a successful businesswoman in the fashion industry. In 2023, she donates her vacation home to a DAF sponsored by a qualified local community foundation. On the date of donation, the home was valued at $950,000 as determined by a qualified appraisal. The sponsoring organization followed its normal protocol of requiring approval of the Board of Directors before listing the property. The Board did not meet until 8 months after the property was donated. The home was put on the market shortly thereafter, but the housing market had experienced a downturn. The property sold four years later for $750,000. Under the ACE Act, Rebecca receives a deduction of $750,000 in 2027.

Nonqualified Donor Advised Fund


A "nonqualified donor advised fund" is defined as a DAF that is "not a qualified donor advised fund or a qualified community foundation donor advised fund."

Deductibility

In the case of gifts other than cash, the new rules would disallow a deduction unless the sponsoring organization sells the asset for cash. Additionally, for cash and noncash gifts, no deduction will be allowed until the sponsoring organization makes a qualifying distribution from the DAF. At that time, the deduction will be limited to the amount of the distribution. Distributions will be treated as made from a first-in, first-out basis. Distributions from nonqualified DAFs must be made by the end of the "49th taxable year beginning after the taxable year in which the contribution was made." If a contribution has not been distributed within six months after the 50-year time frame, an excise tax of 50% of the contribution and any of its attributed earnings will be imposed on the sponsoring organization. The Act defines a "qualifying distribution" as a distribution that is not made to another DAF and one that is not a taxable distribution under the DAF excise tax rules. An acknowledgment will be considered "contemporaneous" if it is provided within 30 days of the date of the qualifying distribution.
Example

Oliver is a wealthy entrepreneur and sailing aficionado. He establishes a DAF at a community foundation that focuses on ocean wildlife and conservation causes around the United States. Assume the ACE Act is in effect. Oliver donates a yacht valued at $1 million to a DAF in year 1, stock valued at $3 million in year 2 and a cash gift of $500,000 in year 3. His total gifts equal $4.5 million over 3 years. The DAF sells the yacht three years after it is received for $850,000 and the stock for $3 million the same year it is received. Oliver will be able to deduct $4.35 million in total over a period of 50 years, but deductions corresponding with distribution amounts must be taken in the years a distribution is made from his DAF. In year 6, Oliver advises a distribution of $1 million to a nonprofit that specializes in researching coral reefs. Oliver can take a $1 million charitable deduction on his income taxes in year 6. Based on the first in, first out rule, and not including any interest earned, $850,000 will be attributed to have come from the sale of the yacht and the remaining $150,000 from a portion of the stock sale.
Because DAFs are often funded with both cash and nonmarketable assets over many years, tracking the "first in-first out" amounts and matching those to the distributions will be complex, especially for foundations with large numbers of DAFs.

DAF Contributions and Public Support


Generally, charities are required to meet a public support test in order to continue to qualify as a public charity rather than a private foundation. Failing to pass the public support test may result in a retroactive downgrade for an organization from public charity to private foundation and a need to file a Form 990-FP for the previous six years. The status change could also mean a retroactive loss of deductions for some donors, among other consequences.

The public support test requires that a charity receive at least one-third of its support from contributions from the general public. If this one-third test is not met, the charity may appeal to the IRS on Schedule A of the Form 990 and demonstrate to the IRS that it has met the 10% facts and circumstances test. This test allows a charity to qualify as a public charity if it receives 10% or more of its support from the public and can demonstrate that under all the facts and circumstances, it normally receives a substantial part of its support from governmental units or from the general public.

Under current DAF rules, donors, both anonymous and named, may advise distributions to be made to charitable organizations. The distribution is treated as if it is from the sponsoring organization to the public charity. When the donor creates a DAF with a sponsoring organization, the donor must give up all ownership and control of the funds. The sponsoring organization owns the funds, but the donor may advise distributions. The sponsoring organization will usually make its best efforts to comply with the donor's desires. Currently, for purposes of the public support test, gifts from public charities, including those that sponsor DAFs, generally qualify as counting toward the nonprofit's general public support amount.

For purposes of applying the public support test, the ACE Act would require "all amounts received from sponsoring organizations... be treated as support received from one person." There are exceptions for when the donor to the DAF is identified and when the funds received from a sponsoring organization are not from a DAF. Thus, support from all anonymous DAF donors to a public charity will be aggregated with all unidentified amounts being reported as if a single individual provided that support to the charity. Anonymous DAF distributions "shall not be treated as if provided from [the sponsoring organization]." Individuals may give up to 2% to a single organization, which will be counted toward that organization's public support. Any gifts over that 2% will not count toward the organization's public support amount. Therefore, all anonymous distributions from DAF sponsors to a public charity will be aggregated and may not count for more than 2% of the charity's public support amount.

Under the ACE Act, if the sponsoring organization identifies the donor, then the distribution will be treated as being provided by that donor, rather than from the sponsoring organization. An individual can currently give to a charitable organization outright, subject to the 2% limit, while the same individual may also advise a distribution be made to the same charitable organization from his or her DAF. Under current rules, the donor's contributions made through a DAF are not considered part of the individual's 2% limit. Under the ACE Act, the donor's DAF contributions would also be considered as part of the 2% limitation.

Conclusion


The proposed ACE Act or a version thereof would introduce new rules and requirements to the DAF landscape. Nonprofits will need to monitor potential legislation to be able to voice concerns or show support for the legislation. If enacted, nonprofits will need to communicate any changes with existing donors, whose current DAFs will likely not be affected by the ACE Act, and with potential DAF donors, whose DAFs will be subject to the new rules.

This information is provided as a service to our readers.

Published December 1, 2021
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Previous Articles

Giving Now and Later: An Overview of Current and Future Donor Advised Fund Rules

Designating Beneficiaries for Retirement Accounts, Part III

Designating Beneficiaries for Retirement Accounts, Part II

Designating Beneficiaries for Retirement Accounts, Part I

Charitable Gifts of Cryptocurrency, Part III

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