Unlike public charities that derive their support from a number of individuals, private foundations are charitable, tax-exempt entities that are created and supported by a concentrated number of individuals, typically a family unit. Since private foundations confer income and transfer (gift and estate) tax benefits, the IRS closely scrutinizes transactions between the family establishing the entity and the foundation itself.
In recent years, the IRS has become more aggressive in policing the self-dealing rules governing private foundations. Generally, it’s immaterial whether a self-dealing transaction is good or bad for the foundation. For example, if a “disqualified person” sells stock at a bargain price to a private foundation, it’s self-dealing regardless of the value of stock or amount paid.
Disqualified persons (DQPs) include a creator of the foundation (either by a trust or by forming a corporate entity), any person who contributed or bequeathed an aggregate amount of more than $5,000 if such amount is more than 2% of the total contributions for that year (and spouse contributions are aggregated), a foundation manager, more than 20% owner of substantial contributor (like a family business or partnership), a member of the family establishing the foundation, “35% entities” (those corporations, partnerships or trusts and estates having a 35% or more beneficial interest) and government officials.
It’s safe to say that almost anyone doing business or benefiting from a private foundation is a disqualified person.
If a DQP sells property, through an agent or otherwise, transfers encumbered property whether the liability is nonrecourse or recourse, lends money, borrows money, furnishes goods or services, pays unreasonable amounts of compensation or reimburses unreasonable expenses, rents office space (even if such rent is below market value), or shares office space to, for or with a private foundation, chances are the DQP has engaged in prohibited self-dealing transactions.
What are the consequences to prohibited self-dealing transactions? Here the IRS imposes either First-Tier or Second-Tier penalties. The First-Tier penalty is ten percent (10%) of the amount involved on the DQP. This penalty may be assessed on any DQP who participates, not just the one who benefits, and the liability is deemed joint and several. This penalty repeats for each year in which the prohibited transaction is outstanding. “Participating” is defined as engaging, taking part in the transaction or directing others to do so.
Foundation Managers are assessed a five percent (5%) penalty. It must be a knowing violation and willful. Again, manager first-tier penalties are joint and several, but they have a $20,000 cap for each act of self-dealing. “Participation” includes silence or inaction under a duty to act. “Knowing” means an actual knowledge of sufficient facts, awareness that the act may violate self-dealing rules, and negligence in failing to make reasonable attempts to ascertain if an action or omission constitutes self-dealing.
Second-Tier penalties are onerous. On the participating DQP, it is two hundred percent (200%) of the amount involved if not corrected within the taxable period. For the participating Foundation Managers, second-tier penalties are fifty percent (50%) of the amount involved but only if the Foundation Manager refuses to correct the issue.
The taxable period begins on the date when self-dealing occurs and ends on the earliest of the date of IRS mailing of the deficiency notice, date when the first-tier tax is assessed or date when the correction is completed.
Correcting Self-Dealing actions are not easy. It means “undoing the transaction to the extent possible but placing the private foundation in a financial position not worse than that in which it would be if the DQP were dealing under the highest fiduciary standards. Any correction cannot be another act of self-dealing. It may involve, for example, recasting a gift by returning cash, or recission of a transaction where possible.
Allow me to illustrate self-dealing with examples. Assume that a private foundation owns a home used for foundation purposes, but the DQP has a lease allowing him to stay there when in town for fair market value rent. DQP learns that the use of the house, even for rent, is self-dealing but doesn’t want to give it up. He proposes to buy the home from the foundation but learns he can’t. The private foundation terminates the lease and makes correction by DQP contributing to private foundation marketable stocks equal in fair market value to the correction amount. The private foundation then makes the grant of the house to a public charity, but the DQP is on the board of the public charity, as are two of his attorneys. The public charity board with DQP recused then procures an appraisal and sells the house to the DQP for fair market value.
Potential issues in all of this is the sale or exchange and leasing of property, the correction itself is an act of self-dealing and the indirect correction via intermediaries.
If you have a private foundation, it’s vital to stay on top of the self-dealing rules and avoid them.
©2022 Craig R. Hersch of The Sheppard Law Firm. Learn more at floridaestateplanning.com
