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:
- Private foundation officer, director, trustee, or individual with powers or responsibilities similar to those positions and their family members—excludes siblings
- Substantial contributor to the private foundation and their family members—excludes siblings
- Person who owns more than 20% of a substantial contributing business entity and their family members—excludes siblings
- Business entity more than 35% owned by disqualified persons
When determining ownership the following rules apply:
- Voting power determines corporation ownership
- Profit interest determines partnership ownership
- Beneficial interest determines trust or estate ownership
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
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 that isn’t encumbered
- Property that’s leased without charge for foundation use, whether it’s the foundation or the disqualified person that leases the property
- Interest-free loans from a disqualified person to the private foundation, but only if the foundation uses the proceeds 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 as the general public
There are a number of common transactions that can incur self-dealing penalties. Some examples of prohibited transactions include the following:
Encumbered 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 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.
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, it’s a self-dealing transaction if a spouse, family member, or employee of a substantial contributor uses the ticket.
Erroneously Paying Expenses of a Disqualified Person
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.
Taxes Paid by Disqualified Person
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.
Taxes Paid by Foundation Officer, Director, or Trustee
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.
How to Avoid Self-Dealing
Although the rules that govern self-dealing can mystify, here are several ways private foundations can lower the risk of conducting a prohibited transaction:
- Educate board members, trustees, officers, and 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 you pay only reasonable compensation to disqualified persons when they provide personal services.
- Maintain accountability by implementing and following procedures for reimbursement to 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 the foundation doesn’t disclaim them.
We’re Here to Help
To learn more about how to prevent self-dealing transactions—including training and educational sessions—contact your Moss Adams professional.