Promise and Peril: Philanthropy at the Precipice

Philanthropy reflects the expansive capacity of our system to reward individual initiative and inspire generosity. Yet it also demonstrates the perils of the inequality this very system engenders.

Now, as disparities in wealth and power grow increasingly stark, many wonder what can be done to foster greater equity. One way to stem the flow of resources upward is to mobilize sequestered charitable funds. Vast repositories of such funds, compiled using tax deductions, are lying fallow in the treasuries of grantmaking organizations rather than being expended to support good works and alleviate suffering.

This is occurring largely because the laws governing philanthropy have not kept pace with economic and social changes. There are divergences between the original intent of the applicable legislation and the way it is currently applied. And there have been oversights and unintended consequences whose importance has only become evident over time.

The system diverges from our national values of fair play, democracy, and equity. For these and a host of other reasons, the legal framework is overdue for reforms designed to help philanthropic funds flow more quickly and abundantly, to make the tax code fairer, to ensure our values are reflected, and to broaden the base of public support for charitable causes.

My new white paper, Promise and Peril: Philanthropy at the Precipice, explores philanthropy as it functions in our society today, revealing areas where oversight has not kept up with current practices. It provides historical context for topical discussions on issues such as transparency, philanthropy’s impact on democratic culture, and the possible impact of current trends such as changes in corporate foundations.

The white paper explores salient legal issues and their role in creating and perpetuating our current system. With a significant emphasis on donor-advised funds (DAFs), the white paper and accompanying policy proposals offer and explain simple, relatively modest changes which, if enacted, could yield a philanthropic order that performs well for all our citizens.

Wealth and Philanthropy in the 21^st Century

U.S. poverty was not viewed as a social problem to be addressed by corrective action until the 19th century, when both government and private groups began providing assistance and services in a systematic manner. The philanthropic landscape was then dramatically altered by the introduction of foundations in the early 20th century.

Foundations and other nonprofit organizations continued to develop throughout the 20th century, operating with little oversight and accountability. To remedy this, the Tax Reform Act of 1969 (the 1969 Act) and the Peterson Commission that followed soon afterward established the framework that remains in place today.

This process made public the distinction between nonprofits, or public charities, and foundations. The 1969 Act also established payout rules, which required foundations to expend a certain amount (later fixed at 5 percent) on grants, minus administrative and other allowable expenses. Excise taxes on foundation investment income were enacted as well.

This framework, deemed the “Grand Bargain” by authors Dana Brakman Reiser and Steven A. Dean in their 2023 book For-Profit Philanthropy: Elite Power and the Threat of Limited Liability Companies, Donor-Advised Funds, and Strategic Corporate Giving, provided the means for wealthy individuals, couples and families to conduct elite philanthropy.

In exchange for targeting contributions to nonprofit groups under rules also including grant timing and requiring a certain amount of transparency, foundations may operate largely independently with scant oversight. Underlying all tax-exempt donations is the idea that because philanthropic activity benefits the public, the funds that support it may be deducted from the donor’s taxes.

Foundations can engage in ambitious experimentation without concern for failure, apply evidence-based techniques toward solving problems in novel ways, meet humanitarian needs and foster behavioral change and institutional transformation in ways that few, if any, other institutions can. While the Grand Bargain has enabled the flourishing of foundations and the cultivation of public trust in their work, there are areas that merit reexamination of the precepts on which this work relies.

Meanwhile, another means of grantmaking has emerged, rapidly becoming the charitable vehicle of choice: the donor-advised fund (DAF). A DAF is a way for donors to make donations of funds or nonliquid assets into a kind of nonprofit checking and savings account managed by a sponsor. The donor officially relinquishes control over the DAF when it is established and receives a tax deduction at the same time, even though no grants have been made. The donor retains advisory rights over the account, which the sponsor virtually always honors.

The use of DAFs exploded in the early 1990s, when commercial financial services companies established nominally nonprofit arms for the purpose of sponsoring DAFs. Commercial sponsors manage a greater portion of DAF assets than any other sponsoring group, controlling approximately $150 billion in DAF resources out of a total of $234 billion in 2021.

