You’re misclassifying donor-advised funds: Here’s why

Donor-advised funds (or DAFs) have existed for almost a century, but Congress didn’t get around to defining them for purposes of federal law until 2006. And then, the IRS didn’t bother proposing regulations under that 2006 statute until late 2023.

As a result, sponsoring organizations—the public charities that host donor-advised funds—have largely had to figure out for themselves how generally applicable federal law applies to DAFs. Their conclusions—what I refer to as their headcanon—haven’t always made sense.

In fact, I believe that several misconceptions about the federal definition of donor-advised funds persist, leading sponsoring organizations to misclassify donor-advised funds as funds of some other type. In this series of posts, I’ll explain why I think that’s the case.

Why it matters

Since 2006, donor-advised funds have been subject to special rules under federal law. In particular, DAFs:

  • Cannot receive Qualified Charitable Distributions from an IRA1;
  • Cannot own more than a limited share of ownership interests in a business entity2;
  • Are subject to stricter rules on excess-benefit transactions3;
  • Cannot grant to individuals4;
  • May only grant to non-tax-exempt organizations if done for a purpose described in section 170(c)(2)(B) and only if the sponsoring organization exercises expenditure responsibility5; and
  • Cannot provide a more-than-incidental benefit to a DAF advisor or certain related persons or business entities.6

In addition, contributions to donor-advised funds are only deductible if, among other requirements, the donor receives a contemporaneous written statement that the sponsoring organization has exclusive legal control over the contributed assets. Finally, sponsoring organizations are not eligible to file Form 990-EZ and must report some DAF-specific information separately on Form 990 Schedule D.

If a DAF sponsoring organization (like a community foundation) misclassifies some of its funds as non-DAFs even though they meet the legal definition of a DAF, then the organization will risk violating substantive provisions of federal law like those above or, at the very least, misreporting its financial information to the IRS.

Here’s what you’re getting wrong

Let’s start with the basics. Under 26 U.S.C. § 4966(d)(2)(A), a “donor advised fund” is

a fund or account—

  1. which is separately identified by reference to contributions of a donor or donors,
  2. which is owned and controlled by a sponsoring organization, and
  3. with respect to which a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges with respect to the distribution or investment of amounts held in such fund or account by reason of the donor’s status as a donor.

“Sponsoring organization” is defined in section 4966(d)(1) as

any organization which—

  1. is described in section 170(c)7 (other than in paragraph (1)8 thereof, and without regard to paragraph (2)(A)9 thereof),
  2. is not a private foundation (as defined in section 509(a)), and
  3. maintains one or more donor advised funds.

Section 4966(d)(2)(B) includes two built-in exceptions from the definition of “donor advised fund”:

The term “donor advised fund” shall not include any fund or account—

  1. which makes distributions only to a single identified organization or governmental entity, or
  2. with respect to which a person described in subparagraph (A)(iii) advises as to which individuals receive grants for travel, study, or other similar purposes, if—
    1. such person’s advisory privileges are performed exclusively by such person in the person’s capacity as a member of a committee all of the members of which are appointed by the sponsoring organization,
    2. no combination of persons described in subparagraph (A)(iii) (or persons related to such persons) control, directly or indirectly, such committee, and
    3. all grants from such fund or account are awarded on an objective and nondiscriminatory basis pursuant to a procedure approved in advance by the board of directors of the sponsoring organization, and such procedure is designed to ensure that all such grants meet the requirements of paragraph (1), (2), or (3) of section 4945(g).

In addition, section 4966(d)(2)(C) authorizes the Treasury Secretary to exempt other types of funds from treatment as DAFs:

  1. if such fund or account is advised by a committee not directly or indirectly controlled by the donor or any person appointed or designated by the donor for the purpose of advising with respect to distributions from such fund (and any related parties)10, or
  2. if such fund benefits a single identified charitable purpose.

With these provisions in mind, let’s consider some of the simple ways in which community foundations or other sponsoring organizations may be misclassifying donor-advised funds.

1. A donor has advisory privileges with respect to investments

Two types of advisory privileges can trigger classification as a DAF: those “with respect to the distribution . . . of amounts held in [the fund]” and those “with respect to the . . . investment of amounts held in [the fund.]”

So, even if no donor has a privilege to advise regarding grants (i.e., distributions) from a fund, the fund will still be a DAF if a donor (or his or her designee) has the privilege of giving advice with respect to investments because of the donor’s status as a donor.

2. A donor reasonably expects to have advisory privileges

When the IRS published proposed regulations under 26 U.S.C. § 4966 in 2023, some commenters criticized them for including what they regarded as an unfair provision that would trigger DAF status based merely on a donor’s belief that he or she had advisory privileges.

For example, in its comment on the rules, Renaissance Charitable Foundation—which manages over 20,000 donor-advised funds—argued: “Basing the determination of what constitutes a DAF on a [d]onor’s unstated belief will make administration of DAFs untenable.”

But that wasn’t what the proposed regulations had done. Refer back to the third element of a “donor advised fund” under section 4966: “a donor (or any person appointed or designated by such donor) has, or reasonably expects to have, advisory privileges[.]”11

The proposed regulations merely reiterated the statute’s own rule that a fund in which a donor (or donor-advisor) “reasonably expects to have” advisory privileges with respect to the distribution or investment of amounts in the fund satisfies the third element of the DAF definition.

