Self-Dealing Pitfalls: How to Avoid Common Foundation Management Mistakes
Self-dealing is a complex and often misunderstood area within foundation management. It involves transactions between a private foundation and its insiders, known as disqualified persons, including substantial contributors, foundation managers, certain family members, and any business or legal entities they are significantly involved with. The IRS takes a hardline stance on self-dealing to prevent misuse of charitable assets. Below, we highlight some common trouble spots and provide examples to help foundation managers navigate these tricky waters effectively.
What is Self-Dealing?
Self-dealing refers to any transaction between a private foundation and a disqualified person. This includes not only transactions that provide an improper benefit but also a broader range of interactions, even if they are fair or beneficial to the private foundation. Disqualified persons encompass significant donors, foundation managers, their family members, and entities under their control. The IRS imposes strict penalties on self-dealing transactions to prevent the misuse of charitable funds and ensure the foundation operates solely for its intended charitable purposes.
Self-dealing can include actions such as selling or leasing property, lending money, or providing goods, services, or facilities between the foundation and the disqualified person. The rules are designed to maintain a clear separation between the foundation's assets and the personal interests of those closely associated with it. While there are certain exceptions, such as payments for reasonable compensation for “personal services” or the provision of specific professional services at fair market value (e.g., legal, accounting, investment stewardship), these exceptions are specific and limited. Understanding and adhering to these regulations is crucial for proper foundation management and compliance with IRS guidelines.
Typical Self-Dealing Examples
Paying Rent to the Business of the Foundation’s Principal Donor
Imagine a scenario where a foundation rents office space from a business owned by its principal donor, who is a disqualified person. Even if the rent is below market rates, this transaction is considered self-dealing. The IRS doesn't consider the fairness of the deal—any rent payment to a disqualified person falls under self-dealing. To avoid this pitfall, foundations should seek alternative arrangements or rent from an independent third party. For instance, if a foundation rents a downtown office from a property company owned by its major donor, even with favorable lease terms, the IRS would categorize this as self-dealing. Instead, the foundation should lease space from an unrelated landlord.
Excessive Compensation for Board Members
Compensating board members and other disqualified persons is permissible, but the payments must be reasonable and the work necessary. Excessive payments can lead to self-dealing allegations. For example, if a foundation pays a board member significantly more than the industry standard for similar duties, it could be deemed unreasonable and subject to penalties. Alternatively, If a foundation hires the principal donor’s family member as a program director at twice the salary of comparable positions, this could also be perceived as self-dealing. Foundations should benchmark compensation against similar roles in other organizations and document the basis for the compensation.
Using Foundation Grants to Fulfill Personal Pledges
A less obvious but equally significant issue is fulfilling personal pledges with foundation grants. Suppose an individual makes a personal pledge to donate to a particular organization and uses a foundation grant to fulfill this pledge. Even if the individual is a major donor to the foundation, this action is considered self-dealing. Foundations must ensure that grants are made independently of any personal commitments by its insiders. For instance, if a foundation trustee pledges $50,000 to a local museum and then directs the foundation to cover this pledge, it constitutes self-dealing. Instead, the foundation should ensure that grants are made based on the foundation’s mission and priorities, not personal commitments.
Family-Owned Business Transactions
When a foundation purchases goods or services from a business owned by a board member or their family, it constitutes self-dealing. For instance, hiring a printing company owned by a board member’s spouse to produce leaflets or flyers is considered self-dealing. Similarly, if a foundation contracts a catering company owned by the principal donor’s daughter for its quarterly board meetings, the IRS would still view this as self-dealing, even if the pricing is competitive. To avoid these issues, foundations should procure services from unrelated third-party vendors.
Loans to Disqualified Persons
Any loan from a foundation to a disqualified person, regardless of terms, is self-dealing. This includes loans made at market rates or even above market rates. For instance, if a foundation provides a loan at a very high rate of interest to a board member as a brief bridge loan to purchase a property, it is self-dealing, even if the loan terms are favorable to the foundation and the loan and all the interest are properly repaid. Foundations should strictly avoid loans to disqualified persons.
Personal Expenses on Foundation Credit Cards
Using foundation credit cards for personal expenses constitutes self-dealing, even if board members reimburse the foundation shortly afterward. The IRS classifies such transactions as loans, which fall under self-dealing rules. For instance, if a board member accidentally uses a foundation credit card to pay for an airline ticket for personal travel and reimburses the foundation the next day, it still constitutes self-dealing. The best practice is to keep personal and foundation finances entirely separate to avoid any appearance of impropriety. Board members should use personal credit cards for personal expenses to maintain clear boundaries.
Sales or Exchanges of Property
Selling foundation property to a disqualified person, even at market value, is prohibited. For example, if a foundation sells a piece of art to a trustee, it is a clear violation. Even if the sale price is fair, the transaction is considered self-dealing because the counterparty is a disqualified person. Instead, the foundation should sell the art through an open market process to an unrelated buyer.
Charity Fundraiser Invitations
Consider a family foundation that buys a table at a charity’s annual fundraiser. They invite trustees and their spouses, who are not trustees, to fill the table. While the trustees may attend to evaluate the results of a grant, the spouses' attendance is problematic unless they pay for their own tickets. Alternatively, the foundation can include the ticket prices as part of the trustees' compensation, reported on Form 1099 or W-2. To avoid self-dealing, spouses should cover their own tickets, or the foundation should treat the cost as taxable compensation.
Navigating the Self-Dealing Minefield
To navigate these complexities, foundation managers should establish robust policies and procedures. Regular training on self-dealing rules, diligent record-keeping, and consulting with legal or tax professionals can help prevent inadvertent violations. Transparency and adherence to IRS guidelines are crucial to maintaining the foundation’s integrity and avoiding costly penalties.
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