The rise in the use of DAFs has been dramatic. There are currently nearly 1.3 million individual DAF accounts in the country. In contrast, there are between 100,000 and 120,000 foundations.

DAFs offer donors many advantages, including no limits on the timing of and amounts to be expended on grants, no excise fees, the ability to donate noncash assets and the prospect of using the instrument as an element of a donor’s investment portfolio and estate planning.

From the perspective of public interest, however, DAFs have several disadvantages. The government has made no requirement that the funds ever be expended. This means that DAF holders may indefinitely harbor funds deducted from their taxes, even bequeathing them to others upon their deaths.

As DAFs become more prevalent, their lack of transparency becomes more problematic. Because so little information on DAFs is required, the public and government cannot oversee their use with specificity. Current requirements only call for the DAF sponsor to report the number of DAF accounts in aggregate. This precludes identifying DAF donors in connection with the specific grants they make. The lack of transparency also opens the door to dark money.

Another practice that merits scrutiny is that funds are being transferred from DAF to DAF. These transactions are opaque, raising additional concerns regarding transparency. Other DAF practices are troubling as well. Foundations are permitted to channel payout funds into DAFs rather than directly into grants to charitable organizations. This defeats the purpose of both the transparency and time-limiting measures governing foundation grantmaking.

Until the recent downturn, foundations were earning much more than the required payout in the capital markets, resulting in ever-larger endowments over time. In addition, foundations may use funds to finance administrative expenses, travel for members of the board of directors and other costs, and those funds will qualify toward the required payout. Such uses can leave much less of the payout amount available for grants.

Foundations may exist in perpetuity, notwithstanding the acute need for grant funding now. Moreover, this practice means that taxpayers are subsidizing donors’ long-term private interests, even though most citizens think the public should not have to do this.

Foundation family members and staff are allowed to sit on foundation boards. In contrast, most professional boards, such as those that govern nonprofit organizations, are independent.

If the business interests of a philanthropist who has established a foundation are bolstered by the foundation’s charitable work, this means the public may be subsidizing for-profit, or even dishonorable, activities.

Another issue arising in connection with both foundations and DAFs is the lack of accountability our system allows. Apart from the IRS requiring that grants be made to 501(c)(3) entities, state attorneys general requiring that grants be made without malfeasance and several state reporting requirements, they are accountable to no person or institution.

The more than $1.7 trillion held in DAFs and foundations represents an utterly colossal public investment. Taxpayers may justifiably ask why up to 74 cents of every tax-exempt dollar that would lie in the public treasury were it not subject to these deductions is instead allowed to languish.

How much authority does, or should, the government and the public have in determining whether donors are benefiting the public with the tax-subsidized funds they control? This question remains unresolved at present.

Areas of Particular Concern

Tax avoidance by donors and its impact on societal equity. Most people agree that our tax system falls short of its aspirations — both because philanthropic programs often do little to spread the benefits of wealth throughout society and because the tax system does not operate as its architects envisioned. In an equitable society, people should not have to depend upon the largesse of philanthropists to make good on rights they enjoy as citizens.

The undue influence of wealthy donors and how this affects democracy. Our system is beset with tension between democracy and the practice of philanthropy. The very nature of a foundation can subvert our democratic system when it uses tax-exempt funding to solve social problems without consulting or considering those who will be affected. And the ability of wealthy donors to seize the public agenda and dominate societal discourse is magnified by the ascension of ultra-high-net-worth donors, who are worth $30 million or more.

While most foundations support the idea of democracy, in practice most of them exist to carry out the vision and goals of one person or family. Even if their programs support democratic ideals, it is rare to find democratic consultation or interaction regarding whether or how those programs should proceed.

Dark money exacerbates and aids the undermining of democracy because it allows organizations with powerful political, antiregulatory, educational, and antidemocratic agendas to exercise clandestine power.

Whenever the government neglects an area for which it is formally responsible, the resulting deficits may be filled by actors neither chosen by nor accountable to the public. The wealthy may also displace government action in democracies because their interests are not closely aligned with the choices of democratically elected governments.

Top-heavy philanthropy. There has been a major change in the origins of charitable funds: a dramatically increasing percentage of overall giving can be attributed to a small number of high-income, high-wealth donors. Top-heavy philanthropy is reshaping the philanthropic sector and diverting massive amounts of revenue from public tax coffers.

