What is self-dealing for private foundations?

Self-dealing is one of the most critical compliance issues for private foundations, encompassing a wide range of prohibited transactions that involve "disqualified persons"—individuals or entities with significant influence over the foundation. These stringent rules aim to safeguard the foundation’s assets from misuse, ensuring they are dedicated solely to advancing its charitable mission. The self-dealing regulations impose strict prohibitions on financial interactions between a foundation and its insiders, regardless of intent, size, or perceived benefit to the foundation. Moreover, the rules extend to indirect arrangements with third parties that may result in economic or financial gains for disqualified persons. By focusing on the nature of the transactions and the roles of the parties involved, these regulations help uphold the integrity of private foundations, shielding them from conflicts of interest and safeguarding public trust.

Understanding Disqualified Persons

Disqualified persons include individuals and entities with significant influence over a private foundation, such as major donors, foundation managers, certain family members, and entities like businesses or trusts they control. These individuals and entities are subject to the strict self-dealing rules designed to prevent conflicts of interest and ensure the foundation's assets are used appropriately. For a more in-depth explanation of who qualifies as a disqualified person, please visit our comprehensive discussion through this link.

The Broad Scope of Self-Dealing Transactions

While legal complications for private foundations are uncommon, those that do arise often center around self-dealing issues. Any business or transactional relationship involving the foundation and its disqualified persons must be approached with caution, as it may be construed as self-dealing. These provisions can be triggered by a wide range of transactions—both direct and indirect—across diverse arrangements and contexts. Special care is warranted when dealing with businesses owned or controlled by disqualified persons, as these interactions carry a heightened risk of violating self-dealing rules due to the close ties of these individuals to the foundation.

For example, direct self-dealing occurs when a foundation engages in business with an entity controlled by one of its managers, such as purchasing supplies from a retail store owned by a foundation director. Similarly, if a foundation hires a trustee’s construction company to renovate a building it owns, this constitutes self-dealing. Even if the terms of the agreement are competitive or below market rate, the transaction is prohibited because it involves a disqualified person.

Indirect self-dealing can be more nuanced. Consider a scenario where a foundation pays above-market fees to a financial advisor who also provides services to one of the foundation's directors. If this director subsequently receives preferential treatment, the arrangement could qualify as indirect self-dealing, as the payments indirectly benefit the director and potentially prioritize personal advantage over the foundation’s philanthropic objectives.

A common misconception in foundation management is the belief that a transaction involving a disqualified person is permissible if it appears fair or beneficial to the foundation. This assumption is often incorrect. Self-dealing rules apply regardless of intent or perceived benefit to the foundation. For instance, if a board member rents office space they control to the foundation at a reduced rate, it would still be considered self-dealing. The law focuses not on the fairness or outcome of the transaction but on the nature of the relationship and the parties involved.

Clarifying Donor Misconceptions About Asset Ownership

One common misunderstanding among donors—whether individuals, families, or businesses—is the concept of asset ownership after a donation is made to a private foundation. Once donated, these assets become the property of the foundation, a separate legal entity subject to strict regulations. Many donors mistakenly view the foundation's assets as an extension of their personal or corporate finances, assuming that any payments made by the foundation are automatically fair or charitable. This misconception can lead to significant self-dealing violations. It is crucial for donors to recognize that once assets are transferred to a foundation, they are governed by rigorous legal and ethical standards, ensuring they are used exclusively to advance the foundation’s philanthropic mission.

Exploring Common Self-Dealing Transactions

Understanding the broad scope of transactions covered by self-dealing rules is essential for ensuring compliance. By default, any transaction between a private foundation and a disqualified person is presumed to constitute self-dealing unless an explicit exception is outlined in the Internal Revenue Code. This stringent approach highlights that the prohibition applies regardless of intent or whether the transaction appears advantageous to the foundation.

The following examples illustrate some common scenarios where self-dealing rules may apply:

• Property Transactions: Buying, selling, or exchanging property between a private foundation and a disqualified person is prohibited. For example, a foundation purchasing an office building from a trustee at below-market value would violate self-dealing rules, even if the transaction seems beneficial to the foundation.

• Lending and Borrowing: Lending or borrowing money between a private foundation and a disqualified person is generally prohibited and constitutes self-dealing, regardless of which party acts as the lender or borrower. For example, if a foundation lends $50,000 to a board member for personal ventures, the transaction is self-dealing, even if the loan terms are favorable to the foundation (like a very high interest rate). Similarly, if the foundation borrows money from a disqualified person at below-market interest rates, it still violates self-dealing rules.

