Over 15 years of advising nonprofit organizations, I have learned that, sometimes, “good deeds do go punished.” This can be especially true when a private foundation, or those in its management, engage in transactions intended and designed to advance an exempt purpose but in reality constitute an act of self-dealing as technically defined by the Internal Revenue Code.
Earlier this year (good ol' 2022), I published a blog about the IRS-issued Guidance on Self-Dealing Rules for Private Foundations. That blog provides the what-is and why-is for self-dealing matters. This Insights blog dives deeper into and hits on a number of tax and governance consequences and considerations for the private foundation that may have engaged in (and that the foundation's managers may have authorized) one or more self-dealing transactions in a particular tax year.
Self-Dealing Taxes. Each payment involved in a transaction that constitutes a self-dealing transaction may be treated as a separate act of self-dealing. Section 4941 of the Code imposes four separate and distinct taxes on each act of self-dealing.
1. First-Tier on the Self-Dealer. An initial (or first-tier) tax, payable by the self-dealing disqualified person. The tax imposed on the self-dealer is 10% of the amount involved in the act of self-dealing for each year or partial year in the taxable period. The term “taxable period” for any act of self-dealing, means the period beginning with the date on which the act of self-dealing occurs and ending on the earliest of these: (i) the date the IRS mails a notice of deficiency for the applicable tax imposed, (ii) the date on which the tax imposed is assessed, or (iii) the date on which correction of the act of self-dealing is completed. See 26 U.S.C. § 4941(e)(1); Reg § 53.4941(e)-1(a).
2. First-Tier on the Foundation's Managers. In addition, a first-tier tax is payable by foundation manager(s) who approved the transaction “knowing” it is an act of self-dealing. The initial tax on a foundation manager is 5% of the amount involved for each year or partial year in the taxable period, up to $20,000. “Knowing” – A person “knows” that an act constitutes self-dealing if that person: (i) has actual knowledge of sufficient facts so that, based solely upon such facts, the transaction would be an act of self-dealing, (ii) is aware that this act under these circumstances is self-dealing, and (iii) negligently fails to make reasonable attempts to determine whether the transaction is an act of self-dealing or is in fact aware that it is such an act. This determination is a fact-intensive one. If more than one person is liable with respect to any one act of self-dealing, all such persons are jointly and severally liable with respect to such act. For example, if two or more foundation managers knowingly participate as foundation managers in an act of self-dealing, there is only one tax on them (the lesser of 10% of the amount involved or $20,000), and they are jointly and severally liable for that amount. See Reg. § 53.4941(c)-1(b)(2).
3. Second-Tier on the Self-Dealer. An additional (or second tier) tax on failure to correct within the taxable period, payable by the disqualified person. If an act of self-dealing is not corrected within the taxable period, Section 4941(b) imposes additional taxes on self-dealers' failure to correct and on participating foundation managers' refusal to agree to correction. A tax of 200% of the amount involved is owed by the self-dealer. Second tier taxes are “imposed” at the end of the taxable period (for the first-tier tax), rather than after the correction period. See 26 U.S.C. § 4941(b). Internal Revenue Code, 26 U.S.C. § 4961(a) provides that any liability for the second-tier tax deficiency determined by the IRS will be abated if timely correction occurs (by the end of the correction period, as defined in Section 4963(e)).
4. Second-Tier on the Foundation's Managers. An additional (or second-tier) tax imposed on refusing to agree to part or all of a correction, payable by a foundation manager. A tax of 50% of the amount involved is paid by any foundation manager (or managers if jointly and severally liable) who refuse to agree to part or all of the correction of the self-dealing act, subject to a $20,000 limitation. However, the IRS must make a formal request for correction before a manager will be deemed to have refused to correct.
Correction Period. “Correction period”, as defined in 26 U.S.C. § 4963(e), means “the period beginning on the date on which such event occurs and ending 90 days after the date of mailing under section 6212 of a notice of deficiency with respect to the second tier tax imposed on such taxable event”, with certain extensions, as applicable. See IRS Guidance / Information on “Correction Period.” If a private foundation learns (or knows) that it engaged in an act of self-dealing, the private foundation should consider “correcting” the self-dealing matter by reimbursing the foundation in an amount to make it whole, plus interest. The amount of interest need not be precise but should, in this practitioner's opinion, be at least the Applicable Federal Rate. Such acts to correct, reimbursement, and “make-whole” should mitigate compounding tax issues in relation to the taxable period for First Tier tax purposes.
Tax Reporting and Payments— IRS Form 4720. The private foundation reports and computes the taxes owed on Part I of Form 4720. The foundation pays the applicable taxes calculated and shown on Part III. “Knowing-participant” managers and the disqualified persons involved in a self-dealing transaction report and compute the applicable taxes on Part II of Form 4720. Such persons pay the applicable tax on Part III, each filing a separate Form 4720. See pgs. 1-3 of the Instructions to Form 4720. A person filing Form 4720 should enter his or her tax year at the top of Form 4720. The IRS Form 4720 asks the organization to identify foundation managers subject to first-tier tax. To complete the Form 4720, the foundation may need to evaluate how the transaction came about and was approved and to strategically report the matter to the IRS to avoid misunderstanding or surmise on the part of the IRS. The amount involved in a self-dealing transaction, or the manner in which the transaction violates the self-dealing prohibitions, may be sufficient for the foundation to consider engagement of special counsel or an accountant consultant (i.e., rather than “tax preparer”) to prepare mock Forms 4720 so that the foundation may better evaluate how any firs- or second-tier taxes may ultimately shake out in the matter.
When to File. According to the IRS instructions to Form 4720, the private foundation filer must file Form 4720 by the due date (not including extensions) for filing the foundation's Form 990-PF. Each manager, self-dealer, or disqualified person must file Form 4720 by the 15th day of the 5th month after the end of his or her tax year. If the IRS finds that the filings are not timely, the IRS may assess a late filing penalty, and that will, generally, be the subject of an official notice from the IRS.
Termination of the Private Foundation. Say, What?? Section 507(a)(2) of the Code provides that private foundation status shall be terminated if the foundation commits either willful repeated acts (or failures to act), or a willful and flagrant act (or failure to act), giving rise to liability for tax under Chapter 42 (which includes excise tax under section 4941). Note: self-dealing-related tax liabilities arise under Chapter 42 of the Internal Revenue Code.
Assessable Penalties – Section 6684 of the Code imposes a penalty upon a person who becomes liable for a tax under Section 4941 for (1) any act not due to reasonable cause, (2) if the person has previously been liable for tax under Chapter 42, or (3) the act is willful and flagrant. The penalty equals the tax imposed under Section 4941.
Insights. For my private foundation friends out there–new, old, and to-be: self-dealing tax issues are no joke. In a perfect world, no private foundation will engage in a self-dealing transaction. But, when a private foundation or its management believes or concludes that the foundation engaged or may have engaged in an act of self-dealing, sincere evaluation and carefully-counseled business decisions are advisable. The methods for correction (if so decided) and, ultimately, reporting to the Internal Revenue Service can (and usually do) involve careful consideration, strategy, and description. Reporting mechanisms and process are especially important when an objective is to avoid a regulatory termination of the private foundation or a finding of “willfulness” by those in management who, in most circumstances, were simply doing what they thought was appropriate to advance the private foundation's qualified exempt purposes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.