Charitable donations and the infrastructure supporting them

Patrick McKenzie (patio11)

I have many weird hobbies, and one of them was that I once tweeted myself into running the U.S.’s shadow vaccine location information infrastructure. It’s a long story for another day. Relevantly to this column, that resulted in me becoming the CEO of a charity, and I got an up-close-and-personal look at how money moves into and out of charities. It is fascinating; charities are both treated far more like regular companies than you’d expect and also have some procedural weirdness.

This issue will unfortunately be a little U.S.-centric both because Americans have a distinct charitable tradition (leading the world in donations by every metric you can imagine) and because a lot of the infrastructural complexity is downstream of a societal decision to subsidize most public charitable works via tax law. Tax treatment of charitable giving varies wildly between countries. In Japan, for example, you can only deduct charitable donations given to the Japanese government itself, which creates its own truly fascinating ecosystem that I’ve written about elsewhere.

(My usual disclaimer here: I’m currently employed at Stripe, was previously the CEO of Call the Shots, Inc. from its formation through dissolution, and am speaking solely for myself.)

How charities are organized in the U.S.

Most organizations with a formally recognized legal existence in the United States are created under the laws of a state. This sometimes surprises non-American observers; companies in Delaware and companies in Illinois very literally aren’t the same thing (except when companies in Illinois were incorporated in Delaware because… that’s another column).

Charities are generally very similar. Some states have particular registration processes for them which are distinct from for-profit companies (or other forms of organization); in other states they’re organized as regular companies which happen to have some differences in their mission, founding documents, and similar. And indeed the rest of the world mostly interfaces with charities as if they were businesses. Mostly. A charity can rent an office, hire a person, buy a carton of printer paper, open a bank account, invent a work of art, or be sued, just like any company.

Most differences in how charities operate compared to for-profit companies are a matter of choice. Much like companies, they are generally given extensive latitude in how they conduct their own affairs, and the rest of the world has extensive latitude in how they choose to interface with them. There is one very conspicuous exception: tax-exempt status.

Lay people often say the word IRS (Internal Revenue Service, the U.S.’s federal tax agency) at this point. Individuals I know who worked at the IRS are extremely, extremely exasperated about this and will expound upon given any provocation or none at all: the IRS does not make tax policy. The American people, through their elected representatives, make the tax policy that they wish to be governed under; the IRS is then in charge of converting those wishes into forms, ingesting (and distributing) a great amount of data and money every year, and assisting taxpayers through the process.

One thing that the American people are overwhelmingly in favor of: charitable works, broadly characterized as “Come on, everyone knows what charity looks like”, are things we want more of in the world at almost all margins, and the government should therefore encourage them via tax policy.

This results in charities having two linked but crucially distinct tax benefits. One is that donors can deduct charitable donations from their income prior to paying income tax. This has the effect of subsidizing donations; the out-of-pocket cost to convey $10,000 to a charity is, for most donors, a few thousand dollars less expensive than spending the same $10,000 on almost anything else.

The second is that charities themselves are exempted from a range of taxes, most prominently (at the federal level) income tax, but again the American public is extremely, extremely in favor of charities and so many state- and locally-assessed taxes also have a carveout for charities. Sales tax, often surprisingly to people not involved, frequently exempts any purchases made by charities, which can very literally result in charity employees flashing paperwork to confused clerks or businessmen at checkout and trying to (sometimes) patiently explain that the total printed on their receipt is illegal and please try again.

This is an enormously valuable privilege and one which is extremely vulnerable to misuse, and so the American people have instructed their elected representatives to square a circle: they don’t want the government making value judgments about charities, because government shouldn’t be in the religion business or pry into the affairs of civil society’s diverse panoply of do-gooders, but they do want the government to make sure not to subsidize putatively charitable organizations which are clearly not actually charities.

And so our benighted friends at the IRS find themselves caught, not for the first time, between multiple priorities the public holds in equally high regard which conflict with each other.

The way the regime (which, again, a creature that the American public caused to be written into law, not a thing the IRS cooked up) works is that the IRS cares not at all about charities per se but exercises pre-authorization and ongoing monitoring of charities which seek to avail themselves or their donors of tax-advantaged status. They explain it in patient and exacting detail on their website.