An important exception exists where a disqualified person lends money to the foundation on an interest-free basis, provided the loan is used exclusively for charitable purposes. Outside of this narrowly defined exception, all lending and borrowing transactions between a foundation and disqualified persons are prohibited to protect the foundation's assets and ensure compliance with self-dealing regulations.

• Personal Use of Foundation Assets: Self-dealing occurs when a disqualified person uses foundation-owned resources for personal purposes. An example is a trustee using a foundation-owned vehicle for personal errands, as it benefits the individual rather than advancing the foundation’s charitable mission.

• Rental and Leasing Agreements: Renting office space from a disqualified person or their controlled entity typically triggers self-dealing rules, even if the terms are favorable to the foundation, such as discounted rates. However, an exception under the Internal Revenue Code allows the foundation to use the space rent-free, provided no other financial arrangements are involved.

• Goods, Services, and Facilities: Exchanging goods, services, or facilities between a foundation and a disqualified person is generally regarded as self-dealing, regardless of the transaction’s terms or perceived benefits. However, specific exceptions outlined in the Internal Revenue Code may apply, such as when goods or services are provided to the foundation entirely free of charge.

• Compensation Concerns: Self-dealing rules also apply when a private foundation compensates its leadership, including directors, trustees, managers, and other disqualified individuals. While the Internal Revenue Code provides specific exceptions for compensating "personal services" (discussed in detail later), such compensation must meet two critical criteria: it must be both reasonable and necessary for the foundation's operations. Any payments exceeding what is reasonable or covering unnecessary or excessive expenses would still constitute self-dealing, even if tied to legitimate services.

• Expense Reimbursement:  Self-dealing can arise when a foundation reimburses or pays for unreasonable or unnecessary expenses incurred by a disqualified person. For example, if a foundation manager uses a foundation-issued debit card for personal shopping, this is a clear instance of self-dealing. To avoid such violations, it is essential to establish and enforce a clear boundary between expenses that advance the foundation’s charitable mission and those that serve personal interests.

• Unwarranted Benefit: An unwarranted benefit occurs when a disqualified person uses the income, assets, or facilities of a private foundation in a manner that provides them with an advantage or benefit unrelated to the foundation’s charitable objectives. These benefits are not limited to monetary or tangible gains—they can also include the personal use of the foundation’s assets. For example, a disqualified person using the foundation's office space for personal business activities constitutes an unwarranted benefit. This misuse could involve hosting meetings with personal business partners, conducting private client engagements, or even using the foundation’s address for personal business correspondence. Such actions violate the foundation's mission and the self-dealing rules designed to prevent these conflicts.

Key Exceptions to Self-Dealing Regulations

The Internal Revenue Code provides specific exceptions to the general self-dealing rules for private foundations. These exceptions outline permissible transactions that do not violate self-dealing regulations. Key examples include:

• Free Services & Goods: Providing free services or goods to a private foundation is not considered self-dealing.

• Rent-Free Office Space: A private foundation may use office space free of charge without triggering self-dealing rules. However, any financial arrangement involving rent would generally violate these regulations.

• Zero-Interest Loans: Disqualified persons may lend money to a foundation on an interest-free basis, provided the funds are used exclusively for charitable purposes. For instance, a zero-interest bridge loan to support a foundation’s grantmaking program is permissible. However, the reverse—disqualified persons borrowing money from the foundation—is strictly prohibited, regardless of the terms or benefits involved.

• Employee Compensation: Disqualified persons can be compensated as employees under specific conditions. The role must be both reasonable and necessary for the foundation’s operations and must qualify as "personal services," as defined by the Internal Revenue Code. This exception primarily applies to white-collar roles such as general management, accounting, legal services, and investment management. Positions outside these areas, such as manual labor or technical work, typically do not meet the requirements of this exception.

• Compensation for “Personal Services”: As an exception to the general self-dealing rules, private foundations may compensate disqualified persons for “personal services” that are essential and directly support their charitable mission. These "personal services" are strictly defined and typically limited to white-collar roles such as general management, accounting, legal services, and investment management. It is important to emphasize that roles outside these professional categories—such as manual labor or technical positions—do not qualify under this exception. For instance, compensating a disqualified person for legal advice provided to the foundation would be permissible, whereas paying for groundskeeping services would violate self-dealing rules.

