Donor Advised Funds: a Philanthropic & Investment Multi-Tool
I first began using a Donor Advised Fund (DAF) in 2008. I established a DAF account at a community foundation and used the tax-advantaged funds deposited into the account to make grants. The dollars granted from the account enabled technology improvements at my daughter’s underfunded inner city public school, supported court appointed advocates for neglected and abused children, funded innovative low cost construction methods for improved housing affordability, and were used to conserve and restore exurban land.
Since then, DAFs have grown exponentially and become sophisticated philanthropic and impact investing multi-tools used for making catalytic grants, accelerating social entrepreneurship and driving shared prosperity across under-resourced communities. Today, there are over 1,000 DAF sponsors across the U.S. with $229 billion in assets funded by two million DAF account holders. Examples of DAF sponsors where accounts are held and administered include: Schwab Charitable, Impact Assets and Seattle Community Foundation.
There are several reasons why donors choose to use DAFs instead of making charitable donations directly to non-profits. These include:
Ability to fund and administer several years of charitable donations
Access to unique for-profit social and environmental impact investments
Reduced income and capital gains tax
Ability to make DAF to DAF transfers to support a wide range of causes and communities
Access to educational and technical support for collaborative and multi-gen gifting
DAF 101: The Basics
A DAF is a separately administered account that is held by a charitable organization. Each DAF account is composed of contributions made by an individual donor or donors, primarily individuals and families, but also companies. Contributions to DAFs can be made with cash or securities. It usually makes the most financial sense to donate appreciated securities into a DAF rather than cash due to the advantageous tax treatment of donated securities.
Once a donor sets up a DAF account and makes a financial contribution into it, the DAF sponsor has legal control over the funds. However, the account’s donor, or the donor's representative(s), retains advisory privileges with respect to deciding how the funds held in the account are invested as well as the amount, timing and recipient of each charitable donation made from the account. Any gains on investments held increase the value of the DAF account and can either be reinvested in or gifted out of the DAF.
DAF 201: Key Features
Innovative Impact Investments
While DAF funds are expected to ultimately be granted out to non-profits, DAF sponsors provide access to a variety of investments where DAF balances can be held until the DAF holder makes grants out of the account. The majority of DAF investment options are in conventional stocks and bonds.
At Humanize Wealth, we highly encourage clients to select DAF sponsors that offer a robust selection of socially responsible investments, particularly private impact investments designed to achieve specific and measurable social and environmental objectives. Why? Because the contributions to DAF’s no longer benefit the person or entity that made the DAF donation, there is no need to generate a specific financial return to support the DAF holder’s financial needs and goals. This enables DAF holders to allocate DAF funds to ‘impact first’ investments that prioritize impact over financial returns.
There is a small but growing list of DAF sponsors that provide DAF holders with access to a wider range of private impact investments - both private investment funds and direct investments into mission driven companies and projects. This includes: community investment notes, social venture startups, private investments in natural resources including timber, farms and critical habitat, BIPOC community access to affordable financing and many other options.
And since DAFs can help aggregate these investments, in some cases they can be accessed at much smaller investment minimums compared to investments made using taxable dollars outside the DAF.
Tax Benefits
As with direct charitable donations, the value of securities or cash deposited into a DAF account can be counted as an itemized deduction for Federal income tax purposes. Cash contributions can be partially deducted while securities donated in kind generally receive more favorable tax treatment. As with all important tax decisions, it is advisable to consult a knowledgeable tax professional and financial advisor before making contributions to a DAF.
A secondary but often significant tax benefit - whether through regular portfolio rebalancing, transferring assets to another manager or an upcoming liquidity event - contributing the most highly appreciated assets to a DAF avoids incurring unnecessary capital gains. This is because the unrealized capital gain of a security transferred to a DAF account becomes the tax liability of the DAF sponsor. And since DAF sponsors are exempt from capital gains taxes, the full value of the appreciated asset is credited to the DAF account, effectively “tax free”.
