IRS Proposes Regulations for Excise Taxes on Taxable Distributions from Donor-Advised Funds

The US Internal Revenue Service (IRS) and US Department of the Treasury (Treasury) recently issued proposed regulations under Internal Revenue Code Section 4966 (the Proposed Regulations) that provide important clarifications and address a number of open issues related to the operation and administration of donor-advised funds (DAFs).

Section 4966 [1] was enacted as part of the Pension Protection Act of 2006 and imposes an excise tax on a taxable distribution made by a sponsoring organization from a DAF as well as on any fund manager who agrees to the making of the distribution knowing that it is a taxable distribution.

Taxable distributions under Section 4966 include distributions to natural persons and, unless the DAF sponsoring organization exercises expenditure responsibility, “disqualified” supporting organizations and noncharitable entities.

PROPOSED REGULATIONS

The long-awaited Proposed Regulations provide more detailed definitions of key terms that were codified in Section 4966. In particular, the guidance answers some important questions and provides more clarity around the following issues:

• What is a “DAF” and a “donor-advisor” for purposes of Section 4966? The Proposed Regulations adopt broad definitions of both terms. Sponsoring organizations will need to assess whether funds that they have historically excluded as DAFS will be required to be treated and reported as DAFs going forward and undertake a similar exercise with respect to donor-advisor identification.
• What is a “distribution” (previously undefined) that could be subject to the Section 4966 excise tax? The Proposed Regulations again adopt a broad definition of this term, meaning DAFs engaging in certain direct transactions, such as the purchase of services, may need to consider whether such transactions could be considered a taxable distribution.
• Who are appropriate recipients of DAF distributions such that the Section 4966 excise tax will not apply? The Proposed Regulations confirm that certain foreign governmental organizations qualify as organizations described in Section 170(b)(1)(A) and adopt rules similar to those in place under the Section 4945 taxable expenditure regulations that permit sponsoring organizations to make grants to foreign organizations with an equivalency determination and treat them as grants to Section 170(b)(1)(A) organizations.

While these clarifications—and others around how a sponsoring organization can exercise the requisite expenditure responsibility under Section 4966—provide guidance for sponsoring organizations, donor-advisors, and tax-exempt organizations that make grants to or receive grant funds from DAFs, some important issues remain, including the following:

• The Proposed Regulations exclude investments from the definition of distributions but note that certain charitable investments (such as a zero interest loan) may be properly characterized as distributions. It will be important to have more clarity around what kinds of charitable investments made by a DAF could be treated as a distribution.
• The Proposed Regulations also prevent outside investment advisors/managers from being compensated from DAF funds if they also provide investment management advice with respect to the donor’s personal assets because such investment advisors are treated as donor-advisors of the DAF (and therefore subject to automatic excess benefit transaction treatment under Section 4958) regardless of whether the donor appointed or designated such advisor as a donor-advisor. It is unclear whether these provisions in the Proposed Regulations might extend to compensation paid to other types of advisors paid by the DAF in ways that might impact the existence or structuring of those relationships.

While, as proposed regulations, these rules will be effective only for tax years ending after the date that they are published in the Federal Register as final regulations, taxpayers may choose to rely on the Proposed Regulations for tax years before that date.

The sector continues to await guidance on other important issues around the administration of DAFs, and we expect further guidance from the IRS and Treasury that will address the following projects listed on the IRS’s 2023-2024 Priority Guidance Plan:

• Proposed regulations under Section 4967 regarding prohibited benefits, including excise taxes on donors, donor-advisors, related persons, and fund management for advising on transactions through which they receive a more than incidental benefit;
• Proposed regulations under Section 4958 regarding the applicability of the intermediate sanctions rules to DAFs and supporting organizations; and
• Guidance regarding the public-support computation for public charities with respect to distributions they receive from DAFs.

TREATMENT OF A FUND OR ACCOUNT AS A DAF

The Proposed Regulations adopt the Section 4966(d)(2)(A) definition of a “DAF” and provide additional guidance regarding whether a fund or account is “separately identified by reference to contributions of a donor or donors” and whether there is at least one donor-advisor with “advisory privileges.”

Under the Proposed Regulations, a fund is separately identified if the sponsoring organization maintains a formal record of contributions to the fund or account relating to a donor or donors (presumably this amounts to something more than the records that would be required to demonstrate public support or provide substantiation of contributions).

If these records are not present, a facts and circumstances test applies, and the Proposed Regulations list a number of facts that tend to show that a fund is separately identified, including whether the fund balance reflects items such as contributions, dividends, interest, distributions, administrative expenses, and gains and losses; the fund is named after one or more donors, donor-advisors, or related persons; the sponsoring organization refers to the fund as a DAF or has an agreement with donors or donor-advisors that it is a DAF; one or more donors or donor-advisors regularly receive a fund statement from the sponsoring organization; or the sponsoring organization generally solicits advice from the donor or donor-advisors.