• Reimbursement of Charitable Expenses: Reimbursing disqualified persons for expenses incurred on behalf of the foundation is generally allowable if the expenses are reasonable, necessary, and properly documented. For example, a director who inadvertently pays for a legitimate foundation expense out-of-pocket may be reimbursed by the foundation. However, all such reimbursements should be conducted under an accountable plan to ensure proper oversight and compliance.

• Fair Access Transactions: Private foundations may extend goods, services, or facilities to disqualified persons if they are equally available to the general public. For instance, a disqualified individual may use a community swimming pool sponsored by the foundation as long as their access is the same as that provided to the general public.

• De-minimis Benefit: Minor, incidental benefits to disqualified persons are often permissible under the de minimis exception. For example, a trustee accepting a token gift, such as a pen or a calendar of nominal value from a grantee, would not violate self-dealing rules. This exception acknowledges that negligible advantages do not compromise the foundation’s operations or charitable objectives.

Understanding the Reasonable Compensation Exception

The self-dealing rules generally prohibit financial transactions between a private foundation and disqualified persons. However, a blanket prohibition on compensating such individuals would create significant operational challenges. For example, without this exception, hiring a key position like a CEO would be impossible, as the individual automatically become a disqualified person upon employment. This exception is essential for enabling foundations to recruit and retain the skilled professionals needed for effective governance and management, ensuring their operations align with industry standards in the nonprofit sector.

The exception permits foundations to compensate disqualified persons when the compensation meets three critical criteria: it must be necessary, reasonable, and limited to personal services directly supporting the foundation’s charitable purposes. Each of these elements is defined as follows:

• Necessity: The services must be essential and directly tied to the foundation's charitable mission. For example, hiring a program director to oversee grantmaking operations is necessary, as this role facilitates the foundation’s philanthropic goals.

• Reasonableness: Compensation must reflect market standards for similar roles in comparable organizations. The IRS evaluates reasonableness by examining the total compensation package, which includes salary, bonuses, fringe benefits, deferred compensation, and other perks. Foundations often rely on independent compensation surveys or market studies to demonstrate compliance with this standard.

• Personal Services: The IRS defines “personal services” quite narrowly, with a clear white-collar bias, recognizing roles like general management, accounting, legal services, as well as banking and investing services. This definition reflects an inclination towards managerial and professional roles, which are directly related to the strategic and operational management of the foundation.

It's important to note that non-managerial and non-white-collar tasks would not typically be included in this definition. For instance, paying for services like manual labor (e.g., landscaping) or clerical support would violate the self-dealing rules because they do not fit inside the definition of “personal services”.  

Best Practices to Prevent Self-Dealing

To mitigate the risks of self-dealing, private foundations should adopt preventative measures that help ensure compliance with applicable regulations. Some best practices include:

• Developing a Conflict-of-Interest Policy: A robust conflict-of-interest policy ensures that board members and staff disclose potential conflicts and recuse themselves from discussions or decisions that could result in self-dealing.

• Consulting Legal Counsel Proactively: Seek advice from legal counsel when contemplating transactions that may fall within gray areas of self-dealing regulations. An upfront consultation ensures that potential risks are identified and mitigated before violations occur.

• Detailed Documentation: Maintain comprehensive records for all transactions, particularly those involving disqualified persons or areas prone to self-dealing risks. Documentation should include meeting minutes, transaction details, appraisals, and any correspondence with legal or financial advisors. Thorough records demonstrate due diligence and help establish compliance with IRS regulations.

Best Practices for Shared Office Spaces in Foundations

Shared office arrangements between private foundations and related family businesses or for-profit companies are common and, when handled correctly, can be permissible. These setups are straightforward when the family or company absorbs all associated expenses, including rent, utilities, and administrative services. However, complications arise when a private foundation contributes to these expenses, potentially leading to self-dealing violations. Below are key considerations to navigate these complexities:

• Rent Considerations: Under self-dealing rules, a foundation is prohibited from paying rent to a disqualified person, even if the terms are at or below market rates. This restriction applies if the foundation subleases from a related business or reimburses it for rent. To avoid potential violations, the best practice is for the foundation to lease space directly from an independent third party.

• Allocation of Service Costs: The foundation can share expenses for services such as janitorial work, utilities, or maintenance, provided it pays its portion directly to third-party service providers. Foundations should avoid paying the family business or for-profit company, which would then pay the service provider. Maintaining detailed records is critical to demonstrate that these payments are fair, equitable, and compliant.

• Shared Office Equipment: For shared office resources like copiers and fax machines, the foundation should allocate costs based on actual usage and ensure payments go directly to third-party vendors who are not disqualified persons. Payments should never be routed through family or corporate businesses associated with the foundation to avoid self-dealing violations.