Some DAF sponsors will even accept stock of privately held companies and securities in other assets like real estate that is transferred to the DAF sponsor in advance of a liquidity event. These are often highly complex transactions that require the support of a CPA, tax attorney and financial advisor and long lead times to diligence and complete. DAF sponsors who accept private securities often have experts on staff to assist in executing these donations.
Financial Planning
Making a large DAF contribution creates a reservoir of charitable assets to distribute in the future. Typically, the amount contributed exceeds what a donor might consider giving directly that year. One rule of thumb is to donate at least three years worth of planned charitable gifts.
Formulating an optimal DAF funding and spending strategy involves several factors including overall philanthropic objectives, cash flow needs and goals, detailed tax analysis and other considerations.
Family Participation & Collaboration
Many DAF sponsors provide educational and collaborative opportunities to donors and families to learn about DAF grant making and investment opportunities that are aligned with their interests and the needs of communities. DAF sponsors can be an excellent resource for surfacing high impact organizations, including community foundations that specialize in a specific geography, usually across a city or country. For those in the greater Seattle area, Renton Regional Community Foundation is an excellent example of a DAF sponsor serving under resourced neighborhoods and families across diverse communities and non-profit programs in South King County.
Pro Tips
DAF funds can be transferred to other DAF accounts, a useful option when a primary DAF sponsor does not offer access to a unique impact investment offered by another DAF. Philanthropic Investment Grants (PHIG) can be similarly made through an on-line non-profit funding platform like Realize Impact using DAF funds or philanthropic donations
DAF accounts cannot be used to make legally binding multi-year grant commitments, but a soft multi year commitment can be made and supported through a series of annual grants made to the same charity and funded through successive annual grant requests made through the DAF account sponsor.
DAFs cannot be used for charitable event tickets or “raise the paddle” commitments. However, unrestricted grant requests that exclude any benefits to the donor can be made from a DAF account in advance of such events and included by the charity in reporting out money raised in relation to the fundraising event.
DAFs must be granted to qualified 501(c)3 entities, which excludes direct political donations. However grants to nonpartisan political advocacy organizations such as those designed to encourage higher voting participation rates often meet the DAF qualification requirements.
Most DAF’s allow grants to be made by account holders anonymously or by name, on a case by case basis.
Criticism
DAF’s have been rightly criticized as a tool abused by some to simply reduce their tax bill, hold DAF balances indefinitely rather than distributing funds to non-profit organizations, and in some cases, benefitting non-qualified charities and individuals. As a result, on November 14, 2023, the Department of the Treasury and IRS released the first installment of long-awaited Proposed Regulations (REG-142338-07) providing guidance on certain tax rules relating to DAF’s.
Despite these outliers, DAF’s have proven to be effective philanthropic tools as demonstrated by data reported within the National Philanthropic Trust’s 2023 DAF Report. An oft cited complaint is that DAF account holders are not legally required to distribute at least 5% of their account balance to charities each year, as is the case with private foundations. But per the 2023 DAF Report, the payout rate across all DAF’s was 22.5% in 2022, with similar payout rates over the prior five years. This is considerably higher than the 6.8% average payout rate of U.S. private foundations in 2021.
At Humanize Wealth, we generally advise clients to fund DAF’s in an amount equal to three to five years of expected charitable donations. We also encourage an annual assessment of the prior year’s DAF grants and creating a budget for the following year. Our team also have the expertise to help formulate gifting strategies and identify values aligned non-profits to support. For larger and more complex cases, we can help identify and engage third party resources that specialize in developing strategic philanthropic plans.
Conclusion
DAFs are an important tool for investors seeking to use their financial resources to foster positive change across various economic, social and environmental systems from climate change to education, housing, biodiversity and even politics.
Over the years, I have learned to appreciate just how powerful DAFs can be in reducing the overall financial planning risk of a values-aligned impact portfolio. This is especially true when DAF funds are used to make impact first investments blended alongside other investments owned outside the DAF.
When used properly, donor advised funds help impact investors maximize the alignment and efficacy of their investments and philanthropic dollars. An astute advisor can help optimize the various factors involved, from cash flow and tax planning to identifying ideal DAF partners and investment strategies.
