The IRS' complicated self-dealing rules require private foundations to be vigilant when entering into a business arrangement with a related party.
Self-dealing is a prohibited business or financial transaction between a private foundation and a disqualified person, regardless of if the transaction is fair to the foundation. When it occurs, both parties can be liable for penalties.
This article is the third in a series taking an in-depth look at topics important to private foundations, including excise tax, excess business holdings, and private-operating foundations.
Disqualified persons
The federal tax definition covers anyone who may have undue influence over a private foundation. It defines a disqualified person as the following:
- A private foundation officer, director, trustee, or key employee and their family members (excludes siblings)
- A substantial contributor to the private foundation and his or her family members (excludes siblings)
- A person who owns more than 20% of a substantial contributing business entity and his or her family members (excludes siblings)
- A business entity that’s more than 35% owned by disqualified persons
When determining ownership, the following rules apply:
- Corporation ownership is determined by voting power
- Partnership ownership is determined by profit interest
- Trust or estate ownership is determined by beneficial interest
Prohibited transactions
Generally, the following transactions between a private foundation and a disqualified person are acts of self-dealing:
- Sale, exchange, or leasing of property
- Lending of money or extension of credit
- Furnishing of goods, services, or facilities
- Payment of a disqualified person’s compensation or expense reimbursements
- Transfer or use of a private foundation’s income or assets by or for the benefit of a disqualified person
- Nearly all payments from a private foundation to a government official
Exceptions
There are a number of exceptions to the self-dealing rules, which is often why they can be so complicated to navigate:
- Gifts from a disqualified person that are purely gratuitous, such as a cash or noncash donation
- Property that’s leased without charge, whether it’s the foundation or the disqualified person that leases it for the foundation’s use
- Money lent to a private foundation, but only if the loan is without interest and the arrangement is used exclusively for exempt purposes
- Reasonable compensation paid to a disqualified person for personal services rendered that are necessary to carry out exempt purposes
- Reimbursement of a disqualified person’s ordinary and necessary business expenses incurred for foundation-related matters
- Goods, facilities, or services provided to a disqualified person on the same basis they’re made available to the general public and to support the foundation’s exempt purpose, such as a museum charging a disqualified person the same admission fee charged to the general public
Common pitfalls
There are a number of common transactions that can incur self-dealing penalties. Some examples of prohibited transactions include the following:
Property gifted by a disqualified person. 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 of which are prohibited transactions. An example of this type of transaction is when real estate that’s encumbered with debt is donated to a private foundation.
Charitable pledges. Fulfilling charitable pledges that are a disqualified person’s legal obligation with a private foundation’s assets.
Companion travel. Paying for a spouse or family member to travel with a board member, trustee, or officer on foundation-related business, unless the spouse or family member is also providing 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.
Tickets to charitable events. 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, if a spouse, family member, or employee of a substantial contributor uses the ticket to attend the event, it becomes a self-dealing transaction.
Penalties
A two-tier excise tax system is used to enforce the self-dealing rules. The second-tier tax applies if the transaction isn’t corrected within a certain period of time.
Disqualified person. The first-tier tax assesses a 10% tax on the self-dealing amount, which is imposed on the disqualified person. The second-tier tax is equal to 200% of the transaction amount.
Foundation officer, director, or trustee. A tax may also be imposed on a foundation manager who knowingly participates in an act of self-dealing. Participation that wasn’t willful and was due to reasonable cause is excluded from this. The first-tier tax on these actions is equal to 5% of the amount involved, and the second-tier tax is equal to 50%.
How to avoid self-dealing
Although the rules that govern self-dealing can be confusing, there are a number of avenues available to private foundations that want to lower their risk of unknowingly conducting a prohibited transaction:
- Educate board members, trustees, and officers as well as key personnel
- Identify and track disqualified persons
- Adopt a conflict-of-interest policy with procedures for identifying and avoiding self-dealing transactions, including annual conflict disclosures
- Implement and follow a compensation-setting process so only reasonable compensation is paid to disqualified persons when personal services are provided
- Maintain accountability by implementing and following procedures for reimbursement and credit card transactions for foundation-related expenses to disqualified persons
- Adopt a policy on grants that result in a return benefit, such as tickets to events, and track who uses these benefits if they aren’t disclaimed by the foundation
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.