Prevent Private Foundation Self-Dealing

Feb 19, 2014

Related Practice: Nonprofit

This is the final post in a three-part series about certain responsibilities involved with serving on the board of a charitable organization. You can read part one, "Joining a Charity Board Can Fulfill Your Heart's Desire--or Crush It" here, and part two, "Fulfilling Your Heart's Desire: Basic Steps to Successful Service on a Charity Board" here.

The closely controlled nature of many private foundations can easily open the door to potential self-dealing. The rules against self-dealing are plain and clear—any transaction between the foundation and “disqualified persons” (those persons who are substantial contributors or foundation managers and their family members in addition to certain affiliates and government officials) is prohibited, with few exceptions. This somewhat rigid definition of self-dealing applies even if the transaction doesn’t provide a significant financial or economic benefit to the disqualified person. Many private foundations fall into traps such as the foregoing example because of the seemingly reasonableness of the transaction from the foundation’s perspective.

Examples of self-dealing that may not be easily identified include the loan of facilities or goods to a disqualified person, a loan or lease (with interest or other charges required) from a disqualified person to a private foundation, or excessive compensation paid to a disqualified person. Acts like these often occur under the mistaken belief that transactions with an insider are acceptable if the foundation comes out even or ahead in the deal. But the laws against self-dealing expressly penalize transactions between private foundations and disqualified persons—even between the private foundation and an unrelated third party—when the transaction provides a direct or indirect financial or economic benefit to a foundation insider.

The penalty for improper self-dealing can be onerous excise taxes on disqualified persons involved, including foundation managers who approved the transaction. The potential taxes related to self-dealing can be mitigated, providing for a tax of 5 to 10 percent of the amount involved, if the self-dealing is corrected quickly. Otherwise, the taxes imposed could equal 50 to 200 percent of the amount involved.

Certain exceptions to the self-dealing rules may apply to provide relief from the strict self-dealing laws, including reasonable compensation for necessary personal services, reimbursement or payment of reasonable and necessary expenses in furtherance of the private foundation’s purpose, the furnishing by the private foundation of goods, services or facilities on the same terms as those provided to the general public and incidental and tenuous benefits.

Tips to Prevent Self-Dealing

1. Entity Choice. Prevention of self-dealing violations begins by analyzing whether the status of the private foundation will fit the purpose and activities of the entity. The decision to form a nonprofit entity and apply for private foundation status under Section 501(c)(3) of the Internal Revenue Code should include a thorough discussion about the intended purposes and activities of the organization in addition to the appropriate entity choice and tax status. If the purpose or activities are not aligned with the required exclusive tax-exempt purpose for a private foundation, then self-dealing or other violations of private foundation rules are imminent.

2. Training. The self-dealing rules may appear simple, but they often arise in subtle situations that may not seem fair to the private foundation or the disqualified persons involved. Directors, officers, other managers and staff should be regularly trained on the rules of self-dealing and operational and governance steps to preclude self-dealing. 

3. Governance. A private foundation should have a conflict of interest policy, compensation policy, pledge policy, expense reimbursement policy, travel policy, fundraising event policy and other governance and operational policies that protect against self-dealing transactions.

4. Checks and Balances. To help identify and preclude self-dealing transactions:

  • Private foundation directors, officers and other managers should be required to regularly disclose any potential self-dealing transactions through a questionnaire with follow-up inquiry on any potential self-dealing.
  • A list of disqualified persons should be maintained to help identify potential self-dealing.
  • An independent accountant familiar with private foundations should be considered for an annual audit.
  • The private foundation should evaluate the composition of the board of directors, trustees, officers, other managers, and legal and accounting counselors to ensure the private foundation has resources for identifying and dealing with conflicts of interests and potential self-dealing.
  • An annual discussion of the conflict of interest policy and other policies should be held and directors, trustees, officers and other managers should be required to certify reading and understanding the conflict of interest policy and related policies.

Self-dealing has long been a troublesome matter for private foundations, and it continues to be so today. But those troubles can be avoided through proper formation, training, governance and checks and balances.