Private Foundations: Self – Dealing & Taxable Expenditures

July 8, 2016 | Article

By Deb Nelson, CPA and Anne Stoll, CPA

The webinar that can be viewed hereThis link takes you to an external website. introduces self-dealing and taxable expenditure transactions for private foundations, through discussion on the following topics:

  • History and background behind the creation of the rules
  • Importance of identifying disqualified persons
  • Common problem areas and exceptions to the rules

History and Background behind the Creation of the Rules
Private foundations are 501(c)(3) charitable organizations generally controlled and supported by a single source or founder. Perceived abuses have resulted from marketing private foundations as a way to manage a family’s wealth rather than perform charitable work. In the 1950’s congress began seeking ways to fix this perceived problem and laid the framework for prohibited transactions, which eventually resulted in the Tax Reform Act of 1969. This act comprised a detailed set of restrictions and prohibitions that make up todays excise taxes, enacted the Chapter 42 taxes and defined disqualified persons and private foundations.

The Importance of Identifying Disqualified Persons for Self-Dealing Transactions
A disqualified person is defined as substantial contributors, foundation managers, owner of more than 20% of stock of a business entity that is a substantial contributor, a family member of any of the preceding (excluding brothers and sisters), or a business entity of which more than 35% is owned by any of the preceding. In general, self-dealing may occur if the foundation engages either directly or indirectly in any of the following six actions with a disqualified person:

  • The sale, exchange or leasing of property
  • Lending of money or other extensions of credit
  • Furnishing of goods, services or facilities
  • Payment of compensation or payment or reimbursement of expenses to a disqualified person
  • Transferring foundation income or assets to or for the use by or to benefit of a disqualified person
  • Agreement to make payment of money or property to a governmental official

It is important to keep track of who is considered a disqualified person to prevent a self-dealing excise tax.

Common Problem Areas and Exceptions
There are notable exceptions to self-dealing transactions, including, but not limited to, leases by a disqualified person to a private foundation without charge, interest free loans by a disqualified person to the private foundation, compensation for reasonable and necessary professional services and a promise, pledge, or similar arrangement to a private foundation by a disqualified person for charitable intent.

Indirect self-dealing can occur with transactions between a disqualified person of a private foundation and an organization controlled by the private foundation. In other words, self-dealing can arise even if a private foundation is not part of a transaction with a disqualified person or if the party transacting with the disqualified person is deemed to be acting for the private foundation.

Private foundations as residuary beneficiaries of an estate or trust also have the potential to trigger indirect self-dealing issues if the foundation has an interest or expectancy in property held by an estate or a revocable trust. If your estate plan or revocable trust includes any plans for distributions to a private foundation, make sure care is taken when structuring the transaction and estate plan to avoid the potential for indirect self-dealing.

Taxable Expenditures
In order to avoid penalty taxes, private foundations should exercise caution when making grants to non-public charities. Devoting resources exclusively for charitable purposes and maintaining records to prove disbursements can assist in accomplishing this. Private foundations must receive pre-approval from the IRS prior to making grants to an individual for travel, study or other similar purposes. Internal Revenue Code Section 4945(g) requires these grants to be awarded on an objective and nondiscriminatory basis, made pursuant to a procedure approved in advance by the IRS and meets one of the following provisions: qualifies as a scholarship or fellowship excluded from gross income to be used for study at an educational institution, qualifies as a prize or award excluded from gross income if the recipient is selected from the general public, or achieved a specific objective, produces reports or similar products or improves/enhances literacy, artistic, musical, scientific, teaching, or similar capacity skills or talents. Additionally, when making grants to an individual the selection members must not be in a position to derive private benefit, either directly or indirectly.

Private foundations are permitted to make grants furthering their tax exempt purpose to any organization, exempt or nonexempt, as long as it properly documents the purpose and follows expenditure responsibility rules or equivalency determination, when applicable. Private foundations should validate the tax-status of all grantees prior to disbursing any funds. Typically, nonexempt grants are given to chambers of commerce, rotary clubs, social clubs, social welfare organizations, other private foundations, Type III non-functionally integrated supporting organizations, foreign charities and for-profit organizations. If giving a grant to a nonpublic charity, private foundations must determine whether equivalency determination guidelines or expenditure responsibility reporting will be followed.  Factors to consider include the length of the relationship with the grantee and the effort required to compile necessary data for making a good faith determination. Expenditure responsibility reporting requires disclosure of certain information in the private foundation’s annual tax filing until all funds have been disbursed for the intended purpose by the grantee.

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