In further explaining that rule, the IRS sensibly focused on the types of objective signs that would render reasonable a donor’s belief in his or her own advisory privileges: for instance,

  • Actual use: “The sponsoring organization allows a donor or donor-advisor to provide nonbinding recommendations”.
  • Agreement: “A written agreement between the sponsoring organization and a donor or a donor-advisor states that a donor or donor-advisor has advisory privileges”.
  • Marketing: “A written document or any marketing material made available to a donor or donor-advisor indicates that a donor or donor-advisor may provide advice to the sponsoring organization . . . (for example, a preapproved list of investment options or distributees that the sponsoring organization provides to a donor or donor-advisor)”.
  • Solicitation: “The sponsoring organization generally solicits advice from a donor or donor-advisor”.12

The point—as always—was to prevent unscrupulous types from winking and nodding their way through noncompliance, giving donors advisory privileges without ever explicitly saying so.

3. A donor serves on an advisory committee

There is a common misconception that mere service on an advisory committee does not constitute “advisory privileges,” but the text of section 4966 shows otherwise.

Consider the exception for scholarship funds, which applies to a fund or account “with respect to which a [donor or donor advisor] advises as to which individuals receive grants for travel, study, or other similar purposes,” but only if three criteria are satisfied:

  • The donor’s or donor advisor’s “advisory privileges are performed exclusively by such person in the person’s capacity as a member of a committee all of the members of which are appointed by the sponsoring organization”;
  • “[N]o combination of [donors or donor advisors] (or persons related to such persons) control, directly or indirectly, such committee”; and
  • “[A]ll grants from such fund or account are awarded on an objective and nondiscriminatory basis” and meet certain additional requirements.

By specifying that some funds in which a donor or donor advisor exercises advisory privileges only through service on a committee qualify for an exception from the definition of donor-advised fund, the text here implies that other such funds—those that fail to meet the other elements of the exception—do not.

The same is true of the provision authorizing the Treasury Secretary to exempt from treatment as a DAF a fund or account that “is advised by a committee not directly or indirectly controlled by [the donor or donor advisor] for the purpose of advising with respect to distributions from such fund (and any related parties)”. By saying that such funds can be exempted by regulation, Congress implicitly recognized that such funds are donor-advised funds by default.13

4. You aren’t actually following the exception for scholarships

The exception for scholarship funds merits closer attention.

First, note that the requirement that all members of the advisory committee be appointed by the sponsoring organization is distinct from the requirement that no combination of donors, donor-advisors (those appointed or designated by a donor), and related persons control the committee.

A pro forma appointment of an advisory committee, for instance, might satisfy the first requirement, but it wouldn’t satisfy the second if the committee consists entirely of a donor and individuals he or she designated to serve on the committee.

Second, notice the requirement that the scholarship grants be awarded “pursuant to a procedure approved in advance by the board of directors.” A sponsoring organization that can’t point to the procedure approved by its board pursuant to which it awards scholarships (and the action approving that procedure) cannot expect to benefit from this exception.

Summary

These are four ways in which I believe sponsoring organizations commonly misclassify (or at least commonly risk misclassifying) donor-advised funds. Given the text of 26 U.S.C. § 4966, that belief should not be controversial.

In my next post in this series, I’ll explore another document from 2006 that I believe has led virtually the entire field of DAF sponsoring organizations astray in interpreting section 4966 and the requirements of federal law. I expect my conclusions in that post will be controversial, so be sure to check back in for that!

  1. 26 U.S.C. § 408(d)(8)(B) ↩︎
  2. 26 U.S.C. § 4943 ↩︎
  3. 26 U.S.C. § 4958(c)(2) ↩︎
  4. 26 U.S.C. § 4966(c)(1)(A) ↩︎
  5. 26 U.S.C. § 4966(c)(1)(B) ↩︎
  6. 26 U.S.C. § 4967 ↩︎
  7. 26 U.S.C. § 170(c) lists the types of organizations to which deductible charitable contributions may be made. ↩︎
  8. Section 170(c)(1) describes states and U.S. possessions, their political subdivisions, the United States, and the District of Columbia. ↩︎
  9. Section 170(c)(2)(A) requires that, to be eligible for tax-deductible charitable contributions, a “corporation, trust, or community chest, fund, or foundation” must generally be a domestic entity. ↩︎
  10. In December 2006, the Treasury Department issued interim guidance exempting certain employer-sponsored disaster-relief funds from treatment as DAFs. In November 2023, the IRS issued proposed regulations that would have, among other things, exempted certain scholarship funds sponsored by certain 501(c)(4) organizations and non-employment-based disaster-relief funds from treatment as DAFs. ↩︎
  11. Emphasis added. ↩︎
  12. Prop. Treas. Reg. § 53.4966-3(c)(2) ↩︎
  13. The IRS’ 2023 proposed regulations made this rule explicit: “Advisory privileges include those arising from service on an advisory committee.” Prop. Treas. Reg. § 53.4966-3(c)(1)(i). On the other hand, the regulations also included an exception for service on a committee—even by a donor—if certain additional criteria were met suggesting that appointment to the committee was not because of a donor’s status as a donor. See id. § 53.4966-3(c)(1)(iii). ↩︎