Section 4941: Self-Dealing Rules for Private Foundations

Private foundations operate under strict regulations to ensure their assets are used exclusively for charitable purposes. Section 4941 of the Internal Revenue Code establishes the rules against “self-dealing,” which refers to a wide range of financial transactions between a private foundation and certain insiders, known as “disqualified persons.” These rules are preventative, prohibiting both direct and indirect acts of self-dealing, and apply even if a transaction benefits the foundation. Violations can lead to significant financial penalties.

Identifying Disqualified Persons

The self-dealing rules are based on the definition of a “disqualified person.” This term encompasses a specific group of individuals and entities with a significant relationship to the private foundation. The primary group includes foundation managers, such as officers, directors, and trustees, or any individual with similar powers and responsibilities. These are the people directly steering the foundation’s operations.

Substantial contributors to the foundation are also disqualified persons. This includes any person or entity that has contributed more than $5,000 to the foundation, if that amount is more than 2% of the total contributions the foundation has received since its inception. The founder of a foundation established as a trust is automatically considered a substantial contributor.

The definition includes the family members of foundation managers and substantial contributors. This includes an individual’s spouse, ancestors, children, grandchildren, great-grandchildren, and the spouses of their children, grandchildren, and great-grandchildren. This broad inclusion prevents insiders from circumventing the rules by conducting transactions through close relatives.

A corporation, partnership, trust, or estate becomes a disqualified person if individuals who are already disqualified persons collectively own more than a 35% interest. This includes more than 35% of the total combined voting power in a corporation, the profits interest in a partnership, or the beneficial interest in a trust or estate. An owner of more than 20% of a business that is a substantial contributor is also considered a disqualified person.

Prohibited Acts of Self-Dealing

The Internal Revenue Code lists six categories of transactions between a private foundation and a disqualified person that are considered acts of self-dealing. These prohibitions cover both direct financial exchanges and more subtle arrangements where a disqualified person might benefit from the foundation’s assets.

The most direct prohibitions involve property and credit. A disqualified person cannot sell property to the foundation, nor can the foundation sell property to a disqualified person, including “bargain sales.” Any leasing arrangement of property between the two parties is forbidden, with a narrow exception for leases provided by a disqualified person to a foundation without charge. Lending money or any other extension of credit is also prohibited, though an exception exists for a disqualified person to make an interest-free loan to the foundation for its exempt purposes.

The rules also cover the furnishing of goods, services, or facilities, which cannot be exchanged between a foundation and a disqualified person. An exception allows a foundation to furnish these items to a disqualified person if they are made available to the general public on the same terms. Payment of compensation or reimbursement of expenses is also self-dealing, but an exception exists for compensation paid for personal services that are reasonable and necessary to carry out the foundation’s exempt purposes, as long as the compensation is not excessive.

The broadest category involves the transfer to, or use by or for the benefit of, a disqualified person of the foundation’s income or assets. This is a catch-all provision that can include a wide array of transactions where a disqualified person receives an economic benefit from the foundation’s resources. The final prohibited act is any agreement by a private foundation to pay money or other property to a government official.

The Two-Tier Tax Structure

When a self-dealing transaction occurs, the Internal Revenue Code imposes a two-tier excise tax system to penalize the violation and encourage its correction. These taxes are not levied on the private foundation but are imposed directly on the individuals involved in the prohibited act.

The first-tier tax is the initial penalty imposed automatically. The primary liability falls on the self-dealer—the disqualified person who benefited from the transaction—who must pay a tax equal to 10% of the “amount involved” in the transaction. This 10% tax is applied for each year or partial year within the taxable period, which begins on the date of the act and ends when it is corrected or a tax is assessed.

A first-tier tax may also be imposed on any foundation manager who knowingly participated in the act. A foundation manager, such as a director or officer, who approved the transaction knowing it was an act of self-dealing is subject to a tax of 5% of the amount involved. This tax on the manager is capped at a maximum of $20,000 per act.

A second-tier tax is imposed if the self-dealing act is not corrected within the “taxable period.” This period generally ends when the IRS mails a notice of deficiency for the first-tier tax or when the tax is assessed. If correction does not happen by then, the self-dealer faces a tax of 200% of the amount involved.

Foundation managers who refuse to agree to the correction of the self-dealing act are also subject to a second-tier tax. This tax is equal to 50% of the amount involved and is also capped at a maximum of $20,000 per act.

Correcting a Self-Dealing Transaction

The Internal Revenue Code provides a path to mitigate the second-tier taxes through the “correction” of the self-dealing act. Correction is a formal process of undoing the transaction to restore the private foundation to a financial position that is no worse than the one it would have been in if the disqualified person had acted under the highest fiduciary standards.

The specific actions required for correction depend on the nature of the transaction. For instance, if a disqualified person sold property to the foundation, correction involves rescinding the sale. The disqualified person must return the cash received from the foundation, and the foundation returns the property.

If the transaction involved the use of the foundation’s property by a disqualified person, correction requires terminating the use of the property. The disqualified person must also pay the foundation any amount that exceeds what they paid for the use, compensating the foundation for the fair market value of the benefit. In cases of excessive compensation, correction requires the disqualified person to repay the foundation the excess amount.

In addition to reversing the transaction, the disqualified person may need to pay the foundation any profits they earned from the self-dealing act. The foundation must be restored to a financial state at least as good as it would have been without the violation.

Reporting and Paying the Tax

Violations of the self-dealing rules must be reported to the IRS, and any resulting taxes must be paid using Form 4720, Return of Certain Excise Taxes. This form is the mechanism for both the self-dealer and any involved foundation managers to calculate and remit the first-tier excise taxes.

When a self-dealing act has occurred, Form 4720 must be completed with specific details about the transaction. The filer must provide a description of the prohibited act, the date it occurred, and the amount involved. The form also requires information about whether the act was corrected and the date of correction, which is used by the IRS to determine which tier of tax applies.

The private foundation itself must file Form 4720 by the due date of its annual information return, Form 990-PF. However, each self-dealer and participating foundation manager who owes a tax must file their own separate Form 4720. Their individual returns are due by the 15th day of the fifth month after the end of their personal tax year. Filers use Schedule A of Form 4720 to report acts of self-dealing, and payment is submitted with the completed form.