Donor-advised funds are in the news, here’s why it matters

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Attributing quotes to famous dead people is, as the great Greek poet Homer is said to have once remarked, one of mankind’s oldest storytelling traditions. In that spirit, I want to pass along Margaret Thatcher’s famous answer when asked to name her greatest achievement in office: “Tony Blair and New Labour. We forced our opponents to change their minds.”

In the US, this mental revolution took a very specific form: taxes — and tax avoidance — have become the primary engines of public policy. And it’s been an unmitigated disaster.

Why are charitable contributions deductible?

Charitable contributions have been deductible for so long it’s become difficult for some people to imagine any alternative. Difficult, but worthwhile. There are, I think, two obvious public policy reasons why charitable contributions might be deductible from taxable income:

• Charitable spending “doesn’t count.” This is a version of the backdoor VAT, which says that only personal consumption should be taxed, not personal income. Even though charitable spending is a form of personal spending (it’s directed by the individual, not the state), since it isn’t a form of personal consumption (it’s the charity’s beneficiaries who benefit, not the donor), it doesn’t belong in taxable income.
• Charitable spending is a “substitute” for state action. This argument says that individuals are able to direct spending more effectively than the state: while federal emergency aid might rely on crude tools like ZIP codes or satellite imagery, individuals close to the ground will know exactly who is affected and how, and they’ll be able to direct their giving in a way that will deliver higher per-dollar benefits than state action.

If you believe either of those things, I won’t try to convince you otherwise. I just want to ask the question, if you believe in your heart of hearts that either of those explanations is true, why are charitable contributions only deductible for high-income taxpayers?

The alternatives are obvious

If the state has determined, upon deep reflection, that individuals are better suited to direct the nation’s resources towards charitable ends than the state itself is, there are obvious solutions:

• the government could offer matching funds, at any ratio and with any limit. For example, in the 37% income tax bracket, a $1,000 donation generates $370 in tax savings. The federal government could simply offer a 59% match — the same $630 (after-tax) donation would generate the same $1,000 in charitable assets. If you think that’s too generous, pick a lower matching rate; if you think it’s too stingy, pick a higher matching rate. In either case, the match could be available to anyone with any level of taxable income, since it would be claimed by the charity, not the taxpayer.
• alternately, the federal government could simply assign everyone funds they can contribute to the charities of their choosing. In 2017, the Treasury department estimated $58.29 billion was spent on the deductibility of charitable contributions — roughly $376 for each of the 155 million individual tax returns filed that year. If that’s the amount of federal money we’re willing to spend on taxpayer-directed charity, then a simple box on each tax return seems like a commonsense way of allocating it. Anyone who’s familiar with United Way knows how this works.

Note that neither of these solutions is more complicated than the current system of tax deductibility. In fact, they’re both far simpler. The key difference is that they’re also more fair: whatever you think the purpose of federal spending on private charities is, there’s no logical reason that fixed amount of federal spending should be directed exclusively by the wealthy, the old and the dead.

Donor-advised funds are in the news because no one knows exactly what they are

All this brings me to the news hook for this post: donor-advised funds.

I said above that charitable contributions are only deductible for high-income taxpayers, but this isn’t exactly true: they’re deductible for high-deduction taxpayers. By far the most common itemized deductions are mortgage interest, state, and local taxes (with the latter two currently capped at $10,000, combined).

As your mortgage gets closer to repayment, or you consider moving to a lower-tax state, it might occur to you that this is a good opportunity to front-load some charitable contributions: once your house is paid off and Florida zeroes out your income taxes, your first $12,000 in charity will be in some sense “wasted,” since taking the standard deduction reduces your taxes by more than itemizing deductions would.

On the other hand, making a large donation immediately has its own drawbacks: there’s nothing more common than a charity run on a shoe-string budget blowing through your donation this year and then begging for more next year, when your tax advantage is much smaller.

Enter the “donor-advised fund:” make an irrevocable contribution to an investment account, take an immediate deduction, and then dole the money out over years or decades to the charities of your choosing.

What could go wrong?

You don’t own your donor-advised fund, but you think you do

Donor-advised funds are under assault for a very simple reason: large, centralized organizations are easy targets, and rightly so.

• In November, Schwab’s fund stopped allowing advisors to direct contributions towards NRA-linked organizations.
• Fidelity’s fund was likewise attacked for allowing funds to be paid out towards white nationalist hate groups like the Family Research Council, Center for Immigration Studies, and the New Century Foundation.

An interesting subplot to this story is that conservative con artists actually foresaw this exact development as far back as 1999: Donors Trust is a donor-advised fund that allows funds to flow exclusively to conservative organizations.

Irrevocable donations have the advantage of immediate tax benefits, but the disadvantage of irrevocability. What people are discovering far too late, to their chagrin, is what “irrevocability” means. You cannot shift your donor-advised assets from one fund to another. You cannot control what charities your fund allows contributions towards.

And the reason is simple: it’s not your money. It stopped being your money the second you claimed a tax deduction for it. It’s Fidelity’s money now, and there’s nothing you can do about it, except “advise.”

Conclusion: it doesn’t have to be this way

On this subject, someone on Twitter responded to me with what, I assume, they thought was an airtight criticism of my position, but which I thought was perfectly correct: “you think DAF custodians want to start to make calls on which legally incorporated charitable organizations meet their standards.“

The only disagreement we appear to have is that what Joseph describes incredulously is, in fact, the status quo: once a custodian accepts an irrevocable charitable contribution, and the donor deducts that contribution, there is no one else who can be responsible for the final disposition of those funds than the custodian. They cannot be rescinded and they cannot be transferred. They are in the hands of the custodian until they are depleted, and that means the custodian is going to be subject to criticism, sometimes fair and sometimes unfair, about where those funds go.

It doesn’t have to be this way. We can eliminate the charitable contribution deduction, eliminate “qualified charitable distributions” from IRA and 401(k) accounts, and wait for these donor-advised funds to die of their own accord. But as long as they exist, they’re going to be subject to criticism for where they send their money.

Because the second you gave it away, it wasn’t yours any longer.

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