Self-Dealing in Nonprofits and Private Foundations
Charitable organizations face heightened scrutiny around usage of organizational funds. Both private foundations and 501(c)(3) tax-exempt entities are subject to many regulations detailing such usage. One major prohibition is self-dealing, which means that organizational funds may not directly or indirectly benefit a disqualified person. Self-dealing can result in both the disqualified person and charitable organization facing sanctions from the IRS including penalties and excise taxes.
Who is a disqualified person?
Defining self-dealing transactions requires first defining a disqualified person. The Internal Revenue Code defines disqualified person to encompass substantial contributors to a private foundation; foundation managers; an owner with more than 20% interest and voting power; a foundation’s family members; a corporation with more than 35% of the voting power; a partnership, trust, or estate with more than 35% of the profits; and a government official.
A disqualified person of a 501(c)(3) organization includes those with substantial influence over the organization, including members of the board of directors and employees who manage the organization. The Code additionally includes a disqualified person’s ancestors, spouse, descendants, and the spouses of those descendants as disqualified persons.
To prevent self-dealing, organizations must understand the definition of disqualified person and create a list of disqualified persons connected to their organization.
What is self-dealing?
Self-dealing is any direct or indirect act between a charitable organization and a disqualified person. Common examples include sale or lease of property, lending money, payment of compensation or reimbursable expenses, and furnishing of goods or services. The Code expressly prohibits transactions between charitable organizations and a disqualified person where the economic value of what the organization receives is outweighed by the economic value to the disqualified person.
When a board member provides a service to the organization, the cost of the service cannot exceed the fair market value that would be charged to an ordinary individual not affiliated with the charitable organization. Any excess service costs would then constitute self-dealing and trigger sanctions and excise taxes against both the organization and board member. From a best practice perspective, organizations should avoid such transactions entirely to avoid risk and possible tax penalties.
Examples of self-dealing
Additional examples of self-dealing transactions include:
A foundation manager who controls grant money for a research university and also owns a side business. If the side business applies and receives grant money, it will constitute a self-dealing transaction because of the foundation manager’s position within both entities.
A private foundation makes a charitable donation to an orchestra and a substantial contributor of the foundation receives orchestra concert tickets in return for the gift; thus, the value of the tickets must be reported as income to the substantial contributor. If not, this transaction constitutes self-dealing.
A board member of a 501(c)(3) organization sells an office building and land to the organization above the fair market value for both assets. This exchange would constitute an excess benefit transaction to the board member, a disqualified person, and hence self-dealing.
Examples of self-dealing are numerous. It is therefore in the best interest of a charitable organization to annually identify all contributors to a foundation, examine all transactions between each contributor (individual, corporate, partnerships, and other potential disqualified persons) and the foundation, and review the activities of each person having authority to control organizational activities (including both board members and organizational employees).
Congress and the IRS continue to target charitable organizations for audits due to the broad risk for abuse, particularly self-dealing. Boards thus must actively work to identify and train members on the specifics of self-dealing and create robust practices to avoid such transactions and protect the organization.
Correction of self-dealing
Upon identification, acts of self-dealing should be promptly corrected. Methods of correction focus on undoing the original act of self-dealing through placing the charitable organization back in its original financial position. Failure to correct the act of self-dealing in a timely manner can subject the organization, board members, and disqualified person to excise taxes and penalties. Initial excise taxes start at 20% of the value of the excess benefit and can increase to 100% or 200% of the value if the act is not corrected within the given taxable period.
Effective foundation and board oversight are critical to avoid these steep penalties. Board members and foundation managers must adopt routine practices to thoroughly review each transaction to identify any potential abuses that may constitute self-dealing. Robust organizational policies and annual training are crucial first steps for charitable organizations to mitigate the risk of self-dealing.
Nonprofit Solutions can assist your organization in policy or training implementation and self-dealing correction. Contact our team for further information at (405) 844-2286.