Transactions between private foundations and their insiders can be complicated to navigate. Even the most innocuous transactions, if not carefully structured, can run afoul of the rules and have serious consequences. Consider the following hypothetical situation.
ABC Foundation (the “Foundation”) is a private foundation in a major city in the United States. The Foundation has been renting office space in the city’s commercial district, for which it has entered into a lease with an unrelated third party at a market rate. The Foundation is expanding, and its staff requires additional space, actively seeking office space in the local area. One of the Foundation’s directors informs the Executive Director that his son owns a building in the heart of the commercial district and is willing to rent office space to the Foundation at a significantly discounted rate. Aside from the steeply discounted rent, the Foundation would reimburse the director’s son for its share of janitorial services. The Foundation’s Executive Director signs a lease for office space with the director’s son and has paid the necessary deposits.
On its face, this hypothetical appears harmless. The Foundation stands to gain a significant financial benefit. Although it seems advantageous, this hypothetical contains a number of prohibited transactions under the United States Internal Revenue Code (the “Code”) known as acts of self-dealing. Before I explore why, let’s review the basics.
Self-dealing involves any direct or indirect transaction between a private foundation and a disqualified person that personally benefits the disqualified individual. The rules governing such transactions are meant to prevent insiders from improperly benefiting from the foundation’s assets.
More specifically, section 4941 of the Code imposes an excise tax on any “disqualified person” who engages in self-dealing with a private foundation and any foundation manager involved in such self-dealing. An initial tax of 10% of the transaction amount is applied to the disqualified person, while the foundation manager faces an initial tax of 5% of the same amount. If the self-dealing is not corrected, it results in a second-tier tax of 200% on the disqualified person and 50% on the foundation manager.
What is Self-Dealing?
Under section 4941 of the Code, the following transactions constitute acts of self-dealing.
- Sale, Exchange, or Leasing of Property
Any sale, exchange, or leasing of property between a private foundation and a disqualified person is considered self-dealing.
- Lending of Money or Other Extension of Credit
The lending of money or other extension of credit between a private foundation and a disqualified person constitutes self-dealing. However, loans without interest or other charges from a disqualified person to a foundation are exceptions if the proceeds are used exclusively for charitable purposes.
- Furnishing of Goods, Services, or Facilities
The furnishing of goods, services, or facilities between a private foundation and a disqualified person is self-dealing unless they are provided by the disqualified person to the foundation without charge and used exclusively for charitable purposes.
- Payment of Compensation
Payment of compensation or reimbursement of expenses by a private foundation to a disqualified person is self-dealing unless it is for “personal services” that are reasonable, necessary, and not excessive.
- Transfer or Use of Income or Assets
Any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation is self-dealing. This includes transactions that affect the price of securities to benefit a disqualified person.
- Payments to Government Officials
Agreements by a private foundation to make payments to government officials are self-dealing, with certain limited exceptions for specific types of payments such as scholarships or awards.
It’s important to understand that the self-dealing rules apply regardless of whether the transaction benefits the private foundation. There is also no minimum threshold—even minor transactions can trigger a violation.
Common Inadvertent Acts of Self-Dealing
Private foundations can inadvertently engage in self-dealing when attempting to operate efficiently or fulfill their charitable mission—often without realizing they’re crossing legal boundaries. Here are five common self-dealing transactions that foundations most commonly run afoul of.
- Paying personal expenses of a disqualified person
- Leasing office space from a disqualified person
- Loans between a foundation and a disqualified person
- Excessive or improper compensation to a disqualified person
- Improper use of foundation assets by a disqualified person
Who is a Disqualified Person?
Generally, a disqualified person regarding a private foundation is anyone or any entity that has significant influence over the foundation’s activities or finances, or who might improperly benefit from the foundation’s assets.
More specifically, section 4946(a) of the Code defines “disqualified persons” (for purposes of the self-dealing rules) as any of the following.
1. “Substantial contributors” to the foundation.
2. Owners of more than 20% of the (i) total combined voting power of a corporation, which includes voting power represented by holdings of voting stock, actual or constructive, but does not include voting rights held only as a director or trustee; (ii) profits interest of a partnership; or (iii) beneficial interests of a trust or unincorporated enterprise; if the corporation, partnership, trust or enterprise is a “substantial contributor” to the foundation.
3. Certain foundation managers
4. Family members of any individual described in paragraphs 1, 2, or 3 above.
5. Corporations, partnerships, trusts, or estates in which persons described in paragraphs 1, 2, 3 or 4 above own more than 35% of the total combined voting power, profits interests, or beneficial interests, respectively.
6. Government officials
Under the Code, a foundation manager is an officer, director, or trustee of a private foundation (or an individual having powers or responsibilities similar to those of officers, directors, or trustees of the foundation). Generally, independent contractors, such as lawyers, accountants, and investment managers and advisors, acting in their respective capacities as such, are not considered officers of the foundation they advise.
The Code defines “family members” as spouses, ancestors, lineal descendants, and spouses of lineal descendants of substantial contributors, foundation managers, and 20 percent owners. Legally adopted children of an individual are the lineal descendants of the individual under this definition. The notable exception here is siblings. Siblings of anyone in the first three categories are not considered disqualified persons.
Key Exceptions to the Self-Dealing Prohibition
Although the self-dealing rule is broad, there are several important exceptions to it. These include the following.
- A disqualified person can loan funds to a private foundation provided the loan is without interest or charge and the proceeds are used exclusively for charitable purposes.
- The furnishing of goods, services, or facilities by a disqualified person to a private foundation is not an act of self-dealing if the furnishing is without charge and if the goods, services, or furnished facilities are used exclusively for charitable purposes.
- In addition, the furnishing of goods, services, or facilities by a private foundation to a disqualified person is not an act of self-dealing if such furnishing is made on a basis no more favorable than that on which such goods, services, or facilities are made available to the general public.
- A foundation’s sharing of office space, equipment and supplies, support staff, and group insurance with a disqualified person is not an act of self-dealing when the foundation contracts with and pays for such services, etc., directly to lessors and vendors who are not disqualified persons.
- Generally, naming opportunities and favorable publicity that benefit a disqualified person due to the private foundation’s payment or grant are considered incidental and tenuous benefits that do not give rise to an act of self-dealing.
- The payment of compensation (and the payment or reimbursement of expenses) by a private foundation to a disqualified person for personal services that are reasonable and necessary to carry out the exempt purpose of the private foundation is not an act of self-dealing if the compensation (or payment or reimbursement) is not excessive. For example, legal services and investment counseling are considered personal services; however, it is prudent to consult with legal counsel to determine what types of services can be considered personal services.
Correction
The Code allows a private foundation to “correct” an act of self-dealing by undoing the transaction to the extent possible, but in any case, placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards. Returning to our hypothetical situation, we can now re-evaluate which options would and wouldn’t be considered self-dealing.
The director’s son, who owns the office building, is a disqualified person in relation to the Foundation. Therefore, he cannot rent space to the Foundation for a fee, no matter how favorable the deal might be for the Foundation. Furthermore, the Foundation cannot reimburse the director’s son for the janitorial expenses; this would be considered self-dealing even though it is only paying its share of the expense. Had the Foundation paid its share of the janitorial services directly to the vendor, that may have been allowed. Several individuals and entities, including the executive director of the Foundation, and the son of the director, who owns the building, could face excise taxes.
In Closing
Sometimes doing a good deed isn’t that simple. Given the complex and extensive tax rules that govern self-dealing transactions, foundations and their disqualified persons should proceed cautiously and seek proper tax guidance before engaging in transactions with disqualified persons.
