Navigating Self-Dealing in Private Foundations: Understanding Excise Taxes and Corrective Actions

by: Kyle Anderson
August 25, 2023

Within the regulatory framework of private foundations, the self-dealing rules play a crucial role in safeguarding against potential conflicts of interest and financial improprieties. These rules are designed to ensure that the resources of private foundations are directed exclusively towards charitable endeavors rather than for personal gain. In this article, we will delve into the mechanics of the self-dealing excise taxes and explore the corrective measures needed in order to rectify transgressions.

At the core of the self-dealing regulations lies the concept of excise taxes. These taxes are essentially financial penalties that are imposed on individuals or entities engaged in prohibited transactions. Notably, these penalties are aimed not at the foundation itself, but rather at those persons who participate in self-dealing transactions. The counterparty of the foundation in such transactions takes on the label of the "self-dealer,” and bears the brunt of the penalty burden. To illustrate, envision a situation where a foundation lends funds to the founder’s son for a luxury car purchase. In this case, the founder’s son would be the self-dealer, standing opposite the foundation in the loan transaction. Consequently, the founder’s son becomes liable for the corresponding excise tax as the self-dealer. Beyond the penalties imposed on the self-dealer, a distinct schedule of excise taxes can also extend to foundation managers who possess the authority to approve these transactions.

For the self-dealer, the excise tax is calculated as a percentage of the transaction amount, with assessment occurring for each year the transaction remains uncorrected. Initially, the self-dealer faces a 10% excise tax based on the transaction amount. However, the financial impact increases by 10% annually for every year the violation persists. To illustrate, consider a scenario where a case of self-dealing unfolds on March 1, 2021, and remains unaddressed until June 15, 2023. In this instance, a 10% tax applies for tax years 2021, 2022, and 2023— cumulatively amounting to a 30% penalty of the transaction amount.

Furthermore, following the IRS's discovery of self-dealing and the assessment of the penalties described above, a second-tier tax of 200% of the transaction amount may be imposed on the self-dealer if correction doesn't happen within a timeframe stipulated by the IRS. Typically, this window is 90 days after a deficiency notice is sent by the IRS, but this can be extended if additional time is reasonable and necessary to correct the self-dealing act. Second-tier taxes are uncommon and usually arise when a self-dealer is unwilling or unable to rectify the transaction. Notably, there's no cap on the liability of the self-dealer, making the potential cost of non-compliance with IRS demands substantial.

It's important to note that foundation managers who knowingly take part in self-dealing transactions encounter financial penalties outlined in a separate and less severe schedule of excise taxes. If a foundation manager knowingly participates in self-dealing, they face a 5% excise tax based on the transaction amount. This tax can be imposed each year until the correction is made. For instance, if this situation persists for three years before correction, the total penalty would amount to 15%. Furthermore, if the IRS identifies instances of self-dealing and imposes penalties on the manager, an additional second-tier tax of 50% of the transaction amount (capped at $20,000 per violation) can be applied. This occurs only when the manager doesn't agree to the correction within the timeframe specified by the IRS.

Beyond paying the excise tax, self-dealers are obligated to take corrective actions to mitigate the repercussions of their transactions. The fundamental principle guiding these actions is that the foundation's financial status should not be negatively affected beyond what it would have been if the highest fiduciary standards had been followed.

Examples of Corrective Measures:

  • In the event that a disqualified person borrows money from the foundation, the corrective measure entails repaying the principal to the foundation along with an additional interest amount calculated at an arm’s length market rate.
  • If a disqualified person sells property to the foundation, the corrective action might involve reversing the transaction by returning the property and money to each party.
  • In cases where a disqualified person uses property owned by the foundation, corrective measures would include ceasing the use and compensating the foundation for the value of the use.
  • When a disqualified person receives excessive compensation from the foundation, rectifying the violation entails reimbursing the excessive amount to the foundation.

The implementation of excise taxes serves as a deterrent against violations, safeguarding the charitable mission of all private foundations. Hopefully, such considerations won't be relevant to your foundation, given that these measures exclusively activate in cases of rule infractions. Yet, if the situation were to arise, grasping the mechanics of excise taxes becomes paramount, alongside an understanding of the corrective steps needed to correct the situation.

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