Private Foundation Self-Dealing Rules: A Cautionary Tale

Volunteers helping serve food to families

Does this story sound familiar?

Bob Businessman was a successful entrepreneur who wanted to give back to his community, so he established the Bob Businessman Family Foundation (BBFF). Bob and several of his family members became trustees of the foundation. One day, a development officer from Local University asked Bob if he’d like to be a sponsor of their spring gala. BBFF signed on as a sponsor at the $10,000 level, granting it a table for 10 at the event. Local University sent a donor acknowledgment letter to BBFF and indicated the value of goods and services provided to sponsors at the $10,000 level was $1,000. Bob, his family and other BBFF trustees attended the gala and enjoyed the evening’s events.

With some very limited exceptions, BBFF likely violated the private foundation self-dealing rules.

Section 4941 of the Internal Revenue Code (IRC) imposes an excise tax on acts of self-dealing between a private foundation and disqualified persons. A self-dealing act can be either a direct or an indirect transaction.

A disqualified person is any of these:

  • A substantial contributor – any person or entity who has contributed more than 2 percent of the total contributions received by a private foundation since its inception
  • A foundation manager – officers, directors or trustees of a private foundation
  • The owner of more than 20 percent of an entity that’s a substantial contributor
  • A family member of a substantial contributor, foundation manager or 20 percent owner – spouses, ancestors, descendants and spouses of descendants
  • A corporation, partnership, trust or estate in which any of the above persons or entities owns more than a 35 percent interest
  • A government official

Self-dealing is defined as any of the following direct or indirect transactions between a disqualified person and a private foundation:

  • Sale, exchange or leasing of property
  • Lending money or extending credit
  • Furnishing goods, services or facilities
  • Payment of compensation or reimbursement of expenses
  • Transferring foundation income or assets to, or for the use or benefit of, a disqualified person
  • Payments of money or property to a government official

There are a number of exceptions to the self-dealing rules. A partial list includes:

  • Transactions with a former foundation manager
  • Property leased to a private foundation without charge
  • Interest-free loans to a private foundation
  • Furnishing goods, services or facilities to a foundation manager, other employee or volunteer if the value isn’t excessive and the items are necessary for carrying out the foundation’s exempt purpose
  • Nonexcessive compensation paid, or expenses reimbursed to, a disqualified person for professional services necessary for carrying out the foundation’s exempt purpose

An initial, or first-tier, excise tax of 10 percent of the transaction amount is imposed on the disqualified person involved in a self-dealing act. A tax of 5 percent will be imposed on any foundation manager who knowingly participates in a self-dealing act, up to a maximum of $20,000 per self-dealing act. If a self-dealing act isn’t corrected, second-tier taxes of 200 percent can be imposed on the disqualified person, and a 50 percent excise tax on the amount involved can be imposed on the foundation manager.

How do these rules apply to BBFF? Bob, his family and other BBFF trustees are all considered disqualified persons in relation to BBFF. When they attended the gala, they received goods and services paid for with foundation assets, which resulted in a self-dealing transaction.

BBFF can safely navigate the self-dealing rules in the future by doing one of the following:

  • Adopt a policy prohibiting grant making for events that will result in the receipt of any type of benefit other than public recognition as a sponsor
  • Refuse to accept any tickets or other items of value offered in exchange for a grant payment
  • Require that the disqualified persons directly pay Local University for the value of the tickets ($100 per person) and BBFF pay the $9,000 grant portion. If BBFF merely has the disqualified persons reimburse BBFF, another self-dealing transaction will result—extension of credit.
  • Adopt a policy that restricts the tickets to use only in furtherance of the foundation’s exempt purpose

While private foundations and public charities (such as United Way, churches and community foundations) are both charitable entities under IRC Section 501(c)(3), private foundations are subject to many restrictions that don’t apply to public charities. The above case is just one example. A thorough understanding of these unique rules is necessary for the proper administration of a private foundation.

For more information, contact your BKD advisor.

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