Private Foundations: What is Prohibited Self-Dealing and Who are Disqualified Persons?

In a previous blog article, we explained the fundamental differences between a 501(c)(3) private foundation and a 501(c)(3) public charity. You will recall that one of those distinctions prohibits private foundations and disqualified persons from engaging in self-dealing.

What is Prohibited Self-Dealing?

Unlike public charities, private foundations are subject to strict self-dealing rules pursuant Section 4941(d) of the Internal Revenue Code.  The following transactions are generally prohibited as acts of self-dealing between a private foundation and an interested/disqualified person (to be defined further below):

1. Sale, exchange, or leasing of property (personal property, stock, real property);

   1. In general, any sale or exchange of property (real or personal) between a private foundation and a disqualified person is an act of self-dealing regardless of the amount paid to the disqualified person.

   2. The transfer of real or personal property by a disqualified person to a private foundation is treated as a sale or exchange if the foundation (i) assumes a mortgage or similar lien, which was placed on the property before the transfer, or (ii) takes the property subject to a mortgage or similar lien that a disqualified person placed on the property in the 10–year period ending on the date of transfer.

2. Leases;

   1. In general, the leasing of property between a disqualified person and a private foundation is an act of self-dealing.

   2. However, the leasing of property by a disqualified person to a private foundation is not an act of self-dealing if the lease is without charge.  The lease will be considered without charge even though the foundation agrees to pay for janitorial expenses, utilities or other maintenance costs it incurs as long as payment is not made directly or indirectly to a disqualified person.

3. Lending money or other extensions of credit;

   1. In general, lending money or other extension of credit between a private foundation and a disqualified person is an act of self-dealing.

   2. However, this does not include lending money by a disqualified person to a private foundation without interest or other charge if the borrower uses the loan proceeds exclusively for purposes specified in section 501(c)(3) of the Code.

4. Providing goods, services, or facilities;

   1. Generally, providing goods, services, or facilities between a private foundation and a disqualified person is an act of self-dealing.  This applies to providing office space, cars, auditoriums, secretarial help, meals, libraries, publications, laboratories or parking lots.

   2. However, it is not self-dealing if a disqualified person provides goods, services, or facilities to a foundation without charge and the goods, services, or facilities are used exclusively for purposes specified in section 501(c)(3) of the Code. 

   3. Also, providing goods, services, or facilities to a foundation manager, employee, or unpaid worker, is not an act of self-dealing if the value of the items provided is reasonable and necessary to the performance of the tasks involved in carrying out the exempt purpose of the foundation and is not excessive.

5. Paying compensation or reimbursing expenses to an interested/disqualified person;

   1. In general, paying compensation or reimbursing expenses by a private foundation to a disqualified person is generally an act of self-dealing.

   2. The general rule does not apply, however, to the extent the payments, which cannot be excessive, are for personal services that are reasonable and necessary to carry out the foundation’s exempt purposes. Personal services are "essentially professional and managerial in nature". See Madden v. Commissioner, 74 Tax Ct. Memo 440 (1997). What typically constitutes "personal services" are legal services, investment counseling services, commercial banking services. On the other hand, janitorial services do not qualify as personal services.

6. Transferring foundation income or assets to, or for the use or benefit of, an interested/disqualified person; and

7. Certain agreements to make payments of money or property to government officials.

In addition, the law prohibits indirect self-dealing. Thus, transactions between organizations controlled by a private foundation may also be taxable self-dealing.

Who Constitutes an Interested/Disqualified Person?

For purposes of the self-dealing rules listed above, Section 4946(a)(1) of the Internal Revenue Code defines the following individuals and entities as “interested/disqualified persons”:

1. All Substantial Contributors to the Foundation.  A substantial contributor is any person who has contributed or bequeathed more than $5,000 to a foundation, when that contribution or bequest constitutes more than 2 percent of the total contributions and bequests received by the foundation from the date of its establishment through the close of the fiscal year in which the contribution or bequest was received.  A person classified as a substantial contributor generally remains so forever, notwithstanding the amount of subsequent contributions by others. Under certain limited circumstances, however, a donor ceases to be a substantial contributor if he or she and certain “related persons” have no connection to the foundation for a 10-year period and aggregate contributions by the donor and the related persons are insignificant when compared with the aggregate contributions of one other person.  Contributions by a donor and related persons generally will be considered insignificant in relation to the contribution of some other person if their contributions are less than 1 percent of the contributions made by the other person.  Private foundations must maintain a running tally of contributions and bequests from all persons, taking into account the attribution rules described below, to identify their substantial contributors. 

2. All Managers of the Foundation.  Officers, directors, and trustees, as well as individuals with powers or responsibilities similar to those of officers, directors, or trustees of the foundation are viewed as a “foundation manager” and, therefore, qualify as a disqualified person of the foundation.  A person is considered an officer of a foundation if he or she is designated as such under the foundation’s governing instruments or regularly makes administrative or policy decisions on behalf of the foundation.  In general, a foundation employee who has authority merely to recommend administrative or policy decisions but must have approval from a superior to implement those decisions, is not an officer.  Independent contractors—for instance, accountants, lawyers, and investment managers or advisors—acting in their capacity as such, are not considered officers of a foundation. 

3. Owners of Businesses that Are Substantial Contributors to the Foundation. A person who owns more than 20 percent of the total combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust or unincorporated enterprise that is (during the ownership) a substantial contributor to a private foundation, is included in the ranks of disqualified persons.  Eliminating the business ownership interest eliminates the disqualified person taint. 

4. Family Members.  Immediate family members of disqualified persons (i.e., a person who is a substantial contributor, a foundation manager, or a 20 percent owner) are also considered disqualified persons.  This category includes the spouse, ancestors, children, grandchildren, great-grandchildren, and the spouses of children, grandchildren, and great-grandchildren, but not siblings.

5. Corporations Owned by Other Disqualified Persons.  Corporations of which more than 35 percent of the total combined voting power is owned by substantial contributors, foundation managers, 20 percent owners, or members of the family of any of these persons meet the definition of disqualified persons. 

6. Partnerships Owned by Other Disqualified Persons.  Like corporations, a partnership is a disqualified person if more than 35 percent of its profits interest is owned by substantial contributors, foundation managers, 20 percent owners, or members of the family of any of these persons. 

7. Trusts or Estates Owned by Disqualified Persons.  A trust, estate, or unincorporated enterprise is a disqualified person if more than 35 percent of its beneficial interest is owned by substantial contributors, foundation managers, 20 percent owners, or members of the family of any of these persons. 

8. Government Officials.  A government official may be a disqualified person with respect to a private foundation, but only for purposes of the self-dealing rules (not for purposes of other private foundation restrictions).  Government officials include all elected executive or legislative officials as well as any person in the executive, judicial, or legislative branch above a certain grade level.

Private foundations are tricky and a trap for the unwary. For more information and assistance, contact us today!