Beware of Self-Dealing within Private Foundations

by Gavin Morrissey, JD, LLM, AIF®
Guest Columnist

Private foundations have long been a charitable planning vehicle for wealthy individuals and families.  While the private foundation can be a wonderful way to implement a charitable giving plan, the organization formalities and ongoing administration can be a challenge.  One area where foundations may find trouble is in the navigation of the self-dealing rules.

For those who have or are considering the establishment of a private foundation it is very important that they understand the potentially complex rules to prevent self-dealing.  Self-dealing is simply defined as a transaction between a foundation and an individual or entity referred to as a “disqualified person.”  A disqualified person is commonly a substantial contributor (and their family members), a foundation manager, certain government officials, and potentially related trusts, estates, and corporations.  Understanding who may be classified as a disqualified person is the first step in keeping a foundation from running afoul of the self-dealing rules.

Once a disqualified person can be accurately identified we then have to turn our attention to the types of transactions with those disqualified persons that the IRS deems to be self-dealing.  Fortunately, the IRS publishes the following list of transactions to be generally considered an act of self-dealing between a disqualified person and a foundation:

1. Sale, exchange, or leasing of property
2. Leases
3. Lending money or other extensions of credit
4. Providing goods, services, or facilities
5. Paying compensation or reimbursing expenses to a disqualified person
6. Transferring foundation income or assets to, or for the use or benefit of a disqualified person
7. Certain agreements to make payments of money or property to government officials

As you can see the list of acts generally considered to be self-dealing is very broad and there are exceptions to self-dealing for which the IRS also provides guidelines.  Regardless of those exceptions it is not uncommon to hear of a foundation being questioned regarding the amount of compensation paid to a foundation employee who is also the founder’s family member.  Is the amount reasonable and necessary to carry out the exempt purpose of the foundation?  If so, an exception may apply.

Determining whether an exception may apply can be a complex and confusing process for the foundation manager. Failure to qualify for an exception can lead to significant penalties for each act of self-dealing.  For instance, a disqualified person involved in a transaction deemed to be an act of self-dealing must reverse the transaction and pay a 10% penalty tax on the value of that transaction.  The foundation manager, not the foundation itself, can also be assessed a penalty tax of 5% on the transaction value subject to certain limitations.

Given the broad number of acts which may be considered self-dealing when a party to the transaction is a disqualified person, it is very important that foundations become vigilant in scrutinizing their transactions.  To avoid trouble from the onset foundations should always seek qualified counsel to provide guidance as to what may or may not be an act of self-dealing. 

Gavin Morrissey is a managing partner of Financial Strategy Associates, Inc., located in Needham, Massachusetts.  Gavin has earned an undergraduate degree in economics and finance, a juris doctorate, a Masters of Law in taxation, and holds the Accredited Investment Fiduciary (AIF®) designation.  He applies the disciplines learned through his education to provide tax-efficient holistic solutions that are customized to each clients’ needs. He is a member of the AEF Council of Advisors.

At American Endowment Foundation, we look forward to discussing how donor advised funds can be an alternative to (or complement to) private foundations. Contact us or call at 1-888-660-4508 to learn more.