What Constitutes Self-Dealing?
In our previous article, we discussed excess benefit transactions and how they affect public charities. In these transactions, a nonprofit “insider” receives compensation or benefits that exceed the fair market value. In this article, we’ll focus on the rules that apply to private foundations. While many of the same rules apply to both public charities and private foundations, private foundations face additional restrictions—one of the most significant being the prohibition against self-dealing.
What is Self-Dealing?
The IRS has strict rules about self-dealing transactions in private foundations. Self-dealing occurs when a private foundation engages in a transaction with certain individuals or entities, called “disqualified persons,” that benefits them personally. These transactions can lead to severe financial penalties for the foundation and those involved.
Who is a “Disqualified Person”?
The IRS defines a disqualified person as someone who holds a significant position within the private foundation. Specifically, a disqualified person includes:
- Substantial donors to the foundation.
- Foundation managers, including officers, directors, and trustees.
- Family members of the above individuals.
- Individuals or entities who own more than 20% of any business that contributes to or benefits from the foundation.
Additionally, disqualified persons also include:
- Corporations or partnerships where any of the above individuals holds more than 35% of the voting power.
- Trusts or estates where these individuals hold more than 35% of the beneficial interest.
Disqualified persons also include government officials and others who have significant control over the foundation.
Why Does This Matter?
If a disqualified person owns more than the permitted percentage of a business, they may incur an excise tax on the excess holdings. The private foundation generally has a 90-day period to reduce these excess holdings through divestment, with potential extensions under specific circumstances.
What Transactions are Considered Self-Dealing?
A disqualified person cannot engage in certain transactions with the private foundation as they may be considered acts of self-dealing. These include:
- Selling, exchanging, or leasing foundation property.
- Lending money or extending credit to or from the foundation.
- Furnishing goods, services, or facilities to the foundation, with few exceptions (e.g., interest-free loans).
- Paying compensation or covering expenses for disqualified persons.
Additionally, the IRS treats transfers of foundation income or assets for the benefit of disqualified persons as self-dealing. This can even apply to certain government officials or transactions between entities controlled by the private foundation.
What Are the Consequences of Self-Dealing?
The IRS has very strong penalties for engaging in self-dealing. Under Internal Revenue Code Section 4941, a disqualified person involved in self-dealing is subject to a minimum 10% excise tax on the amount involved in the transaction. Foundation managers (such as officers, directors, or trustees) who knowingly participate in self-dealing face a 5% excise tax on the transaction amount.
It’s important to note that participation in self-dealing is not limited to actively engaging in the transaction. Failure to act or speak up when required—such as remaining silent or not intervening when there’s a clear duty to prevent self-dealing—can also result in penalties.
If the violation isn’t corrected, the IRS imposes a 200% excise tax on the amount involved for the disqualified person. Additionally, if foundation managers fail to take corrective action, they face an additional 50% excise tax on the amount involved in the self-dealing transaction.
Are There Exceptions?
There are a few exceptions to these self-dealing rules. For instance, payments made to disqualified persons are not considered self-dealing if they are for reasonable and necessary services that help the foundation carry out its exempt purposes. However, the IRS closely scrutinizes what constitutes “reasonable and necessary,” so it’s essential for foundations to carefully document and justify such payments.
Final Thoughts
When managing a private foundation, it’s crucial to avoid casual transactions and approach relationships with insiders carefully. Engaging in self-dealing or violating IRS rules can result in serious financial penalties and damage to the foundation’s reputation. To ensure compliance with the law, always consult with a tax professional or accountant before engaging in any potentially questionable transactions.
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Fundraising managers may wonder, “Stocks? Isn’t that more of an investor thing?”, and they would be correct. However, accepting donations of stock or securities offers much more than an investment opportunity. It’s a tax-saving strategy that results in a win-win-win for the non-profit, its donors, and the causes it supports.
This material has been prepared for informational purposes only and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
