Philanthropists have many options for where to donate, but donor advised funds are a favorite among the ultra-wealthy. These close cousins to private foundations are accounts held through grant-making entities called commercial donor advised fund sponsoring organizations, or “DSOs.” Like private foundations, DSOs are subject to more restrictions than public charities. But unlike private foundations, those restrictions do not include a payout requirement.
As a result, DSOs offer a unique opportunity for donors to amass social influence through contributions that are never actually allocated to grants. Read that again: it is possible that contributions made to a DSO may never be used to fund real charity. In fact, IRS data suggests that roughly a fifth of DSOs averaged a payout rate of zero during the period for which information was available. But do low payout rates like these always reflect donor preferences? In a new essay, Professor Brian Galle offers compelling empirical evidence that the answer is no. At least part of the problem, according to Galle, can be attributed to agency costs that arise after a donor dies.
Galle begins by reviewing the “dead hand” problem in the context of private foundations. The dead hand theory suggests that once an initial funder dies, new managers may fail to serve the initial mission of the foundation. Instead, they may spend the charitable dollars on their own interests. This “gap between what a principal desires and what her agents accomplish” is known as “agency cost,” and it is presumed to be largest in long-lived organizations. Donors can try to curb agents’ opportunistic behaviors by drafting organizational documents, but monitoring for compliance and enforcing their terms is itself costly. For this reason, the law of private foundations includes payout requirements that help reduce agency costs by reducing the duration when funds are under agents’ control.
Remember, DSOs do not have payout requirements. Presumably, this is a flaw (or is it a feature?) that begs for an amendment. Or is it? How big of a problem are these agency costs? Galle argues that the answer to this question is key to evaluating whether payout requirements should be required of DSOs—and to assess the wisdom of perpetual foundations more generally. To help answer the question, Galle draws on data from two large datasets about private foundations, the IRS Core-PF file and the Foundation Directory (“FD”). From this data, Galle exploits the natural experiment of donor death dates to test whether agency costs increase after the last living donor dies. He finds that they do.
Galle examines two metrics: payout rate and overhead costs. He explains, that if there are “sharp changes in overhead and payout closely following the date of death, that would accordingly be powerful evidence that these changes are related to the inability of the donor to continue to influence them, rather than broad organizational factors such as size or mission.” In his analysis, Galle demonstrates precisely these changes. He finds that there is a “sharp rise in overhead the first reporting period after the last donor has died.” Similarly, the “payout rate drops immediately after the death of the last donor.” These results are further confirmed by regression analyses.
These findings provide strong support for Galle’s thesis that “donors and managers have different preferences about how quickly to spend the organization’s money, and that managers’ views prevail as soon as the donor’s direct influence is removed.” From a policy perspective, Galle’s study suggests that payout rules are justified as a way to reduce agency costs. Although DSOs are “somewhat different” from private foundations, Galle argues that his findings also suggest that donor advised funds “should not provide easy loopholes for escaping payout rules.”
Finally, the results cast doubt over state laws that encourage perpetual funding and accounting rules that require foundation managers to “act as though endowment funds are meant to last forever.” Galle argues that the better approach—if our main concern is to reduce agency costs—is to encourage faster giving, ideally during the donor’s lifetime. Here, Galle suggests that the estate tax might be used to encourage the wealthy to make larger gifts before they die.
Not only does Galle’s data-driven analysis shed new light on enduring questions, but it provides an accessible overview of issues surrounding the law of private foundations and donor advised funds. As a relative novice to the subject, I would have liked to see just a little more background about the definitional “quirk” that allows DSOs to escape payout requirements. I’m increasingly skeptical that true quirks exist, and I’d love to hear more about why DSOs are treated differently from private foundations with respect to payouts. But maybe that’s the subject of a different essay.
I recommend this essay to all tax scholars interested in nonprofits and foundations, estate planning, empirical legal studies, or wealth and inequality.