Charity Scams: Private Foundations and Donor-Advised Funds

Lewis B. Cullman is a wealthy old man who has given many millions to charitable causes.  He was in a bad mood when he wrote an article for The New York Review of Books in 2003.  It was titled Private Foundations: The Trick.  Scam would have been a more appropriate term, but Mr. Cullman is apparently also a gentleman.

“The next time you read about a rich person donating $100 million to charity, you should be aware that this seemingly generous gift may never actually reach the institutions that need it. The chances are that the donation is being used to set up a private foundation. The gift will earn the donor a full deduction against income or estate taxes. But the little-understood trick of this form of philanthropy is that the $100 million that launched the foundation need never go to charity.”

The “trick” involves hiding behind the IRS requirement that private foundations must spend at least 5% of their assets each year.  However, the IRS does not require those funds be issued as a grant of some sort.  It is perfectly legal to charge 5% against the assets for administration costs.  Consider also that it is relatively easy for smart money managers to earn at least 5% on $100 million nest eggs.  Given that private foundations have no termination date, a charitable foundation could go on forever without donating a significant amount to charity.

“Some large foundations typically pay out about 3 percent of their assets each year in the form of charitable gifts and divert 2 percent to administrative expenses and the like. Since even a mediocre money manager should be able to average a 5 percent return on a foundation’s principal, the IRS is in effect requiring that the foundation spend only its income plus capital gains. None of the principal need go to an active charity that provides services.”

Now consider the wealthy person who wanted to avoid estate taxes and still provide for his children.  The $100 million could be administered by a son or daughter or multiple offspring.  This task would provide a salary and expense account worth millions every year that could be passed on to subsequent generations.

Cullman’s anger arises from the fact that many of those who use this procedure to avoid taxes are also using it to avoid actually contributing the money to charity.  He was still angry a month ago when he returned to the same publication with a new article: Stop the Misuse of Philanthropy!

“In the past twenty years, I’ve given away close to $500 million of my own money.”

“At ninety-five, as a businessman and philanthropist, I want to call attention to little-known ploys in US philanthropy that rob our society of hundreds of millions of dollars earmarked for important charitable causes—leaving money stashed away in financial institutions and doing no good for anyone except money managers and other financial intermediaries.”

Cullman renews his disgust with private foundations and adds this bit of information:

“Recent estimates indicate that at least $700 billion is tucked away in private foundations, money that could be doing good for charities and for the economy—and you and I as taxpayers have underwritten the tax benefits awarded those foundations.”

The real reason for the current article is to alert us to what he fears is yet another scam that diverts money from charitable purposes to feather the nests of investment managers.

“The more aggressive game in philanthropy I have in mind, one with a soothing but misleading name, is called Donor-Advised Funds (DAFs). Back in 1991, the Boston-based Fidelity Investments applied to the Brooklyn IRS and got a ruling that drastically changed the tax landscape governing charitable donations.”

A Donor-Advised Fund appears to be a simplified way to shelter funds from taxes, but without the hassle of setting up a foundation.  Ownership of the funds is transferred to whomever is administering the fund— Fidelity for example.  The donor can specify when and how the funds are to be distributed.  It is not clear what happens when the donor passes on.  Presumably, the administrators acquire full control. 

“Donors get the same tax benefits when they give to a DAF that they would get by contributing to a museum, soup kitchen, university, or any other federally accepted charity. But rather than having the gift made directly to a charity, the funds can simply sit in the account awaiting instructions from the donor. If the donor never gets around to making distributions, they stay in the account earning substantial fees for investment managers. Recently, mutual fund management companies such as Fidelity, Vanguard, and Charles Schwab have set up separate charity accounts to compete for funds.”

“Professor Ray Madoff at Boston College Law School has long argued for laws that require timely payouts from DAFs; she says that there is now more than $60 billion tied up in them, and that the amount of money involved is growing at a high rate. Rather than the American people benefiting, it’s Fidelity and others who are thriving.”

Cullman finishes with this wish.

“Before I hit one hundred, I’d like to see all money designated as “charitable”—which the American government and its people underwrite through tax deductions—get into the hands of those who really need it. There should be a simple, uncomplicated bill relating to foundations and DAFs, fair and easy to understand, requiring that donated money not come under the control of profit-making financial managers.”

Some are distressed to learn how so little of the funds ostensibly designated as charitable contributions actually arrive in the hands of charitable organizations.  Others are outraged to learn how easy it is to avoid taxes and create a legacy to be passed on like an inheritance.  Those in this latter class can stoke their populist indignation by checking out an article in Slate by Alexander Arapoglou and Jerri-Lynn Scofield: 10 tax dodges that help the rich get richer.

Some might also find it useful as an estate-planning tool.