Recordkeeping for charitable donations

Many (but probably not most, interestingly) transactions made in the economy need to have records kept of them for tax purposes. The IRS generally awards taxpayers an extreme degree of latitude in choosing the form of their records. So much so that, as a one-time first-time small businessman, I spent hours looking for a sentence which would clarify whether I could keep my records in a database or not—the IRS is so neutral about format that they used to not mention software at all. The exceptions to this format neutrality are records which would be needed to substantiate tax positions that have historically been extensively abused.

Charitable donations fall into that category, and so (over a low limit, currently $250) donors seeking to deduct their donations need to get a written acknowledgement from the charity substantiating the donation.

The requirements for that acknowledgement are simple enough that a seven year old child could produce a conforming one with two minutes of instruction. So of course there are billions of dollars of professional labor and software spent on charitable recordkeeping every year.

My opinions on this are, candidly, complicated.

One is that infrastructure always sounds easier to build at societal scales than it actually is, and given the American people’s decision that they would build and subsidize a national fundraising mechanism which is materially implicated in literally every community and literally every field in life, the American people were of course deciding to invest in some expensive infrastructure. That infrastructure is extremely operationally complex, costs what it costs, and the public benefits enormously from it.

One of the numerous non-obvious requirements is that the charity needs to be able to produce a report at the end of the year (Form 990 Schedule B) listing any donors who made more than $5,000 in aggregate tax-advantaged donations, which causes data processing and retention issues that regular businesses don’t have. (Those probably seem like pretty minor issues, but I would say with a high degree of confidence that none of AppAmaGooBookSoft could today answer the question “How much did I spend with you last year across all transactions?” to a degree of rigor their accountants would be comfortable with signing off on to the IRS.)

This requirement serves dual purposes: it allows the IRS to cross-check claimed deductions with the charity’s own return. This helps foil tax cheats getting a convenient seven year old to forge charitable receipts. It also allows the IRS, and by extension the public, to verify that the charity isn’t primarily rich people self-dealing. The test used effectively (partially) outsources the judgement to the public. You are a charity if you do good deeds, and you are presumptively doing good deeds if you can convince widely disparate Americans that you are so effective at doing good deeds that they should part with their own money to have you do more of them, without getting any direct benefit in return.

A fun two-opposing-ideas-synthesized part of charitable tax policy: while almost all charitable tax returns are public records and have to be both published by the charity and released by the IRS on request, the identities of donors are kept private. The American public both doesn’t want people to cheat the system but also expects privacy in their dealings with e.g. their churches, schools, medical providers, etc. If you find a charity’s Schedule B on their website, they should have all large donations listed with one line per donor but the name and address of the donor redacted.

My third thoughts, though, whisper that the charitable-industrial complex partially arises because charities are extremely price insensitive when it comes to taking donations, because donations are (of course) free to them at the margin, and so they tolerate leaking very large amounts of money during the fundraising process. The tolerable degree of fundraising (and administrative) expenses in the charitable-industrial complex has caused substantial debate over the years, both inside and outside of it. We won’t resolve that debate today, but just know that every e.g. portal you’ve ever used for online giving has as one of its primary selling points to charities “We replace part of your massive recordkeeping operation with software for less money than it would cost you to hire people to do it, but that software won’t be exactly cheap.”

There is a surprising bit of nuance in the real world, one reason it is so infinitely interesting.

Charitable donations and time travel

My elevator pitch for why anyone should care about finance: it is in the business of teleporting value through space and time, no more and no less. This is a stupendously useful capability for society to have, which is why substantially all societies place an immense deal of importance on it.

The subsidy for charitable donations causes some donors to have a problem which needs a time machine: the times at which they gain access to money, at which they earn that money for tax purposes, and at which they want to donate that money to charity may be several years apart. This complicates receiving the subsidy, because income taxes are assessed on an annual basis.

Enter an infrastructural innovation which relatively few people have heard about: donor advised funds. Despite having something of a hobby in Weird Types of Accounts You Could Find At Financial Institutions, I had never heard about them until a few of our donors told me that they would, of course, be donating through their DAF.

