Federal tax law prohibits nonprofit organizations from providing private inurement and unwarranted private benefit. Failure to comply with these basic rules jeopardizes an organization’s tax-exempt status. Layered on top of these general rules, private foundations, which are typically controlled and funded by a single family or a corporation, are subject to special rules designed to prohibit a variety of transactions between the foundation and its insiders. Congress enacted measures to prohibit these insider transactions, referred to as acts of “self-dealing,” by imposing punitive taxes on those engaging in these transactions.
Importantly, this prohibition on self-dealing does not include any type of general exception for situations where the act results in a benefit to the private foundation, nor does it include a de minimis threshold to trigger these rules. For example, a private foundation is prohibited from purchasing an asset (a building or equipment) from certain insiders at the foundation at a cost of $10 even if the asset had a value of $10 million. This act itself is prohibited and must be corrected to avoid additional punitive taxes.
Below is a refresher on the basics of the self-dealing rules, common situations private foundations face and how to address the self-dealing rules.
Prohibited acts of self-dealing, if engaged in directly or indirectly by a private foundation and a disqualified person (defined below), include:
- A sale or exchange between the private foundation and a disqualified person, even on terms that are favorable to the private foundation.
- A lease of property between the private foundation and a disqualified person, unless the lease is without charge and furthers exempt purposes.
- A loan or other extension of credit between the private foundation and a disqualified person, unless the loan is interest-free and the proceeds of the loan are used exclusively for exempt purposes.
- The private foundation’s payment of compensation or expense reimbursement to a disqualified person, unless not excessive and for personal services necessary to carry out exempt purposes.
- A disqualified person’s use of a private foundation’s income or assets by or for the benefit of the disqualified person, as well as the provision of goods, services or facilities between the private foundation and a disqualified person, except for goods or services that are furnished to the disqualified person on the same terms as are furnished to other members of the public or are provided without charge and used exclusively for exempt purposes.
- Payments to certain government officials.
The self-dealing rules apply to any “direct” or “indirect” act of self-dealing. Direct self-dealing occurs when the private foundation is a party to the transaction with the disqualified person. An act of indirect self-dealing occurs when a disqualified person engages in a transaction with an organization controlled by the private foundation or its foundation managers (i.e., its directors or officers) and such transaction would be an act of direct self-dealing if entered into by the private foundation and the disqualified person. The indirect self-dealing rules are deliberately broad and all-inclusive.
Before an act of self-dealing can occur, there must be a direct or indirect transaction between the private foundation and a disqualified person. Disqualified persons are defined as:
- Substantial contributors to the foundation (generally, anyone contributing more than $5,000).
- Foundation managers (officers, directors or trustees of the foundation).
- Any 20 percent owner of a business that is a substantial contributor to the foundation.
- Any family member of the persons described above (a spouse, ancestors, children, grandchildren, great-grandchildren, and a spouse of any child, grandchild or great-grandchild).
- Any corporation, partnership, trust or estate in which persons described above have more than a 35 percent interest.
- Any government official.
While a number of exceptions under the self-dealing rules might be available for certain transactions, foundations and their disqualified persons should exercise caution and obtain appropriate tax advice before engaging in transactions.
Excise Tax Penalty
The penalty for self-dealing is an excise tax imposed on the disqualified person who engages in the act of self-dealing with the private foundation. It may also be imposed on any foundation manager with respect to the private foundation that participated in the act. There is no self-dealing tax imposed on the private foundation. An additional tax is imposed on the disqualified person and possibly participating foundation managers if the act of self-dealing is not corrected within the statutorily defined correction period.
Disqualified Person. An initial tax of 10 percent of the amount involved with respect to the act of self-dealing is imposed on the disqualified person. This tax on the disqualified person may not be abated for reasonable cause or otherwise. Further, there is no requirement that the disqualified person know that the act was an act of self-dealing at the time of the transaction before the tax can be imposed.
Foundation Manager. Any foundation manager who participated in an act of self-dealing for which a tax is imposed on the disqualified person is liable for a tax of 5 percent of the amount involved (up to $20,000 per act for all managers in the aggregate), unless such participation was not willful and was due to reasonable cause. If more than one foundation manager is liable for the tax imposed with respect to an act of self-dealing, the foundation managers are jointly and severally liable for the tax.
If a disqualified person participates in a transaction both as a self-dealer and as a foundation manager, the disqualified person can be liable for both the tax imposed on the disqualified person and the tax imposed on participating foundation managers.
With respect to any act of self-dealing, the amount involved means the greater of: (1) the amount of money and the fair market value of the other property given, or (2) the amount of money and the fair market value of the other property received. The fair market value is determined on the date on which the act of self-dealing occurred. In the case of compensation for personal services, the amount involved is only the amount of such compensation that is excessive (i.e., not reasonable). Where the use of money is involved, however, the amount involved is the greater of the amount paid for such use, or the fair market value of such use for the period for which the money is used.
