REPRINTED FROM NONPROFIT ISSUES Vol. XII No. 7 - REVISED SEPTEMBER 2018

Private Foundations Must Avoid Self-Dealing
Disqualified persons and foundation managers can be personally liable for excise taxes
for certain transactions even where it is clear that the foundation has suffered no loss 

Private foundations are subject to a number of limitations and restrictions on their operations, but none is more sweeping — or potentially more likely to cause personal liability than the limitations on “self-dealing” transactions.

Individuals and organizations that are considered “disqualified persons” and the foundations for which they are disqualified are essentially prohibited by Tax Code Section 4941 from participating in a whole series of economic transactions with each other. Subject to limited exceptions, these transactions include any direct or indirect selling or leasing property to or from the foundation, making loans or extending credit to or by the foundation, providing goods or services to or by the foundation, paying compensation  a disqualified person (other than for certain personal services necessary for the foundation to carry out its purposes), transferring income or assets of the foundation for the benefit of the disqualified person, and making payments to public officials.

Unlike the excess benefits tax provisions applicable to insiders at public charities, which trigger penalties only if the insider receives more from the charity than he or she provides in return, the private foundation self-dealing rules apply to any regulated transaction, even if the foundation clearly receives the better part of the bargain. A disqualified person may give things to the foundation, but, with limited exceptions such as certain personal services, may not receive anything of value in return.

If the parties engage in an improper self-dealing transaction, both the disqualified person and the foundation managers can be personally liable for significant excise taxes. They can be liable even where it is clear that the foundation has not suffered a loss.

Disqualified Persons

There are several categories of disqualified persons. They include:

•Substantial contributors to the foundation, which includes any person who has contributed more than$5,000 or 2% of the total of gifts, grants, and contributions received by the foundation since its inception, whichever is greater.

•Owners of more than 20% of the total combined voting power of a corporation, or interest in the profits of a partnership, or beneficial interests in a trust which is a substantial contributor.

•Foundation managers such as officers, directors or trustees or other employee having responsibility for any specific self-dealing transaction.

•Members of the family of an individual disqualified under the foregoing criteria, which include only a spouse, ancestor, child, grandchild, great-grandchild and the spouses of such lineal descendants.

•Corporations, partnerships, trusts, or estates in which any of the foregoing, other than family members, owns more than 35% of the total combined voting power, profits interests, or beneficial interests, respectively.

•Governmental officials.

A charitable organization described in Section 501(c)(3) of the Tax Code, including another private foundation(but excluding an organization operated exclusively for testing for public safety) is generally not considered a disqualified person. This exclusion permits transactions within the charitable community among related and affiliated entities.

How do the rules apply?

•Sale, exchange or lease of property. Neither a disqualified person nor a foundation may sell, exchange or lease property to the other. A sale of a $1 million painting to the foundation for $100,000 would trigger the tax, as would a donation of a $1 million piece of real estate subject to a mortgage or similar lien which has not existed for more than 10 years. The rule has been interpreted by the IRS to cover even a sale to a disqualified person at a public auction, where anyone had the chance to bid.

Redemption of stock by a disqualified corporation would generally be a self-dealing transaction unless it falls within a limited exception for certain sale or exchange transactions between a foundation and a disqualified corporation if they involve a liquidation, merger, redemption, recapitalization, or other corporate reorganization, I fall securities of the class held by the foundation are subject to the same terms and conditions, and if the terms provide for the foundation to receive no less than fair market value.

•Loans and other extensions of credit. Loans between the foundation and a disqualified person are considered self-dealing transactions even where they are adequately secured and made at fair interest rates.

The rule is so stringent that the IRS has had to provide special guidance about advancing funds to foundation managers when going on trips or otherwise needing to pay expenses for which they will be reimbursed. Advancing funds is permitted only in limited amounts when reasonable and necessary for the foundation to function.

•Furnishing goods, services or facilities. This rule covers items such continued from other as office space, automobiles, secretarial help, libraries, publications, laboratories and parking lots. A foundation manager who gave a home to the foundation but continued to live there after the gift was completed was deemed to be involved in an act of self-dealing.

Foundations can provide incidental meals and lodging to a foundation manager that is reasonable and necessary to carry out the purposes of the foundation. A foundation may also provide goods or services to a disqualified person if they are supplied on a basis no more favorable than supplied to the general public.

•Payment of Compensation and Expenses. A foundation may pay a disqualified person reasonable compensation for personal services which are necessary to carry out the exempt purposes of the foundation. It may pay a bank trustee for ordinary and necessary banking services, but the IRS ruled in 1973 that it could not pay the bank an overdraft charge of more than it cost the bank to process the transaction. It may pay brokerage fees, but may not buy securities from or sell them to a disqualified person which acts as a dealer for its own account. It may pay investment management fees and legal fees, but one case has ruled that a foundation cannot pay a disqualified person for property maintenance services since the services were not professional or managerial.

•Use of assets. A private foundation created by a corporation has been held to commit self-dealing by allowing officers of the corporation to use tickets to a fundraising dinner purchased by the foundation, although use of the tickets by foundation officers was permitted. Providing foundation artwork to a disqualified person’s home is an act of self-dealing, unless used only in the foundation office, or otherwise generally available to the public. The IRS does not object to the prestige that disqualified persons obtain from making foundation gifts, calling it only incidental personal benefit.

After considerable controversy, the IRS issued rules in1995 to provide that a foundation could pay for insurance or directly provide indemnification, including settlement costs and judgments, for foundation managers involved in litigation without committing an act of self-dealing so long as the payments are reasonable, the manager did not act willfully and without reasonable cause, and the foundation does pay a manager’s liability for excise taxes due under the foundation rules of the Tax Code.

•Payments to governmental officials. A foundation may not make payments to government officials, with limited exceptions such as public awards and scholarships.

A disqualified person is subject to a tax of 10% of the amount involved, whether or not the violation was knowing. A foundation manager is liable for 5% of the amount involved, but only if the violation was knowing and not due to reasonable cause. If the transaction is not corrected, the disqualified person can be subject to an additional tax of 200% of the amount involved and the manager can be subject to a tax of 50%, to a maximum of $20,000.