A DAF is a chimera which holds itself out to the world as a freestanding charity whose primary charitable purpose is funding many other charities, and holds itself out to donors as being essentially a financial institution that can time travel in return for allowing you to direct but not withdraw your deposits.

Here’s why they matter: for people who have lumpy income, like business owners or employees of Silicon Valley startups, putting money into a DAF is a charitable donation effective immediately. If, for example, you’ve just sold a company (and made more money on that transaction than you expect to over the vast majority of years of your working career), you can sweep your expected charitable contributions for many years into the DAF now, take the tax break in the year which it is most advantageous (right now, when your income is higher than in other years), and then get to actually distribute the money from the DAF to charities at any time of your choosing in the future.

DAFs aren’t a secret, per se, but they are extremely well-known in a relatively small community of practice and not broadly understood outside of it.DAFs are some of the largest charities in the world. Fidelity Charitable, for example, has 250,000 donors and has distributed more than $60 billion to other charities. (Including, disclosure necessitated not by law but just by my personal sense of propriety, the one I ran, at the recommendation of two donors.)

The “recommendation” thing is… interesting. After you give money to a DAF, it is the DAF’s money, to fulfill its charitable mission however it sees fit. Do donors really believe that? Well, they mostly believe that they have a phone number, website, or mobile app they can operate where they can make a polite recommendation to the universe that a particular charity quickly receive a particular amount of money. The DAF might, in a purely optional way you understand, use that recommendation as part of its charitable decisionmaking process. Perhaps that process might include having a member of an operational team confirm that the suggested charity is indeed tax-exempt. Perhaps they might choose to note that fact in a log. Perhaps they could reach out to that charity to briefly discuss the best way to get them money. Perhaps they could send them an amount of money exactly corresponding to the amount that their donor recommended.

Or they could do anything else at all, as long as it was charitable.

Just like the little old lady next to the pachinko parlor who has an odd hobby of buying exactly the brand of pencil the pachinko parlor awards as a no-cash-value gift prize for an oddly high amount of money, DAFs have quixotic preferences and are very effective at convincing sophisticated donors that they will maintain those preferences in the future.

Described like this it probably sounds like a loophole, which, the IRS might explain in an exasperated tone of voice, is a synonym for a very thick book of regulations exhaustively written to be compliant with the desires of the American people as expressed through their elected representatives.

How the money actually physically arrives at the charity is interesting. DAFs are, like all organized charities, corporate entities which have full access to the banking system. They’re capable of making electronic funds transfers like e.g. ACH payments and wires.

But a surprising portion of donations are sent via paper checks. Why, when paper checks are the worst way imaginable to move money? Because paying someone with a check requires only three things: you need to know their official name, you need to be able to put the check physically in their hands, and you need to know that they will quickly deposit the check after they receive it.

Paying someone with a paper check does not require telling them that you’re going to pay them with a paper check, getting their approval prior to sending the check, or coordinating with them on check receipt. This is unlike e.g. credit card payments; you, a church school in Nebraska, need to have taken some action to enable credit card payments, but you don’t need to have taken any specific action to be able to cash a check (beyond having a formal existence and a bank account).

And the DAF can ride on the coattails of tax administration to determine your official name, tax-exempt status, and address you can receive mail at. Those are all public records. Almost all charities in the country have their name and address in a database that you can get from the IRS or a variety of commercial providers.

So if a DAF reaches out and contacts a charity to give it money, it doesn’t strictly speaking need the charity to respond to their phone call or email. It might choose, in its charitable wisdom, to just send the charity a check at the address the charity has promised the government has a responsible officer who quickly opens any mail addressed to it. (Why would a charity not respond to that unsolicited phone call or email? Many charities are quite busy, and particularly for smaller charities, the pitch "I represent a multi-billion dollar pot of money. We've decided we like what you're doing and might want to give you some money. Tell me a bit about yourself and we will probably decide to do that. Can we begin with the number on the top of your tax forms and your banking information, please." sounds a bit suspicious.)

