While any Section 501(c)(3) organization must be cautious when entering into a business arrangement with a related party, it’s particularly true for private foundations in light of the federal tax law’s self-dealing rules. Under these rules, a private foundation is generally prohibited from engaging in a business or financial transactions with one or more “disqualified persons,” regardless of whether the self-dealing transaction is fair—or even more than fair—to the foundation.
Private foundations that engage in self-dealing can find themselves subject to hefty excise taxes, and even more important, they could put their exempt status in jeopardy and endanger their reputation with the public and regulatory agencies. For all of these reasons, it’s important to understand what constitutes self-dealing, including what kinds of transactions are prohibited, whom they’re prohibited with, and what the ramifications can be.
In the experience of professionals at the law firm Davis Wright Tremaine, the answers to the following questions should help your private foundation identify potential self-dealing transactions and avoid running afoul of these rules.
What is self-dealing?
Self-dealing is a prohibited business transaction between a private foundation and a disqualified person.
Who is a disqualified person?
The federal tax law defines disqualified persons broadly so that it captures a large group of persons who may have undue influence over a private foundation. This includes a private foundation’s officers, directors, trustees, key employees, substantial contributors, persons that own 20 percent or more of a business entity that’s a substantial contributor, and their immediate family members. Family members, by the federal tax definition, include spouses; ancestors (including parents, grandparents, and great-grandparents); children, grandchildren, and great-grandchildren; and the spouses of children, grandchildren, and great-grandchildren; but they don’t include siblings.
A business entity can also be considered a disqualified person if it’s more than 35 percent owned by disqualified persons. For these purposes, the ownership of a corporation is determined by voting power, the ownership of a partnership is determined by profit interest, and the ownership of a trust or estate is determined by beneficial interest.
What business transactions are prohibited?
As a general rule, the following transactions between a private foundation and a disqualified person are considered acts of self-dealing:
- The sale, exchange, or leasing of property
- The lending of money or other extension of credit
- The furnishing of goods, services, or facilities
- The payment of compensation to or the reimbursement of expenses of a disqualified person
- The transfer or use of a private foundation’s income or assets by or for the benefit of a disqualified person
Accordingly, nearly any transactions involving payment from a private foundation to a disqualified person will constitute self-dealing, unless an exception applies. In addition, nearly all payments from a private foundation to a government official—even those with no preexisting relationship to the foundation—are considered self-dealing.
What about gifts from disqualified persons?
As a general matter, a gift from a disqualified person won’t violate the self-dealing rules as long as the arrangement is entirely gratuitous. For example, a disqualified person may lease property or lend money to a private foundation if the lease is without charge or the loan is without interest and if the arrangement is used exclusively for exempt purposes. However, an arrangement in which the rent or interest rates are offered merely at below-market rates would be prohibited.
What are the common exceptions to the self-dealing rules?
Exceptions to the self-dealing rules include:
- Payments of reasonable compensation to a disqualified person for certain reasonable and necessary personal services, which typically must be professional or managerial in nature
- The provision or reimbursement of a disqualified person’s reasonable and necessary expenses incurred for foundation-related matters, such as the cost of transportation, meals, and lodging incurred for foundation-related travel
- The private foundation providing goods, services, or facilities to a disqualified person on the same basis they’re made available to the general public (such as admitting a disqualified person to a museum the private foundation operates at the general admission rate)
What are common self-dealing pitfalls?
Common self-dealing pitfalls that private foundations should avoid include:
- Assuming a mortgage or similar lien on a gift of property from a disqualified person. This type of arrangement is treated as a part-gift, part-sale transaction for federal tax purposes; as a result, it’s a prohibited property sale under the self-dealing rules.
- Fulfilling a charitable pledge of a disqualified person. Because the pledge is the legal obligation of the disqualified person, it cannot be satisfied with foundation resources.
- Paying for a spouse or family members to travel with a director or trustee 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 to the director or trustee (and the total compensation paid to that individual is reasonable), payment of these expenses will constitute self-dealing.
What are the penalties for self-dealing?
The self-dealing rules are enforced through a two-tiered excise tax system. The first-tier tax equals 10 percent of the amount involved and is imposed on the self-dealing disqualified person. A second-tier tax may also be imposed on the disqualified person if the self-dealing transaction isn’t undone or corrected within a certain period of time.
A second two-tier excise tax system may be imposed on a foundation officer, director, or trustee who participates knowingly in an act of self-dealing. Participation that isn’t willful and was due to reasonable cause is excluded. The first-tier tax on these actions is equal to 5 percent of the amount involved, and the second-tier tax is equal to 50 percent of the amount involved. Similar to the previous penalty system, the second-tier tax applies if the transaction isn’t undone or corrected within a certain period of time.
What are steps a private foundation can take to avoid self-dealing transactions?
To avoid inadvertently engaging in a self-dealing transaction, private foundations should:
- Make sure officers, directors, trustees, and key personnel are aware of and sensitive to self-dealing issues.
- Identify and keep track of disqualified persons.
- Adopt a conflict-of-interest policy that has procedures specific to identifying and avoiding self-dealing transactions and involves annual conflicts disclosures.
- Implement procedures to ensure any reimbursement to a disqualified person for foundation-related expenses is pursuant to an account plan.
- Implement a compensation policy to ensure no more than reasonable compensation is paid to a disqualified person if the foundation plans to pay any disqualified person for personal services permitted under the self-dealing rules.
Take Steps to Protect Your Organization
To learn more about how your private foundation can track its disqualified persons, assemble and benchmark reasonable compensation, and strengthen its compliance program, contact your Moss Adams not-for-profit professional. For legal advice or assistance related to self-dealing, contact: