Satisfying Personal Pledges through Donor Advised Funds and Private Foundations
A tool often used by donors to give to charity is the pledge or promise to give. Pledges are obligations or promises to give money in the future, and are executed either in written or in oral form. The legal enforceability of pledges is governed by contract law and applicable state law. Although it is uncommon for charities to sue donors who renege on their promises to give, courts have sided with charities to enforce pledge agreements when disputes have arisen.
On their financial statements, charities record this promise as an asset (a pledge receivable) and record contribution revenue. They then relieve the pledge after receiving the funds.
With the recent growth of donor advised funds (“DAF”) and the use of private foundations (“PF”) as an estate/tax planning tool, donors are tapping into the assets of their PFs or DAFs to satisfy their pledges. Charities should be concerned about whether a pledge should actually be recorded on its books if the receivable is being paid off with funds from these sources. Even though the likelihood of collecting on the pledge is high, charities should be cautious about recording an asset on their books in this situation.
This whitepaper will discuss the risk to charities in accepting these pledges as well as the issues these types of gifts can cause to their donors. Charities can educate their donors about the pros and cons of using a DAF or PF to honor a personal pledge and can offer their donors alternatives to reduce these risks.
Donor Advised Funds
Donor advised funds are an increasingly popular giving tool. They allow donors to take a charitable deduction immediately, even if they wish to postpone their giving. A DAF is an account with a sponsoring organization, the public charity which controls the fund. Therefore, donors making contributions to a DAF can claim a charitable deduction on their tax returns. An individual who chooses to donate to a DAF relinquishes legal control of the funds. This is because, by definition, a donation can only be made when the donor‘s control over the assets is surrendered. Therefore, the individual’s ability to direct the use of the funds they contributed to the DAF is limited to making recommendations. In fact, the DAF has no obligation to abide by the donor’s suggestion, although in reality, DAFs rarely reject the donor’s request.
Now, if a donor plans to fulfill a pledge made to a charitable organization through a DAF, they may face some legal issues because the donor no longer retains control of the money. Specifically, if assets from a DAF are used to fulfill a donor’s pledge to a charity, the prohibited benefit rules would be violated because the charitable assets of the DAF are being used to satisfy a legal obligation of the donor. A detailed discussion of the prohibited benefits rules is beyond the scope of this paper, but it is useful to introduce this topic since penalties for violation of the rules are significant [125% of the private benefit].
If the DAF does choose to comply with the donor’s recommendations and donate to the charity of the donor’s choice, these funds are technically coming from the DAF and not the individual making the pledge.
Often, individuals choose to gift their money to a private foundation, which is a separate legal entity established by the individual or other persons for philanthropic purposes. In this case, direct financial transactions between a PF and all persons related to the foundation are strictly prohibited. Persons related to the foundation are referred to as disqualified persons. These individuals are not allowed to have their personal transactions flow through the PF, as this would violate self-dealing laws.
Therefore, an individual donating to their PF legally relinquishes the funds to the PF. If this individual made a pledge to a charitable organization, and the foundation makes the pledge payment, there is a financial benefit to the donor because the PF satisfies the donor’s legally binding obligation.
Legal Consequences to Involved Parties
Severe penalties can be imposed for violating laws relating to legally enforceable contracts. As described above, those who have sponsoring organizations fulfill obligations from a DAF and receive a benefit from the transaction may be subject to an excise tax equal to 125 percent of the benefit. Any fund manager with knowledge of the benefit from the transaction would also pay an excise tax equal to 10 percent of the benefit. With PFs, a disqualified person who receives a benefit from a transaction of the foundation, would pay 5 percent of the amount of the transaction, and a foundation manager who participates in self-dealing would pay 2.5 percent of the same transaction amount.
Practical Considerations for 501(c)(3) Organizations
There is no penalty on charitable organizations that accept pledges from individuals who fulfill their obligations through DAFs or PFs. Yet, charities should still understand the legal rules surrounding these transactions to help educate their donors about the potential pitfalls of these types of pledges.
From an accounting perspective, if it is noted that the payments are coming from either a DAF or a PF, the charity should consider whether it is reasonable to accept the pledge from an individual who no longer possesses ownership of their funds. Of course, it may not be possible for a charity to know at the outset whether a donor is satisfying a personal obligation from their DAF or PF. Often it is only when the first check is received that the charity notices that the payee is a DAF or PF. This presents a dilemma for the charity who may have recorded a pledge in good faith believing that the donor’s personal funds would pay off the gift. This is even more problematic when the charity has recorded an installment pledge. Should the charity write off the pledge? Ask the donor to satisfy the pledge with personal funds?
One suggestion to avoid this problem is to include information in the pledge form about how the pledge will be paid, whether with personal funds, a DAF or PF. When donors indicate their intention to pay the pledge with DAF or PF assets, the development department can reach out to the donor to discuss other alternatives for giving. For instance, when donors wish to give to a charity with DAF or PF funds, it may be beneficial to the charity and the donor to set up procedures for non-legally enforceable pledge intentions. This type of intention is not a binding commitment, but instead a notice that the donor plans to recommend that the DAF or PF donate to that specific charity. This creates no obligation by the donor, and the charity would not create a receivable based upon this notification.
Charitable organizations should also consider who should be thanked for making the pledge. If the charity is receiving the pledge from either a DAF or a PF, it should thank the organization providing the asset. Charities may also choose to thank the donor for recommending the PF or DAF that contributed to their charity. Development officers are often concerned about to whom credit should be given for a gift. This method of acknowledging a gift may help to alleviate this concern.
Although charities may not be legally affected by how their donors contribute, by understanding the regulations and responsibilities, the charity can help alert their donors of any possible legal violations. In addition, charities can avoid unnecessary accounting issues, including large write-offs of pledges, by having a solid understanding about how their donors intend to satisfy their gift commitments.
In summary, potential problems can arise when donors fulfill personal pledge commitments from their DAFs or PFs. In order to mitigate the problems caused by these transactions, charities can do the following:
Obtain information upfront from donors about how the pledge will be fulfilled,
Educate donors about the pitfalls and providing alternatives, and
Establish procedures for instituting non-legally enforceable pledge intentions which give donors credit for their gifts.
With the growth of DAFs, in particular, and the increased prevalence of PFs, charities can help avoid unexpected hits to their bottom lines by identifying these situations while also engaging their donors in a value-added conversation about their giving options.