Article
How private foundations can avoid self-dealing penalties
Oct. 14, 2021 · Authored by Patty Mayer
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Article
Oct. 14, 2021 · Authored by Patty Mayer
Self-dealing is a prohibited business or financial transaction between a private foundation and a disqualified person.
When self-dealing occurs, both the disqualified person and the foundation manager can be penalized. Also, the IRS can’t abate the self-dealing penalty due to reasonable cause. Plus, mistakes don’t count for relief of penalty assessment. It’s irrelevant if the transaction is “fair” or “below market” value.
What kind of transactions cause penalties and what are the exceptions? To gain understanding, first you need to know who counts as a disqualified person as it relates to the private foundation.
The federal tax definition covers anyone who may have undue influence over a private foundation. It defines a disqualified person as a:
When determining ownership the following rules apply:
Generally, the following transactions between a private foundation and a disqualified person are acts of self-dealing:
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
There are a number of exceptions to the self-dealing rules, which is often why they can be so complicated to navigate:
There are a number of common transactions that can incur self-dealing penalties. Some examples of prohibited transactions include the following:
Assuming a mortgage or similar lien on property gifted by a disqualified person is construed as a sales transaction, and assuming the mortgage of a disqualified person is interpreted as lending money or providing an extension of credit — both are prohibited transactions. Real estate encumbered with debt and donated to a private foundation exemplifies such a case.
Alternatively, if a person makes a gift of property and isn’t considered a disqualified person at the time — but would be after the gift via the substantial contributor rules — the transaction wouldn’t be considered self-dealing.
Fulfilling charitable pledges that are a disqualified person’s legal obligation with a private foundation’s assets is considered use of foundation’s assets, and therefore self-dealing.
Paying for a spouse or family member to travel with a board member, trustee, or officer on foundation-related business could be considered self-dealing — unless the spouse or family member also provides services to the foundation or the payment is treated as additional compensation.
The service provided to the foundation must be more substantial than attending a luncheon or dinner event.
Often a private foundation will award a grant to a qualified public charity that provides benefits to it in return, such as tickets to an art museum or annual charity event.
A board member, trustee, or officer can use the ticket or attend an event as long as it’s for foundation-related business, such as becoming better acquainted with a grantee. However, it’s a self-dealing transaction if a spouse, family member, or employee of a substantial contributor uses the ticket.
A private foundation can’t pay personal expenses of a disqualified person. This can inadvertently happen, for example, when the wrong checking account is used to pay an expense.
It’s still self-dealing even if there was no intention of paying an expense of a disqualified person.
A two-tier excise tax system enforces the self-dealing rules. The second-tier tax applies if the transaction isn’t corrected within a certain period of time.
The first-tier tax assesses a 10% tax on the self-dealing amount, which is imposed on the disqualified person. The 10% penalty applies to each tax year the transaction isn’t corrected.
If a disqualified person received an unintentional loan because the foundation paid a personal expense in error — and discovered and corrected the error the second year it occurred — the penalty would be 10% for each of the two tax years, or 20% total.
Correction of the transaction happens through making the foundation whole, such as reimbursing for the expense, but the first-tier tax is still due. If imposed, the second-tier tax equals 200% of the transaction amount.
A tax may also be imposed on a foundation manager who knowingly participates in an act of self-dealing, excluding participation that wasn’t willful and was due to reasonable cause.
The first-tier tax on these actions equals 5% of the amount involved, and the second-tier tax is equal to 50% of the amount involved.
Although the rules that govern self-dealing can mystify, here are several ways private foundations can lower the risk of conducting a prohibited transaction:
