Tales of Self-Dealing: Concrete Scenarios Faced by Private Foundations

by: Kyle Anderson
June 5, 2023
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Navigating the self-dealing rules that govern private foundations can be a complex and challenging task, even for experienced and well-intentioned foundation leaders. These rules impose strict restrictions on a specific group of individuals known as "disqualified persons," preventing their involvement in transactions with the foundation, unless a specific exception exists as outlined in the Internal Revenue Code or Treasury Regulations. Disqualified persons encompass individuals or entities closely affiliated with the foundation, such as board members, officers, substantial contributors, and their family members or controlled entities. It is crucial for disqualified persons to prioritize adherence to the self-dealing rules when engaging in transactions with the foundation, even if the transaction appears to clearly benefit the foundation.

By exercising caution and ensuring strict compliance, foundations can effectively steer clear of punitive financial penalties and maintain their reputation as responsible and trustworthy entities. To shed light on the intricacies of self-dealing issues, here are some illustrative scenarios:

1.  Compensation to the Family Business: The family patriarch puts forth the idea of running the family foundation from the offices of the family business. This arrangement would foster closer collaboration between the foundation staff and the foundation directors who work at the offices of the family business on a daily basis. The family business offers the foundation an exceptional deal on office space and related services, such as janitorial support, at a price significantly lower than market rates. Despite the favorable terms, this arrangement raises self-dealing concerns due to the family business being considered a disqualified person, as it is controlled by the family patriarch. Under the self-dealing rules, foundations are prohibited from engaging in financial transactions with disqualified persons, even at below-market rates. One possible alternative is for the family business to provide the office space to the foundation at no cost, while the foundation directly covers its share of cleaning expenses by separately contracting with the janitorial company.

2.  Loan to a Foundation Board Member: One of the foundation's board members is currently facing a significant financial challenge due to a medical emergency involving their child. To address this situation, the board member plans to sell an investment property, which could take between three to six months. In light of these circumstances, the board member has approached the foundation, requesting a six-month loan. The board member is offering a high interest rate, ensuring an excellent return for the foundation. Moreover, the board member is willing to use the investment property, valued higher than the loan amount, as collateral to minimize the foundation's risk of financial loss. However, despite the seemingly valid reasons and the potential benefits as an investment opportunity for the foundation, this loan transaction would be considered self-dealing. Private foundations are explicitly prohibited from providing loans to disqualified individuals. To ensure compliance and avoid potential legal penalties, it is essential for the board member to explore alternative financial solutions and refrain from borrowing from the foundation.

3.  Board Member Travel Expenses: A foundation organizes a board meeting in Texas, where three out of four board members reside. The foundation covers all travel expenses for the fourth board member who lives out of state, as well as for his spouse. This arrangement raises self-dealing concerns as foundations cannot make their income or assets available for the benefit or use of a disqualified person or their family members. It is perfectly acceptable for the foundation to pay for the fourth board member’s travel expenses. However, it is unacceptable for the foundation to pay travel expenses for the board member’s spouse. To avoid self-dealing, it is essential to ensure that the foundation only pays for the necessary travel expense for the board member, while all other travel expenses for the spouse are directly paid using personal funds.

4.  Director's Personal Investment Advisor: A foundation director persuades the foundation to transfer its assets to the director’s personal investment advisor. As a result, if the foundation proceeds with the asset transfer, the investment advisor would lower the director's investment management fees by 50% due to the increased total assets under management. This scenario triggers self-dealing concerns as foundations are prohibited from utilizing their income or assets for the benefit of disqualified persons. To prevent self-dealing, it is crucial to clearly communicate to the investment advisor that the foundation's assets are separate and must be managed independently from the director's personal assets. The director cannot personally benefit by bringing the foundation’s business to the investment advisor.

5.  Grants and Personal Relationships: A foundation would like to provide a grant to a local nonprofit theatre for the production of a play. However, a potential self-dealing issue arises as the director of the play, who holds a paid position, is the daughter of the foundation's president. According to the self-dealing rules, foundations are prohibited from using their income or assets to benefit disqualified persons or their family members, unless the services provided qualify as reasonable and necessary personal services. Unfortunately, directing a play is unlikely to meet the criteria for the exception. To address the self-dealing concern, the foundation has two options: either refrain from granting funds to the theatre altogether, or proceed with the grant but with a clear stipulation in the agreement that the funds must not be utilized for the play project. If the foundation proceeds with the grant it is advisable to allocate the grant towards a specific cause, such as upgrading the theatre lighting, ensuring that there is no ambiguity regarding foundation funds supporting the foundation president's family.

In navigating the complex landscape of the self-dealing rules that govern private foundations, it is vital for foundation leaders to prioritize compliance and transparency. The examples provided shed light on the intricacies of self-dealing and offer insights into mitigating potential issues. Whether it's exploring alternative financial solutions, ensuring fair allocation of travel expenses, or avoiding conflicts of interest in grant-making, foundations can proactively address self-dealing concerns. By doing so, they can uphold the integrity of their operations and foster a sense of trust among stakeholders. Ultimately, by understanding and navigating the nuances of self-dealing, foundations can continue making a positive impact while maintaining compliance with the law.

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