While any Section 501(c)(3) organization must be cautious when entering into a business arrangement with a related party, it’s particularly true for private foundations in light of the federal tax law’s self-dealing rules. Under these rules, a private foundation is generally prohibited from engaging in a business or financial transactions with one or more “disqualified persons,” regardless of whether the self-dealing transaction is fair—or even more than fair—to the foundation.
Private foundations that engage in self-dealing can find themselves subject to hefty excise taxes, and even more important, they could put their exempt status in jeopardy and endanger their reputation with the public and regulatory agencies. For all of these reasons, it’s important to understand what constitutes self-dealing, including what kinds of transactions are prohibited, whom they’re prohibited with, and what the ramifications can be.
In the experience of professionals at the law firm Davis Wright Tremaine, the answers to the following questions should help your private foundation identify potential self-dealing transactions and avoid running afoul of these rules.
Self-dealing is a prohibited business transaction between a private foundation and a disqualified person.
The federal tax law defines disqualified persons broadly so that it captures a large group of persons who may have undue influence over a private foundation. This includes a private foundation’s officers, directors, trustees, key employees, substantial contributors, persons that own 20 percent or more of a business entity that’s a substantial contributor, and their immediate family members. Family members, by the federal tax definition, include spouses; ancestors (including parents, grandparents, and great-grandparents); children, grandchildren, and great-grandchildren; and the spouses of children, grandchildren, and great-grandchildren; but they don’t include siblings.
A business entity can also be considered a disqualified person if it’s more than 35 percent owned by disqualified persons. For these purposes, the ownership of a corporation is determined by voting power, the ownership of a partnership is determined by profit interest, and the ownership of a trust or estate is determined by beneficial interest.
As a general rule, the following transactions between a private foundation and a disqualified person are considered acts of self-dealing:
Accordingly, nearly any transactions involving payment from a private foundation to a disqualified person will constitute self-dealing, unless an exception applies. In addition, nearly all payments from a private foundation to a government official—even those with no preexisting relationship to the foundation—are considered self-dealing.
As a general matter, a gift from a disqualified person won’t violate the self-dealing rules as long as the arrangement is entirely gratuitous. For example, a disqualified person may lease property or lend money to a private foundation if the lease is without charge or the loan is without interest and if the arrangement is used exclusively for exempt purposes. However, an arrangement in which the rent or interest rates are offered merely at below-market rates would be prohibited.
Exceptions to the self-dealing rules include:
Common self-dealing pitfalls that private foundations should avoid include:
The self-dealing rules are enforced through a two-tiered excise tax system. The first-tier tax equals 10 percent of the amount involved and is imposed on the self-dealing disqualified person. A second-tier tax may also be imposed on the disqualified person if the self-dealing transaction isn’t undone or corrected within a certain period of time.
A second two-tier excise tax system may be imposed on a foundation officer, director, or trustee who participates knowingly in an act of self-dealing. Participation that isn’t willful and was due to reasonable cause is excluded. The first-tier tax on these actions is equal to 5 percent of the amount involved, and the second-tier tax is equal to 50 percent of the amount involved. Similar to the previous penalty system, the second-tier tax applies if the transaction isn’t undone or corrected within a certain period of time.
To avoid inadvertently engaging in a self-dealing transaction, private foundations should:
To learn more about how your private foundation can track its disqualified persons, assemble and benchmark reasonable compensation, and strengthen its compliance program, contact your Moss Adams not-for-profit professional. For legal advice or assistance related to self-dealing, contact:
Marisa Meltebeke
(503) 778-5215
marisameltebeke@dwt.com