This consolidation of resources also gives top donors undue sway over the public agenda. And it creates increased volatility and unpredictability in charitable funding by placing organizations — especially smaller ones — in a position of greater risk.

Political considerations. 501(c)(4) organizations are permitted to engage in political activity, clouding the line between philanthropy and politics. The lack of transparency with such organizations is problematic because dark money can easily be deployed through them without any oversight.

New uses of existing legal entities, such as forming LLCs to carry out philanthropic activities, are not subject to any restrictions on political activity. While such activity may be harmless, whenever the public assumes an institution has a neutral position when in fact its position is being promoted by a special interest, there are grounds for concern.

Institutional limitations of the current oversight system. At present, only the IRS and state attorneys general are charged with oversight of philanthropic activity. Yet these entities are neither adequately staffed nor sufficiently knowledgeable about philanthropic practices to perform the kind of broad-based, substantive oversight that the philanthropic sector needs.

Reductions in funding for nonprofit organizations. A healthy sphere of working nonprofits is vital to maintaining our philanthropic sector overall, but recent developments in charitable giving patterns have resulted in reduced funding for these organizations, impeding their ability to thrive.

A troubling lack of transparency. DAFs operate with absolute discretion over what information, if any, is disclosed regarding their resources’ origins or disbursements. Foundations may resist transparency because they need freedom to deliberate in privacy about prospective grants.

Yet grant applicants need to know the bases of donors’ decisions. Concerns regarding transparency also arise when donors seek to keep private the origins of their wealth. In addition, LLCs and other organizations that do not receive tax deductions are not obligated to disclose their investors’ interests.

Nonprofit tax filings are theoretically available to the public, but the IRS is overburdened and cannot provide the kind of streamlined, timely and complete online access that the public should have.

Policy Solutions

Although the origins of the system’s problematic features vary, their solutions can be grouped into three general categories. The individual reforms, along with details on their scope and coverage, are accessible in the Policy Proposals for Charitable Reform, originally issued by the Institute for Policy Studies on August 9, 2023.

Reforms to discourage the warehousing of charitable funds. Extensive warehousing of funds has resulted from oversights in drafting the legislation currently in force, loopholes that avert and subvert the legislation’s intent, inadequate governance of grant funds and practices that stretch beyond reason the meaning of measures currently in place.

This set of policy proposals would ensure that the large quantities of charitable funds currently lying fallow flow to their intended beneficiaries without delay. The policy proposals would also foster greater accountability and curb abuse by the many indirect giving mechanisms foundations and DAFs have devised and are using to slow and even halt the distribution of tax-exempt funds.

Reforms to protect the integrity of our tax system. This set of reforms addresses the fact that the tax system permits and even encourages many inequitable and undemocratic practices, as well as violating our notions of fair play.

Many problematic practices have proliferated because our system uses the tax code to govern areas extending far beyond its proper purview and current capacity. And widespread tax avoidance characterizes and funds the philanthropic sector, raising concerns regarding the proper formulation and execution of public policy.

Reforms to encourage broad-based giving. The rise of economic inequality, the decline in economic security for the middle class, and the advent of top-heavy philanthropy have decimated the generous giving for which average people have been known in this country.

Expanding and improving the fortunes of those in the middle would be the best way to address this. The next best, and likely more feasible, way to make charitable giving more broad-based is to target tax incentive structures.

Because philanthropy seeks to solve public problems with private resources, the power to channel those resources resides with a few wealthy individuals and institutions. How can we temper that power so that it does not usurp public prerogatives, while continuing to allow philanthropic institutions to use their creativity and freedom to devise innovative and effective programs?

Until recently, the Grand Bargain operated with broad public trust. Indeed, it is only that trust that has enabled the system to work. Now, that trust has eroded across the political spectrum, yielding increasing calls to reform the rules governing philanthropy.

Establishing, protecting, and fostering a democratic and equitable legal framework to govern philanthropy is the key to rebuilding trust in the sector. In fact, quieting mistrust with clear, just rules may be just the right bargain for this moment in history.