Typically when you think of a nonprofit you generally think of a public charity. However, private foundations (and private operating foundations) are also 501(c)(3) organizations under the IRS’ classification system. Understanding the difference between the different tax-exempt organization is key because, while public charities and private foundations have much in common, there are also major differences. The most important of these differences to understand is that private foundations are subject to much stricter regulations and oversight than public charities.
Because this can get complicated in this post let’s just cover private foundations and the rules related to “self-dealing.”
Look to the Code
Section 4941 of the Internal Revenue Code (IRC) and related regulations prohibit any direct or even indirect financial transaction between a private foundation and virtually every person closely associated with it, who are known as “disqualified persons.”
The IRS code is quite specific as to who “disqualified persons” are—and they can be individuals, as well as legal entities, trusts, and even other foundations; it’s a very wide net.
Disqualified persons include:
- Any substantial financial contributors to the foundation
- Officers, directors, trustees, or persons who can act on behalf of the organization
- All family members, including spouses, children, grandchildren, and spouses of children of individuals described above
- Controlled entities (e.g., a corporation of which disqualified persons own more than 35% of the combined voting power)
- Certain government officials
Simply put, if a person has influence over the decisions of the private foundation or a particular relationship with it, it’s extremely likely that they are a “disqualified person.”
Specifically Prohibited Self-Dealing Acts
Self-dealing occurs when a disqualified person acts in his or her own financial interest, rather than in the best interest of the private foundation he or she serves.
The IRS code lists these six (6) specific acts of prohibited self-dealing:
- The sale, exchange, or leasing of property
- The lending of money or other extensions of credit
- The furnishing of goods, services, or facilities
- Payment, 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
- An agreement to pay a government official
As you can see, rules against self-dealing are quite expansive when it comes to financial transactions.
Exceptions to Self-Dealing Rules
Like most areas of the law, there are exceptions to the self-dealing rules for private foundations. But great care must be taken because they are relatively narrow and require both skill and care to use.
Exceptions to self-dealing rules include:
- A disqualified person can make a loan to a private foundation with no interest or charge if the funds are used exclusively for purposes related to the foundation’s charitable goals;
- A disqualified person can enter into a no-rent lease with a foundation or otherwise make its facilities available free of charge;
- Compensation and reimbursement of expenses for services provided by disqualified persons are permissible if the amount is both reasonable and necessary to carry out the foundation’s charitable goals;
- Certain scholarship, travel, and pension payments to government officials are allowed.
Common Problem areas
There are several self-dealing hazards for private foundations. The most common include:
- Allowing the foundation to satisfy a personal pledge of a disqualified person with foundation dollars is considered self-dealing.
- The foundation’s purchase of event tickets for a disqualified person unless the disqualified person attends a grantee’s event in order to evaluate the charity’s activities.
Family member expenses
- Family members of disqualified persons are considered disqualified persons, so allowing a foundation to pay their expenses is considered self-dealing if they don’t have foundation duties to justify payment of their expenses.
- If a company devotes office space, staff, or other resources to a private foundation it establishes, the private foundation must keep meticulous records to avoid self-dealing.
Protect Your Private Foundation with a Team of Advisors
If you’re thinking about forming a private foundation, I highly recommend you see the advice of an attorney well-versed in the nuances of nonprofit law. The info in the blog is, at best, a mere outline of the complex and stringent laws governing private foundations. That said, forming and growing a private foundation can be immensely rewarding to the communities and causes you want to serve. To best execute, it’s wise to build up a team of knowledgable professional advisors that can safely guide the way through the legal hoops.