Editor's Note: This blog post originally appeared here.

Impact investing, broadly defined as investing for the purpose of generating both a social or environmental as well as a financial return, continues to grow in popularity. Impact investing can also include the use of environmental, social, and governance (ESG) factors in making investment decisions. Donor advised funds (DAFs) can prove to be a useful tool for impact investing, provided that donors and their advisors are aware of certain points before making these investments.

Are there any limitations on to whom a DAF may make an impact investment?

A DAF administrator (the charity that sponsors the fund) wants to avoid making any distribution that could be deemed a taxable expenditure. Usually a distribution from a DAF is in the form of a grant to a charitable organization to fulfill its charitable purpose.  Although it is unlikely that an impact investment made out of a DAF will qualify as a distribution, that term is not specifically defined in the Internal Revenue Code, and guidance from the IRS is still forthcoming. 

Certain rules apply to all donor advised fund distributions, regardless of intent. For example, a DAF cannot make a distribution to an individual.  Therefore, a distribution to a sole proprietor, regardless of the ESG merit of the activity, cannot be made from a DAF.  In addition, a distribution to a non-charity would require a process known as expenditure responsibility that some DAF sponsors may prefer not to conduct.  A distribution out of a DAF to a charitable intermediary, such as a nonprofit loan fund, is one route available for impact investors to explore.

Does the investment need to be “prudent?”

A DAF impact investment is likely subject to state prudent investor requirements.  Almost all states have adopted some version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which includes a fiduciary standard for the management and investment of funds.  While an exception exists for “program-related assets,” many impact investments will not qualify.

However, donor intent often can override statutory prudent investment requirements.  A DAF donor could considering authorizing certain types of investments at the time of his or her gift, which may provide the donor advised fund sponsor with more comfort and flexibility in making impact investments that are higher-risk.  The sponsoring organization also can adopt an investment policy that includes impact investments, so any decisions regarding an individual DAF can be made consistent with its policy.

Can a DAF own too much equity?

A DAF, together with its donor advisor(s) and family members and related businesses, may own no more than 20% (in some cases 35%) of the voting shares of a corporation or of the profits interest in a partnership or limited liability company.  To avoid the possibility of an inadvertent excess business holding, a donor advised fund could make loans or other non-equity investments.

Can donor advisors (and their family members and businesses) be paid out of a DAF?

No. Any grant, loan, compensation, or “other similar payment” from a DAF to a donor advisor or certain family members and related businesses is automatically deemed an excess benefit transaction, and the entire amount could be subject to a 25% tax (more if not corrected).  Therefore, DAF investments should avoid any payment to a donor advisor or other “disqualified person.” This might be a concern, for instance, if a donor-related entity will be compensated as a general partner in, or an advisor to, an investment recipient.

Can there be co-investment by a donor advisor and a donor advised fund?

This could raise questions. A donor advisor may wish to invest personally, or already has invested, in the same vehicle in which the DAF might invest.  The DAF sponsor and the donor advisor should consider whether the DAF investment could result in a “more than incidental” benefit to the donor.  The IRS has addressed when co-investment involving a private foundation and its disqualified persons may result in self-dealing, which may provide a useful analogy. 

Can an impact investment result in taxable income?

DAF investments could be subject to unrelated business income tax (UBIT), in particular investments that involve debt or that are made in flow-through entities such as a partnership or limited liability company.  The DAF sponsor might require that any taxes be paid out of the DAF.  A donor advised fund sponsor also may refuse to make investments that introduce the possibility of UBIT (and the complexity of making that determination).

By being aware of these points, savvy donors, their trusted financial advisors, and the DAF administrator can work together in making impact investments that address each of their concerns.