In addition to paying the initial tax, the disqualified person must correct the self-dealing by undoing the transaction and restoring the foundation to the position it would have been in if no self-dealing had occurred. If the act of self-dealing is not corrected, an additional tax of 200 percent of the amount involved is imposed on the disqualified person, and an additional tax of 50 percent of the amount involved is imposed on foundation managers who refused to agree to part or all of the correction (with an aggregate cap of $20,000).
To correct an act of self-dealing, the disqualified person must undo the transaction to the extent possible and must place the private foundation in a financial position not worse than that in which the private foundation would be if the disqualified person were dealing under the highest fiduciary standards.
In the case of excessive compensation for personal services, undoing the transaction requires that the disqualified person repay to the foundation any amount that is excessive. Termination of employment is not required.
In the case of a disqualified person’s use of property owned by a private foundation, undoing the transaction includes, but is not limited to, terminating the use of such property. In addition to termination, the disqualified person must pay the foundation both of the following:
- The excess (if any) of the fair market value of the use of the property over the amount paid by the disqualified person for such use until such termination.
- The excess (if any) of the amount the disqualified person would have paid for the use of such property on or after the date of such termination, for the period such disqualified person would have used the property (without regard to any further extensions or renewals of such period) if such termination had not occurred, over the fair market value of such use for such period.
Shared Offices/Personal Services. With proper structuring, a private foundation can pay the following expenses and compensation with respect to an affiliated family or corporate office:
- If a private foundation enters into a separate lease arrangement with a third-party landlord, a private foundation should be able to pay for the space it uses in the affiliated office. A private foundation could also pay its share of any janitorial services, utilities or other maintenance costs as long as these payments are made directly to a third-party provider of such services or utilities and are for a private foundation’s share of such services, which could be based upon the proportion of office space used by a private foundation.
- A private foundation can pay its share of any costs associated with any office equipment or supplies as long as payments are made to third parties for these costs.
- A private foundation could pay the family or corporate office directly for financial and other personal services as long as the fees paid by a private foundation are reasonable and the services the family office provided are necessary to carry out a private foundation’s exempt purposes.
- A private foundation could enter into an employee-sharing arrangement with the related family or corporate office or any other disqualified person whereby certain employees would work for a private foundation on a part-time basis. These employees would be required to keep records of time spent on the private foundation’s business. A private foundation could pay these employees directly for their services rendered on behalf of a private foundation. Even if these employees are disqualified persons with respect to a private foundation, the payment of compensation should be permissible as long as the compensation is reasonable and the services provided are personal services that are necessary to carry out a private foundation’s exempt purposes.
Determining Reasonableness of Compensation for Personal Services. The reasonableness of compensation for purposes of the private foundation self-dealing rules is determined under the same standards that apply to for-profit businesses under the rules related to the deduction for ordinary and necessary business expenses. The standards are also the same regardless of whether the person compensated is an individual or an entity.
Compensation for services is generally reasonable if it is an amount that ordinarily would be paid for like services by like enterprises (whether taxable or tax-exempt) under the circumstances. In determining whether compensation is reasonable, all economic benefits provided by the private foundation in exchange for the disqualified person’s services would be considered, including:
- All forms of cash and noncash compensation, such as salary, fees, bonuses and severance payments.
- Liability insurance premiums, plus payment or reimbursement for any amounts not covered by such insurance.
- All other compensatory benefits, whether or not includable in gross income for income tax purposes.
Fundraising Events. A private foundation’s payment of the ticket price for a fundraising event can give rise to an act of self-dealing if a disqualified person then uses the ticket. It is permissible for directors and officers of the foundation to attend the fundraising event with tickets purchased by the foundation if such attendance is reasonable and necessary in connection with their duties and responsibilities to the foundation. But it is generally not acceptable for a disqualified person, who is not a director or officer of the foundation, and family members to attend using the tickets purchased by the foundation. Having the disqualified person pay the portion of the ticket price associated with the cost of the dinner, entertainment, etc., would not change this result because it relieves the disqualified person of having to pay the charitable portion of the ticket price required to attend the event and gives rise to an economic benefit.
Foundation’s Payment of Legal Obligations or Pledges. A grant or payment by a private foundation that satisfies a disqualified person’s legally binding obligation is an act of self-dealing. The most common violation of this rule is a foundation’s payment of a legally enforceable charitable pledge made by a disqualified person.
Favorable Publicity. As a general rule, naming opportunities and favorable publicity arising for the benefit of a disqualified person as a result of 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 fact that the foundation and the disqualified person have common names also does not give rise to an act of self-dealing.
Grant-Making With Benefits to Disqualified Person. Certain grants by a private foundation may provide a direct or indirect benefit to a disqualified person with respect to the foundation. Unless these benefits are incidental and tenuous, the grant may give rise to an act of self-dealing. Incidental or tenuous benefits are essentially indirect promotional benefits that are unavoidable as a result of the foundation’s charitable activities. But any grant or payment by a private foundation that provides a tangible economic benefit to a disqualified person will generally give rise to an act of self-dealing.