The 7 Deadly Sins of Self-Dealing
March 24, 2017
Candice Meth, National Leader for EisnerAmper’s Not-for-Profit Services Practice, discusses what private foundations need to know about self-dealing: the types of transactions involved, consequences for violating the rules, what private foundations can do to protect themselves and more.
READ our blog on “The 7 Deadly Sins of Self-Dealing”
DP: Candice, these rules are under whose auspices?
CM: These rules fall under Internal Revenue Code (IRC) 4941 of the Internal Revenue Service, and that section actually lists a series of transactions between a foundation and what will be defined as disqualified persons that would typically give rise to an excise tax.
DP:What do we mean by self-dealing?
CM: You can think of this as a related-party transaction but with an added twist. These are transactions where a foundation will engage with persons who have influence over the decision- making process of the foundation. Examples would include founders, foundation managers, board members, large donors, politicians, and they would be considered disqualified from taking part in a transaction. The official definition of disqualified persons is actually covered in a different code, IRC 4946.
DP:What kinds of transactions are involved?
CM: Here are the seven deadly sins: 1) sales or exchanges of property between a private foundation and a disqualified person; 2) leasing a property between a disqualified person and the foundation; 3) lending money or extending credit between the foundation and the disqualified person; 4) providing goods, services or facilities—such as office space, vehicles or meals—between the disqualified person and the foundation; 5) payments and reimbursements by the foundation to the disqualified person. I want a caveat that reasonable and necessary payments to carry out the foundation’s mission are okay. So reimbursement of expenses would be considered okay; 6) use or transfer of foundation’s income or assets to benefit a disqualified person; and 7) payment to a government official. You’ll notice that some of these don’t mean that the foundation has actually suffered a detriment. But nevertheless these are still considered self-dealing.
DP:We’ve heard the term indirect self-dealing. What do we mean by that?
CM: This generally occurs as a transaction between a disqualified person and an organization controlled by the private foundation. There are some transactions between the disqualified person and organization that will not be treated as indirect and those would include things such as grants.
DP: What are the consequences of a party violating the self-dealing rules?
CM: The IRS imposes an excise tax of 10% on the disqualified party and 5% on the participating foundation manager. The tax applies for each year or partial year in the taxable period. Furthermore, additional taxes are imposed if the act is not self-corrected. So a tax of 200% of the amount involved is imposed on the self-dealer. A tax of 50% of the amount involved is imposed on the foundation manager. And something that’s really important to note is that when the disqualified person and the foundation manager are paying the taxes they really need to do so by personal check or by money order, not via foundation check, because that would trigger another act of self-dealing.
DP:Wow. Is there any way to correct an act of self-dealing?
CM: Absolutely. So the correction period starts the day the self-dealing act occurs and ends 90 days after a notice of deficiency for the additional tax is mailed. Filing for an extension is possible. You’re going to report the self-dealing on Form 4720, and if you need to file an extension before you’re ready to file the form you can do so on Form 8868. The parties must undo the transaction that is considered self-dealing. The remedy could not take place if the foundation is put in a worse financial position than it would have been had the act of self-dealing not occurred under the highest fiduciary standard—so the foundation doesn’t get put in a worse situation, but the action must be corrected.
DP:Are there exceptions to the rules?
CM: There certainly are and these are really important to note. The first is pro bono services. For example, a private foundation can lease property from a disqualified person for no rental payment at all. A disqualified person can lend money to a foundation if there is no interest charge and there is a charitable purpose for the loan. Additionally, there are some very specific exceptions, such as in the area of investment management services, whereby a disqualified person could provide investment management services for a reasonable fee to a foundation and that is not considered self-dealing.
DP: How common would you say it is that non-profits violate the self-dealing rule?
CM: I think it’s more common than people realize, again, because a lot of these transactions on the face don’t create any harm or detriment to the foundation. For example, it is possible that a disqualified person is providing rent to the foundation at what they believe to be below market rates. So in their mind they’re actually helping the foundation. However, in the IRS purview that is still an act of self-dealing. I think it is easy to trip over these rules, and that’s why it’s so important to keep them in mind and also to know how to correct them should you accidentally stumble upon it.
DP:Is there anything proactively that foundations can do to protect themselves?
CM: Sure. I think the best way to look into potential self-dealing transactions is to start by identifying related parties, and then once you’ve done that look at related party transactions and see whether or not they fall under our aforementioned list or perhaps whether they are with somebody who is considered by definition a disqualified person. Once you go through those transactions of related parties, you want to look at whether or not there is money being exchanged or whether they are pro bono, and then certainly you want to work with your tax professional and in some cases a lawyer who has expertise in these areas to help you identify threats and avoid certain issues and certainly take corrective action should it be needed.
DP:Tell us about yourself. You’re on the front lines day in and day out with these nonprofits. What’s your role as their financial and business advisor?
CM: We work with public charities and private foundations all year long, and we’re happy to answer our client’s questions should they be considering a transaction. We try to have a very close relationship with them and offer advice and suggestions to help protect them against these pitfalls. We also talk to them about things such as jeopardizing investments. We really encourage our clients to pick up the phone throughout the year so we can talk to them about these transactions and help them best achieve their missions without stumbling across our seven deadly sins.
DP:Well, Candice, thanks for your expertise and your insight.
CM: Thanks so much, Dave.
DP:And thank you for listening to EisnerAmper’s Not-For-Profit podcast series. Visit EisnerAmper.com for more information on this and a host of other topics, and join us for our next EisnerAmper podcast when we get down to business.