Why Private Foundations Need to Avoid Self-Dealing

As a leader of a private foundation, you likely know about the prohibition against self-dealing transactions between foundations and “disqualified persons.” However, understanding what constitutes self-dealing and identifying who is considered disqualified is crucial. Violating these rules can lead to severe financial repercussions.

Identifying Disqualified Persons

The IRS defines disqualified persons as substantial contributors (generally large donors), managers, owners of more than 20% of organizations that are substantial contributors, and their family members.

Additionally, corporations or partnerships in which any of the above parties hold more than 35% voting power, and trusts or estates in which they hold more than a 35% beneficial interest, are considered disqualified. Persons effectively controlling a foundation are disqualified, as are government officials.

Prohibited Activities

Disqualified persons are prohibited from engaging in acts of self-dealing with a foundation. According to the IRS, self-dealing includes:

• Selling, exchanging, or leasing property
• Lending money or extending credit
• Providing goods, services, or facilities

Foundations cannot pay compensation or expenses to a disqualified person or allow the use of the foundation’s income or assets for their benefit. Certain payments to government officials and transactions between organizations controlled by a foundation may also constitute taxable self-dealing.

Consequences of Rule Violations

Violating self-dealing rules can result in significant taxes. Under Internal Revenue Code Section 4941, a 10% excise tax is imposed on disqualified persons involved in self-dealing transactions. Foundation managers who knowingly participate face a 5% tax on the amount involved. Participation includes both affirmative acts and inaction where there is a duty to act.

If a violation is not corrected, the tax on disqualified persons (other than foundation managers) increases to 200%. An additional 50% excise tax is imposed on any foundation manager who refuses to correct the self-dealing act.

Exceptions to Self-Dealing Rules

There are some exceptions. For instance, compensation paid to disqualified persons isn’t considered self-dealing if it is for reasonable and necessary services to further the foundation’s exempt purposes. However, relying on exceptions is risky, and it’s best to avoid any appearance of self-dealing.

Understanding and avoiding self-dealing is essential for maintaining the integrity and financial health of your foundation. If you have questions or need guidance, we are here to help ensure your foundation remains compliant with all regulations.