So these two guys walk into a bar.

Actually, I was one of them. It was the end of a conference in Minneapolis last fall, and I had to kill time (and find food) while I was waiting for a colleague to finish a meeting. So I grabbed lunch at a bar and struck up a conversation with the guy next to me.

He and I really hit it off. We talked movies, politics, and books. Lunch passed quickly. At the end we shared what we did for work. When he said he was a criminal lawyer, he saw me do a bit of a double-take. (He seemed used to that reaction.) So he said, in an obviously practiced response: “Remember: criminal lawyers are civil. Civil lawyers are criminal.”

A good line, with all due apologies to you civil lawyers out there.

So here’s my parallel reminder when thinking about charitable foundations: Private foundations are public. Public foundations are private.

Here’s what I mean. If a family establishes a private foundation, they have the right to maintain great control.  Most notably, they can populate the board with family members and friends. But in exchange for that control, they have to disclose each and every grant (along with many other details) in their federal tax return, which is part of the public record. The notion is: “Hey, wealthy family! You have control of this tax-exempt entity, so you are subject to significant scrutiny!”

On the other hand, a different family may choose to create a donor-advised fund at a public charity like a community foundation or the Fidelity Charitable Gift Fund. (I talked about donor-advised funds in an earlier blog post.) In this case, the donors have less control. They can only recommend grants from their funds: the final decisions are up to the boards of the larger public charities in which they are lodged. And there is also less scrutiny. The names of the advisors can be anonymous, and there is no requirement to list which grants came from which advised funds. The notion is: There is an independent board of directors at this public charity, so they will keep an eye out for any chicanery. No need for the public at large to know every detail!

But lately I’ve noticed a trend where clever managers of private foundations use donor-advised funds as a way of avoiding scrutiny.

Here’s how it works:

Instead of the private foundation making, say, 50 different grants to nonprofit organizations, all of which will be itemized in its tax return, it makes a single grant to a donor-advised fund within a community foundation or at a commercial gift fund, such as those run by Fidelity, Schwab, or Vanguard. Then the donor-advised fund makes the grants – but without having to disclose the names of which grant recipients received money from which funds. (Again, the donor-advised funds are embedded in public charities. And what is public… is private.)

For nonprofits, this is an unsettling turn of events. In years past, they could easily research foundations and see their pattern of grantmaking, learning how much went to which nonprofit for what purpose. This is critical for gauging what sort of new grant request might receive funding. Now – the trail goes cold. Knowing that Foundation A made a single grant of $1.5 million to the Fidelity Charitable Gift Fund tells us nothing about their charitable interests, because we don’t know who the final beneficiaries are.

That’s assuming that the donor-advised fund made any grants. Indeed, this is the biggest issue: there’s no requirement for donor-advised funds to distribute anything at all in grants in a given year. Though most, of course, do make grants, and though the average donor-advised fund actually distributes generously each year, they don’t have to.

In other words, a hypothetical $100 million private foundation is required by federal law to distribute $5 million in grants this year – 5% of the market value of its assets. The foundation makes a single $5 million grant to a donor-advised fund it controls. It then chooses not to make any grants out of that donor-advised fund. Technically, the private foundation has made its required distribution to a public charity (the organization housing the donor-advised fund). But not a single homeless person has received shelter. Not a single hungry person has been fed. No students have received scholarships, no books have been purchased for libraries, and no illnesses cured.

This is unnerving. Though we can appreciate that family members overseeing a private foundation don’t want their every move analyzed and dissected, the family received a significant tax break and great control when they established the foundation. In exchange, the federal government said: We want the community to benefit, and we want everyone to be able to see what you do with the money. By manipulating their grantmaking through a donor-advised fund, there’s no guarantee that anything at all will go to benefit the community, and nobody can trace what happens to the money. Neither the government nor the public can see the actual end users of the funds, only the name of the intermediary (the public charity housing the donor-advised fund).

There’s nothing illegal about this maneuver. But that doesn’t make it right. It essentially provides the kind of privacy that specifically is not allowed by private foundation regulations. It reduces transparency – drastically. And there’s no guarantee that the funds are going out into the community for grants.

This slight-of-hand approach to grantmaking strikes me as disingenuous at best. And if this practice grows in popularity (as I’m guessing it might), it may attract the scrutiny of regulators and encourage the creation of new restrictions on donor-advised funds. And, frankly, it should.

If you’ve also seen this trend, let me know. And if you’re one of the folks who figured out this end-around for your private foundation – please feel free to give your side of the story!

Copyright Alan Cantor 2012. All rights reserved.

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