This is the first post in an ongoing series on private foundation issues. Check back in upcoming weeks as we discuss other issues like jeopardizing investments, required distributions, and specialized grantmaking considerations.

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Self-dealing is an issue that private foundations must wrangle with on an ongoing basis. Essentially, under section 4941 of the Internal Revenue Code and related regulations, a private foundation’s disqualified persons—those who control and fund the foundation—are prohibited from direct and indirect financial transactions with the foundation unless a specific exception applies. Unlike the regime around intermediate sanctions, which applies to public charities, fair market value and reasonableness are not the guiding standard for self-dealing; the rules are often described as draconian and rightly so. This post will address some self-dealing basics, as well as highlight areas where private foundations can most easily get into trouble.

Who Is a Disqualified Person? A disqualified person includes a substantial contributor to the foundation; foundation managers (officers, directors, trustees, or person with similar powers);  any owner of more than 20 percent of the combined voting power of a corporation, profits interest of a partnership, or beneficial interest in a trust/association which is a substantial contributor; family members (spouses, ancestors, children, grandchildren, great-grandchildren, and spouses of children, grandchildren and great-grandchildren) of an individual described above;  controlled entities (e.g., a corporation of which disqualified persons own more than 35 percent of the combined voting power); and certain government officials.

What Are the Specific Self-Dealing Acts? The statute mentions six acts of prohibited self-dealing between a foundation and a disqualified person: the sale, exchange or leasing of property; the lending of money or other extension of credit; the furnishing of goods, services or facilities; payment or compensation or reimbursement of expenses; transfer to, or use by or for the benefit of, a disqualified person of any income or assets of the foundation; and an agreement to pay a government official.

What Are the Exceptions? There are several exceptions to the self-dealing rules to keep in mind, however. Here are a few key ones:

•  A disqualified person can make a loan to a private foundation with no interest or other charge, if the funds are used exclusively for the foundation’s exempt purposes;
• A disqualified person can enter into a no-rent lease with a foundation, or otherwise make its facilities available free of charge;
• A private foundation can furnish a disqualified person with the exempt function goods, facilities or services that it regularly provides to the general public, so long as the transaction is on the same terms as available to the public;
• Reasonable compensation, payment of expenses and reimbursement of expenses for personal services provided by disqualified persons paid by the foundation is permissible, if the amounts are reasonable and necessary to carry out the foundation’s exempt purposes; and
• Certain scholarship, travel and pension payments to government officials are allowed.

In addition, the fact that a disqualified person gets an incidental or tenuous benefit from use of a private foundation’s assets or income does not, by itself, give rise to self-dealing. This means that it can be permissible for a foundation to acknowledge a gift from a disqualified person in a variety of ways.

Where Do Private Foundations Often Get into Trouble? There are several areas where private foundations most often can go afoul of the self-dealing rules.

• Pledges. Allowing the foundation to satisfy a personal pledge of a disqualified person with foundation dollars is a self-dealing issue. A common problem that can arise is where a director has made a pledge to a charity and then the foundation makes a grant to that same charity. If the grant is considered by the charity to satisfy the pledge, that is a problem from a self-dealing perspective.
• Event tickets. The foundation purchase of event tickets, which then are used by a disqualified person, can be a problem because the tickets do have value. However, if a disqualified person attends an event of a grantee in order to monitor and evaluate the charity, that can be OK. Another potential way to handle is for the disqualified person to treat the ticket as taxable income, though it is likely not very attractive to the disqualified person.
• Family member expenses. A foundation paying the expenses of a disqualified person’s family members is also a common trap. Remember that the family members generally will be considered disqualified persons as well, and if they don’t have foundation duties to justify payment of expenses, there is a self-dealing problem. This comes up with director retreats or meetings that require travel; paying for the spouse’s plane tickets for such an event could mean trouble.
• Sharing resources. This situation comes up often with company foundations, where staff and other resources may be shared between the corporation (a disqualified person) and the foundation. It is fine for the company to donate resources to the foundation. However, the foundation can pay for its clear share of resources if it pays its portion directly to an outside vendor. It also could pay the company directly for personal services provided (i.e., legal, accounting or investment services). Meticulous record keeping is needed in order to document what the foundation’s share is and demonstrate it is not subsiding the company’s share.

How Does a Foundation Deal with Self-Dealing Risk and Occurrences? Most of all, it is important for  foundation boards and management to be familiar with the self-dealing rules and what they prohibit and allow. Maintaining an updated list of disqualified persons can be helpful. In addition, certain policies such as a conflict of interest policy, a travel policy and an event ticket policy should be considered; the conflict policy is particularly important and recommended for all foundations, and can be most helpful when combined with an annual disclosure form for directors and officers that helps to identify potential conflicts. Training for staff and board members is also key. If a self-dealing situation has occurred, it is important to work with advisers to address the situation as soon as possible.

For questions on self-dealing or other private foundation issues, contact us at kschauble@leafferlaw.com or bseidel@leafferlaw.com.