Column: The charitable funds that benefit rich donors and the financial industry

Editor’s Note: This exclusive byline to the NewsHour is adapted from “The Undermining of American Charity,” co-authored by philanthropist Lewis B. Cullman and Boston College Law School professor Ray D. Madoff, in the New York Review of Books, dated July 14, 2016.

— Paul Solman, Economics Correspondent

I’m a businessman who has been fortunate in many ways. The successful sale of my company in 1999, At-A-Glance, along with other assets, brought my net worth close to $500 million. Since that time, I have given most of it away — over 90 percent to charities.

It was my mother who helped me understand that there’s more enjoyment in giving money away when you’re alive than after you’re dead. (In 2004, I wrote a book about my life and that philosophy, titled “Can’t Take It With You.”)

Our American system depends on an adequate flow of private donations to working charities. And our government encourages philanthropy by providing significant tax benefits to donors. Clearly, anything that disrupts this flow can have critical consequences for the charitable organizations and the people they serve.

Here’s the problem. In 2015, while the most popular charity (measured in donated dollars) was the United Way, the second was Fidelity Charitable. Ever heard of it? It was created and is serviced by Fidelity Investments via “donor-advised funds” (also referred to as DAFs), which give donors all of the tax benefits of charitable giving, but impose no obligation that the money be put to active charitable use!

Most Americans have never heard of donor-advised funds, in which “charitable contributions” are invested and held until the clients give instructions (or “advise”) about distributions to operating charities. Clients get exactly the same tax benefits when they transfer property to donor-advised funds as by making outright contributions to a museum, soup kitchen, university or any other federally recognized charity. But no deadline is imposed for the eventual distribution of these funds to an operating charity. If a donor fails to distribute the account during her lifetime, she can pass on the privilege of making distributions to her children or grandchildren or anyone else she chooses. The effect of these rules is that assets that have been given the tax benefits of charitable donations can be held in a DAF for decades or even centuries, all the while earning management fees for the financial institutions managing the funds and producing no social value.

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The funds serve a purpose for clients, of course. Individuals or families with a windfall often don’t know how much to give away or which deserving organizations to give to. Thus, middlemen like Fidelity or Schwab Charitable or Goldman Sachs will offer to put the money into a DAF for safekeeping until decisions can be made. But in the meanwhile, the donor receives sizable tax advantages as if he or she had already given the money. And guess who makes money holding and “administering” the funds that await distribution?

This DAF business plan has been highly successful. Many billions of dollars have been drawn into the orbit of charitable middlemen, and there is no end in sight. According to the National Philanthropic Trust, one leading DAF sponsor, annual contributions to DAFs hit an all-time high of $19.66 billion in 2014. The increase in contributions combined with a rising stock market, “drove total donor-advised fund assets above $70 billion for the first time,” the Trust reports. The leader, Fidelity Charitable, has had particularly strong growth, and it is widely expected that in 2016, it will surpass the United Way and receive more donations than any other charity in the country.

One of the most surprising aspects of the rise of DAFs is that donors participate in this $70 billion industry without any legal protections regarding their control over the distribution of the assets held in DAFs. When donors open donor-advised fund accounts, they do so because they expect to have continuing control over their donations.

However, not all donors have been so lucky. In one case, a DAF sponsor went bankrupt, and the donated funds were seized to pay its creditors. In another, the DAF sponsor used donated funds to pay its employees large salaries, hold a celebrity golf tournament and reimburse the cost of litigation when a dissatisfied donor sued. In both cases, courts ruled against the donors and upheld the rights of the fund sponsor to exert full legal control over DAF funds.

The main beneficiaries of commercial DAFs are the financial industry and its wealthy clientele. Financial institutions profit because DAFs are a source of investment assets: the more money they manage, the more profits they make. Moreover, they earn fees by providing management services to the charities set up specifically to hold the DAF funds. Finally, commercial DAFs also provide financial benefits to individual financial advisers who can continue to receive fees for investing their clients’ charitable donations.