• Main Exception for Shared Resources: A disqualified entity, such as a family business or for-profit company, may provide goods, services, or facilities to the foundation at no cost. This is allowable as long as the resources are used exclusively for the foundation’s charitable purposes.

Managing Board Overlap Between Foundations and Public Charities

It is not uncommon for private foundations to grant funds to public charities where an individual serves as a board member for both the grantor (foundation) and the grantee (charity). While such overlapping board memberships do not automatically constitute self-dealing, they can raise concerns about potential conflicts of interest or undue influence. To address these concerns, it is crucial to prioritize transparency and to handle potential conflicts with care.

Foundations should implement conflict of interest policies that require board members with overlapping roles to disclose their dual affiliations. Additionally, these individuals should recuse themselves from any decision-making processes related to grants or activities involving the grantee organization where they hold a leadership position. This ensures grant decisions are made objectively and free from bias.

Navigating Self-Dealing Concerns in Enforceable Pledges

Self-dealing regulations explicitly prohibit foundations from fulfilling enforceable pledges made by disqualified persons. The enforceability of such pledges depends on state law, which varies, but written pledges that are signed and relied upon by a charity are often considered enforceable. These pledges are viewed as personal debts or obligations of the disqualified person or entity, making it improper to use foundation funds to satisfy them.

To avoid inadvertently creating enforceable obligations that could lead to self-dealing, donors should carefully structure their pledges to ensure they are made directly by the foundation, not by the individual or corporation. Consulting legal counsel before making a pledge is a best practice, as is maintaining clear documentation of pledges and their fulfillment.

To avoid this issue, disqualified persons wishing to have their pledges fulfilled by their foundation should ensure that the pledges are made directly by the foundation itself, not by the disqualified person.

Understanding Penalties for Self-Dealing Violations

When self-dealing occurs within a private foundation, the financial and legal consequences fall squarely on the disqualified persons and foundation managers involved, not the foundation itself. Penalties for self-dealing are categorized into first-tier and second-tier excise taxes, with the self-dealer—the individual responsible for the self-dealing—bearing the majority of the burden. For instance, if a foundation director misuses the foundation's funds for personal purposes, they are deemed the self-dealer and are subject to penalties.

In addition, foundation managers who knowingly approve self-dealing transactions may also face penalties. Resolving a self-dealing issue typically involves returning the asset involved or paying an amount equivalent to the benefit received. The most common penalty is an excise tax based on the value of the self-dealing transaction, which applies to both the self-dealer and, in some cases, the approving foundation managers. As previously mentioned, the foundation itself is generally not penalized for these violations.

• Initial First-Tier Tax on Self-Dealer: The self-dealer is subject to a 10% excise tax, calculated based on the value of the self-dealing transaction. For instance, if a foundation director improperly uses $50,000 of foundation funds for personal travel, they must pay a $5,000 excise tax and reimburse the foundation for the $50,000 misused.

• Initial First-Tier Tax on Foundation Manager: If a manager knowingly participates in the self-dealing, they are subject to a 5% tax on the transaction amount, capped at $20,000 per violation. Managers can avoid penalties if their participation was not willful and they acted with reasonable cause, such as relying on legal counsel.

• Requirement to Correct Violations: To avoid additional taxes, self-dealing transactions must be corrected by reversing the prohibited action to the extent possible. This involves restoring the foundation to its original financial position before the violation occurred. For example, if foundation funds were improperly used, the disqualified person must repay the full amount along with any associated costs. The primary goal of this corrective action is to ensure that the foundation’s financial position is fully restored and not negatively impacted by the self-dealing incident. Essentially, the foundation should be returned to a state as close as possible to what it would have been if the disqualified person had adhered to the highest fiduciary standards.

In cases where no direct financial payments occurred, such as a disqualified person using a foundation-owned vehicle for personal purposes, correction might involve reimbursing the foundation for the vehicle's rental value during the period of improper use thereby restoring the foundation’s lost benefit.

• Multi-Year Penalties: If the violation persists over multiple years, the first-tier taxes (10% annually for self-dealers and 5% for managers) continue to accrue until the issue is corrected. For example, an unresolved $10,000 self-dealing transaction could result in $3,000 ($1,000 x 3) in excise taxes over three years.

