Private Foundation Self-Dealing and Disqualified Persons

Many private foundations find themselves having to undo certain transactions that appear perfectly reasonable but are prohibited due to the complex rules that apply to them. Often, these transactions would be allowable if done by a public charity or social welfare organization; however, with private foundations, these same transactions are not allowed. Some transactions are prohibited because they are with persons of influence, known as “disqualified persons,” and some are legally prohibited by the nature of the transaction.

Who Are Disqualified Persons?

The first step in avoiding problematic transactions is for each foundation to know who is considered a disqualified person under code Section 4946. ‍

Disqualified persons include:

1. Substantial contributors to the foundation:some text
   1. In general, a person (or other legal entity) who has given more than 2% of the total contributions or bequests to the foundation since the inception of the foundation, or
   2. If the foundation is a trust, the creator of the trust.
2. For substantial contributors that are entities, the 20% or greater owners of that entity. Ownership is determined by:some text
   1. The total combined voting power of a corporation;
   2. The profits interest of a partnership; or
   3. The beneficial interest of a trust or unincorporated enterprise.
3. Certain foundation managers, which include:some text
   1. An officer, director, trustee, or individuals with similar responsibilities or powers, and
   2. In the case of certain prohibited transactions, the employee who has the authority or responsibility to act (or not) act on the transaction.
4. Family members of any individual described in paragraphs 1, 2, or 3 above, which include the spouse, ancestors, children, grandchildren, great-grandchildren, and the spouse of their children, grandchildren, and great-grandchildren. Siblings are not included in the definition of family members.
5. Certain government officials.

Once the private foundation knows who the disqualified persons are it is easier to identify when a transaction should be reviewed by tax or legal experts before entering it. This list should be maintained by the management of the foundation and reviewed at least annually for its completeness. It is best practice to refer to the disqualified person list prior to writing any checks or completing any transactions. If the transaction is with a disqualified person, it should be paused until it is determined the transaction is permitted. It is also best practice to document the reason the transaction with any disqualified person meets one of the exceptions to the various rules private foundations face.

Transactions with Disqualified Persons

Transactions with disqualified persons, except for most charitable contributions or in-kind gifts of property or services from the disqualified person to the foundation, should be reviewed by tax or legal counsel before the transaction is entered into to determine if it is In the event it is an act of self-dealing, the transaction will need to be corrected or undone, and the disqualified person would have to pay a 10% excise tax on the transaction. Further, transactions that are not corrected and remain in future years may be considered additional self-dealing, which incurs additional excise tax. This is not a hard and fast rule, and there are exceptions that should be carefully reviewed.

What is Self-Dealing?

Self-dealing occurs when a prohibited transaction takes place, directly or indirectly, between a disqualified person and the private foundation. Any of the following transactions between a private foundation and its disqualified persons is considered an act of self-dealing subject to an excise tax. This includes actions done directly or indirectly through an entity controlled by the private foundation.

• Sale, exchange, or leasing of property;
• Lending of money or other extension of credit;
• Furnishing of goods, services, or facilities;
• Paying compensation (or paying or reimbursing expenses) to a disqualified person, (but see exceptions described below);
• Transfers to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and
• An agreement by a private foundation to pay a government official, other than an employment agreement, entered into 90 days before the official’s government service terminates.

Exceptions

• A disqualified person may transfer or gift real or personal property with indebtedness more than 10 years old;
• A disqualified person may lend money to the foundation interest-free if the proceeds are used for the foundation’s charitable purpose;
• A disqualified person may furnish goods, services, or facilities at no charge to the private foundation;
• A private foundation may provide goods, services, or use of facilities to a disqualified person if it is done in fulfillment of the foundation’s exempt purpose and is made on a basis no more favorable than made to the public (e.g., if a private foundation operating an arts center may charge the disqualified person admission at the same rate as charged to the general public);
• The payment of compensation and reimbursement of expenses to disqualified persons for personal services which are not excessive and are reasonable and necessary for carrying out the exempt purpose of the foundation (this exception does not apply to government officials). Personal services include legal, investment, managerial, and banking. It does not include services that are not professional or managerial, such as janitorial services;
• Certain liquidation, merger, redemption, and reorganization transactions between an entity-disqualified person and a private foundation;
• A private foundation may make certain prizes, scholarships, and pension payments to a government official who is a disqualified person; and
• Disqualified person(s) engaging in certain transactions with an entity controlled by a private foundation (exceptions to the indirect self-dealing rules), such as a transaction from an earlier business relationship that is as favorable to the controlled entity as an arms-length transaction with an unrelated person, and the controlled entity would suffer hardship by transacting with another person.

These self-dealing rules governing private foundations can be exceptionally precise and complex. When engaging in any transaction with a disqualified person, even if it is beneficial to the foundation, contact us. We can determine if the transaction is completely prohibited or if it can be structured to meet an exception to these rules.