But why would donors contribute billions of dollars to DAF middlemen, preserving only the right to make nonbinding recommendations about the distribution of the funds? The answer is that DAFs help donors get maximum tax advantages for their charitable contributions in at least three ways.

First, commercial DAFs make it easy for donors to time their charitable donations in a way that maximizes tax benefits. As any donor knows, the value of the charitable deduction is directly linked to his or her marginal tax bracket. (The margin is the threshold above which all income is taxed at a new higher rate.) For a married couple in 2016, any earned income above about $450,000 is taxed at the highest marginal rate: 39.6 percent. Thus, a $100 donation reduces income by $100 — $100 on which the taxpayer would normally owe $39.60 but no longer does.

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The benefit is much smaller for less well-heeled Americans. A married couple whose income doesn’t rise above about $75,000 never moves higher than the 15 percent marginal tax bracket. The value of the deduction is then worth only $15. And for the vast majority of Americans who don’t itemize their deductions, the charitable deduction provides no benefit at all.

For the rich, a key advantage of DAFs is that they allow donors to maximize tax savings by making large charitable contributions to DAFs in years when they owe high taxes (maximizing the tax benefit) and then using the funds to make distributions to charities in later years when their income is lower and the donation would otherwise be worth less.

In addition, commercial DAFs make it easy for donors to make contributions of property — including shares of stock — rather than cash. These donations can save an additional 20 percent in the capital gains taxes the donor would otherwise have to pay. Thus, while a $100 cash gift from a high-income taxpayer can save that taxpayer nearly $40, a gift of $100 in property can save the taxpayer close to $60 in combined income and capital gains taxes.

Finally, DAFs make it easy for donors to save on taxes by getting the maximum tax benefit for contributions of “complex assets” — property that is not publicly traded stock such as commercial and residential real estate, art, private business interests and even mineral rights, yachts and taxidermy collections. This is particularly valuable for taxpayers with investments in hedge funds and other business interests that are not publicly traded. If a donor were to give one of these property interests to a private foundation (the other charitable vehicle that allows a donor to have ongoing control), only the amount of the initial investment could be deducted. But if the donor were to give this interest instead to a DAF, the full current value of the asset could be deducted, because Congress was concerned about problems of valuation. So if a donor invested $100,000 in a hedge fund and it grew to $2 million, the donor would get only the $100,000 deduction if he donated to a private foundation. But the donor would get a $2 million deduction if the “complex asset” were given to a DAF. One proponent of DAFs has referred to this exploitation of previously untapped resources as “philanthropic fracking.”

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Some argue that DAFs, by providing additional tax benefits, might prompt more charitable giving overall. However, this is not the case. Charitable giving has been monitored for the past 40 years and, though subject to minor fluctuations, has remained remarkably constant at 2 percent of disposable net income.

In addition, the added tax benefits from contributions of appreciated property are disconcerting because of the inequitable way that these super-benefits are allocated. The wealthiest Americans are most likely to own stock and other appreciated property and, therefore, are in the best position to take advantage of this benefit. Indeed, taxpayers with annual income over $10 million made more than 33 percent of all charitable donations of appreciated property.

Particularly troubling to me is the detrimental effect caused by the diversion to DAFs of funds that would otherwise have been contributed directly to operating charities. Many donors make annual contributions to their favorite charities at the end of the year in order to obtain the tax benefits of their charitable gifts. Anyone familiar with this process knows that there is often some degree of anxiety in deciding which charities to support and how much to give. DAFs relieve this anxiety by allowing taxpayers to get the tax benefits of charitable giving without having to make hard decisions about how their funds will be allocated. The problem is that once money is put into a DAF, it is likely that a significant proportion of it will stay there.

My New York Review of Books co-author Ray Madoff and I are not knocking community-based foundations. We see instead an incentive for a DAF held by a financial services company to remain unallocated — either because it resembles a savings account that is pleasing for the donor to look at, or there is a desire to pass the DAF along to children or other family members.

But for 2015, for which the latest figures are available, some $70 billion has been sitting in DAFs, money that to my mind should be going directly to operating charities.