• Second-Tier Taxes: Second-tier tax penalties come into play if a self-dealing transaction remains uncorrected within the timeframe specified by the IRS, significantly escalating the consequences. In such cases, the self-dealer may face a 200% excise tax on the transaction amount, while foundation managers who approved the act can incur a 50% excise tax, capped at $20,000 per act of self-dealing. These severe penalties highlight the IRS's expectation for prompt correction of violations. While rare, the imposition of this second-tier tax typically occurs when a self-dealer refuses to take corrective action, reinforcing the importance of addressing self-dealing issues without delay.

Beyond Financial Penalties: Legal Consequences of Self-Dealing

Self-dealing violations within a private foundation can lead to consequences that extend far beyond financial penalties, encompassing severe legal and operational risks. Persistent or egregious self-dealing may trigger direct legal actions against the foundation or its managers, including injunctions. Courts may issue these orders to halt certain activities or mandate specific corrective measures, potentially causing significant disruptions to the foundation's operations.

In extreme cases, the IRS has the authority to revoke a foundation's tax-exempt status if it determines that the organization has consistently engaged in self-dealing or other prohibited activities, fundamentally misusing its charitable assets. Such a revocation not only terminates the foundation’s tax advantages but also effectively ends its ability to function as a nonprofit entity.

In addition to federal penalties, state-level regulations can impose their own sanctions for self-dealing transactions where foundation assets are misappropriated. These state penalties can include fines, additional taxes, or legal actions initiated by state authorities, which may be applied alongside federal penalties, compounding the financial and legal impact on the foundation and its managers.

Moreover, self-dealing can expose disqualified persons or foundation managers to civil lawsuits from third parties who have been adversely affected. For instance, donors who contributed funds with specific conditions attached might take legal action if they discover their donations were diverted or misused in a self-dealing arrangement. Such lawsuits could claim that the foundation violated the terms of the gift, further compounding the financial and reputational risks.

Critical Questions to Prevent Self-Dealing in Foundations

Preventing self-dealing begins with asking the right questions to uncover potential risks and ensure compliance. Proactively addressing these questions can help identify red flags and avoid legal complications before they escalate. Here are some good questions to consider:

Conflict of Interest and Personal Benefits

• Board Decisions Involving Personal Interests: Are there situations where board members participate in decisions that could benefit them financially?

• Event Tickets: Are foundation-acquired tickets for fundraising and other events being used by spouses, family members, or other disqualified persons?

• Grant and Pledge Alignments: Do any foundation grants fulfill pledges made by board members, trustees, or other disqualified persons?

• Investment Decisions: Do investment decisions benefit disqualified persons, directly or indirectly, such as joint ventures where a disqualified person, their family members, or affiliated businesses hold a financial interest or exert significant influence?

• Asset Usage: Are foundation assets (e.g., vehicles, equipment, or property) used by disqualified persons for personal purposes?

• Beneficiary Selection in Grantmaking: Are grants awarded to organizations where disqualified persons have significant influence or stand to benefit personally?

Financial Transactions and Compensation

• Compensation Assessment: Are there processes in place to ensure staff compensation and board fees are reasonable and justifiable?

• Expense Reimbursements: Are there instances where disqualified persons are reimbursed for personal expenses such as travel costs for spouses or other family members?

• Assessing Financial Ties: Are there any financial interactions between the foundation and its board or staff members, beyond regular compensation?

Business and Family Ties

• Contract Awards: Are contracts for goods or services awarded to companies owned or operated by disqualified persons or their families?

• Employment of Relatives: Are family members of disqualified persons employed by the foundation, and what are the terms of their employment?

• Real Estate Transactions: Has the foundation bought, sold, or rented real estate to or from a disqualified person, or is it considering such transactions in the future?

• Loans and Loan Guarantees: Has the foundation ever issued or guaranteed a loan for a disqualified person or related entity, or is it considering doing so in the future?

• Office Sharing Concerns: Does the foundation share office space with related parties, such as family businesses or associated entities?

Conclusion

In conclusion, navigating the intricate self-dealing regulations governing private foundations demands both vigilance and a proactive approach. These rules are essential for preserving the integrity and public trust that underpin the charitable mission of private foundations. By understanding the broad scope of prohibited transactions, recognizing the role of disqualified persons, and adhering to the outlined exceptions, foundation managers can effectively mitigate risks and ensure compliance. Moreover, fostering a culture of transparency, implementing robust oversight measures, and seeking expert guidance when needed are critical steps in safeguarding the foundation’s assets and ethical standing. Ultimately, staying informed and diligent not only helps avoid legal pitfalls but also reinforces the foundation’s commitment to its philanthropic goals, ensuring its resources are used solely for the greater good.

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