DAFs and their donors rely on the (reasonably good) assumption that a charity which finds an unsolicited check in the mail will quickly deposit it. If they don’t, eventually the DAF will void the check and have to decide to do something else with its money, perhaps in reference to recommendations made by people who have previously donated to the DAF.

If a charity does answer the phone/email the flow is good and pretty straightforward, I say from experience. I was asked to briefly explain our charitable aims, produce a copy of the IRS determination letter, and (optionally) confirm banking information in case we wanted to receive electronic payments in preferences to checks if the DAF decided, in its charitable wisdom, to make donations in the future. A check arrived in the mail within about a week. It was more straightforward than almost any other channel money came into our organization by, seen from our perspective. (The joys of charitable fundraising and e.g. grant approval processes deserve a book, probably titled something like Painful Processes One Hopes Exist in the World Without Ever Encountering Personally.)

An additional feature of DAFs is that, between the donation of the money and the disbursement for the charity, the donation can be invested, in the same way that all charities can invest money that they do not need for current-year operations against their future needs. The investment returns are tax-free from the perspective of the original donor; after all, they never receive the investment returns, they merely gain moderately more karma with the DAF for making future recommendations, which karma the DAF chooses to denominate in dollars and keep exactingly precise records of.

This feature forms most of the business model of DAFs: Fidelity Charitable is an offshoot of Fidelity Investments, and invests most of its money in vehicles that Fidelity has put together. Fidelity charges Fidelity Charitable to manage those investments, between 0.015% and 0.99% per year. This model replicates well enough that many large financial institutions targeting the mass-affluent have an associated DAF; Schwab, for example, does.

As a taxpayer with obligations to both Japan and the U.S. there is literally no entity on earth that all laws I’m subject to consider worthy of tax subsidy, so I do not have the typical use case for DAFs. But since I'm fascinated by infrastructure, I started using Daffy, a startup by some Wealthfront-associated folks who apparently don’t care about unbeatable competition in their brand search results from cartoon characters. I find it useful just from a management perspective; DAFs (and Daffy) allow you to donate anonymously, and the app functions as a single “Figure out how to give these do-gooders money for me” portal, enough to justify the $3 a month that they charge me. I’d recommend it if you want to play with one casually.

In a strictly personal capacity, I will mention that Fidelity Charitable basically created the category and is the commanding favorite among people I know who have an opinion on this, largely due to being the commanding favorite of the professionals they ask for advice. Strongly consider asking your competent professional advisor for recommendations if e.g. you work in the tech industry and will, over the course of your career, want to donate appreciated stock.

(Your advisors can tell you about the tax consequences of that, which are a compelling bonus given that you are charitably minded. An important operational consideration is that large DAFs know how to use the ACATS system to move shares of stock around and your local public basketball program probably does not. You can use the DAF as an intermediary to transform the stock into a check to the basketball program; they absorb the complexity there on behalf of many thousands of charities in parallel.)

This is a pattern seen elsewhere

So charities have at least two purpose-built financial products that the rest of the world doesn’t need, DAFs on the donor side and specialized recordkeeping systems on the charity side. Where else do we see this phenomenon?

Charitable bank accounts basically look like all bank accounts, at least in the status quo, but that will likely change over time. The advantages to having software which is aware that you’re a charity and aware that you accordingly have charity-specific needs are overwhelming, and the people who specialize in the needs of charities will likely partner with the banking sector to bring better charity-specific banking products to market.

Charities are not the only sector with a relatively small number of extremely high-salience requirements, often caused by regulation. Increasingly, these requirements are going to be administered not just by professionals who have specialized in those requirements for most of their career, but by software systems catering to those professionals. You’ll see a lot of the dollars follow the software, rather than the software merely keeping track of the dollars.

← Plastic (and payments) in the fantasy supply chain
Accounting for SaaS and swords →

Want more essays in your inbox?

I write about the intersection of tech and finance, approximately weekly. It's free.

Thanks for subscribing to Bits about Money (for free). You will receive an email every Friday.
Thanks for subscribing to Bits about Money (for free). You will receive an email every Friday.
Welcome back!
You somehow managed to pay money for this! Which is curious, because patio11 wanted to Charge Less this time.
Success! Your billing info is updated.
Billing info update failed.