The Proposed Regulations also establish a facts and circumstances test to determine the existence of advisory privileges and clarify that, with certain limited exceptions, advisory privileges are generally deemed to exist by reason of a donor’s status as a donor.

Advisory privileges also exist if any of the following are true, regardless of whether a donor or donor-advisor actually exercises such rights: (1) the sponsoring organization allows a donor or donor-advisor to provide nonbinding recommendations regarding distributions or investments; (2) a written agreement between the sponsoring organization and the donor or donor-advisor states that they have advisory privileges; (3) documents or marketing materials indicate that a donor or donor-advisor may provide advice; or (4) the sponsoring organization generally solicits advice from a donor or donor-advisor.

The Proposed Regulations also include specific rules for determining whether individuals appointed by the donor to an advisory committee have advisory privileges.

DAF EXCEPTIONS

While DAFs are broadly defined under the Proposed Regulations, there are some clear exceptions to the definition of a DAF:

Funds making distributions only to a single identified organization. Funds that make distributions only to a single identified organization described in Section 170(c)(2) or 509(a)(1), (2), or (3) (other than a “disqualified” supporting organization, which includes a non-functionally integrated Type III supporting organization or a supporting organization controlled by a donor or donor-advisor).

Certain funds granting scholarships. Funds that make grants to individuals for travel, study, or similar purposes and meet certain conditions that align with the requirements for private foundations under the Section 4945(g) individual grant rules. However, the exception does not apply if the selection committee is directly or indirectly controlled by any combination of the donor(s), donor-advisor(s) or related persons. The Proposed Regulations define “indirect control” to include any person who is an employee or independent contractor of the donor, donor-advisor, or related person.

Certain scholarship funds established by certain 501(c)(4) organizations. Funds established by a broad-based Section 501(c)(4) membership organization, such as a Rotary Club, that make grants to individuals for scholarships described in Section 4945(g)(1) and meet certain conditions. The preamble to the Proposed Regulations requests comments on whether this exception should be extended to other organizations that use committee-advised scholarship funds such as those described in Section 501(c)(5) and 501(c)(6).

Certain disaster relief funds. Funds that provide relief from qualified disasters within the meaning of Section 139(c)(1), (2), or (3) and meet certain conditions. As with the scholarship exception, the exception will not apply if 50% or more of the members of the selection committee are employees or independent contractors of the donor, donor-advisor, or related person, or otherwise controlled by such persons.

NEW DEFINITIONS OF KEY TERMS

The Proposed Regulations include the following definitions for purposes of providing clarity in applying the Section 4966 rules:

Distribution

Any grant, payment, disbursement, or transfer, whether in cash or in kind, from a DAF. However, investments and reasonable investment- or grant-related fees are not considered distributions. The preamble to the Proposed Regulations signals that certain charitable investments may be properly characterized as distributions. The Proposed Regulations do not attempt to define charitable investments and ask for comments on the issue.

Donor

Any person described in Section 7701(a)(1) that makes a contribution to a fund or account of a sponsoring organization other than a contributor that is a governmental unit described in Section 170(c)(1) or an organization described in Section 509(a)(1), (2), or (3) that is not a disqualified supporting organization.

Donor-Advisor

A person appointed or designated by a donor to have advisory privileges, including delegees. A person who establishes the fund or account and provides advice regarding distributions will be treated as a donor-advisor regardless of whether the person contributes to the fund or account.

This definition also includes investment advisors who provide advice regarding both the assets maintained in the fund and the personal assets of a donor to that fund regardless of whether the donor appointed or recommended them (except advisors who only provide services to the sponsoring organization as a whole, rather than to the DAF).

Members of an advisory committee who are recommended by a donor are donor-advisors unless (1) the recommendation is based on objective criteria related to the member’s expertise; (2) the committee consists of three or more individuals, a majority of whom are not recommended by the donor; and (3) the member is not a related person with respect to the recommending donor.

TAXABLE DISTRIBUTIONS AND EXPENDITURE RESPONSIBILITY

The Proposed Regulations adopt certain concepts from the Section 4945 taxable expenditure rules applicable to private foundations in determining whether a distribution from a DAF is a taxable distribution under Section 4966. Specifically, the Proposed Regulations provide that sponsoring organizations will be treated as exercising expenditure responsibility if they follow the procedures in Section 53.4945-5(b)-(e), with certain modifications adapting the requirements to the DAF context.

In addition, the Proposed Regulations confirm that certain foreign governmental organizations qualify as organizations described in Section 170(b)(1)(A), and sponsoring organizations can treat grants to foreign organizations with an equivalency determination (obtained using procedures similar to those set forth in Section 53.4945-5(a)(5)) as grants to Section 170(b)(1)(A) organizations.

REQUEST FOR COMMENTS

Comments are invited on a range of important topics under the Proposed Regulations and are due to the IRS and Treasury by January 16, 2024. We encourage organizations impacted by the Proposed Regulations to consider submitting comments.