A donor who funds a private foundation (PF) must assess the likelihood and nature of any future dealings she has with the PF. Other than paying reasonable compensation for services rendered or providing goods and services to the PF without charge, no self-dealing between the donor and PF is permitted. Self-dealing between the donor (a disqualified person) and the PF is allowed so long as the PF either: (1) controls the disqualified person, or (2) has an interest in the property that’s part of the transaction.1 Direct acts of self-dealing should be apparent, as it would include lending of money or extension of credit between a disqualified person and a PF.2 The Internal Revenue Service deems the temporary placement by a PF of paintings in the home of a disqualified party (a substantial contributor) as an act of self-dealing, notwithstanding that the paintings were intermittently made available for public viewing.3 Other direct acts include the indemnification of a lender by a PF of a disqualified person’s loans.4 Avoiding a direct act of self-dealing shouldn’t be a high hurdle to clear.
A PF trustee always must be alert to self-dealing issues arising indirectly. Those who control a PF can’t transfer personal assets of disqualified parties into and out of a PF to the potential detriment of the charitable purpose.5
The penalty excise taxes governing PFs merit the advisor’s vigilance. The price for noncompliance is high: specifically, a 10 percent first tier excise tax of the amount involved, to be paid by the disqualified person.6 If the self-dealing act isn’t corrected, the IRS imposes a 200 percent second tier excise tax.7
Notwithstanding their complexity, the rules can be successfully navigated. One of the navigational tools is the limited liability company (LLC), which is used more conventionally as a discounting technique to minimize the cost of gift and/or estate taxes.
Creative Use of LLC
Private Letter Ruling 201723005 (released June 9, 2017) shows how an LLC can be used to comply with the self-dealing prohibition against lending between a disqualified person and a PF.
The co-founder of a PF sought assurance that a testamentary transfer from her revocable trust of a nonvoting interest in an LLC to her PF wouldn’t be either a direct or indirect act of self-dealing under Internal Revenue Code Section 4941. The sole asset of the LLC was a promissory note from a disqualified person; namely, the irrevocable trust.
The founder created an IRC Section 501(c)(3) PF, for which she served as a director with her two sons. The PF had a fourth independent and outside director. The founder’s planning involved four transactions:
1. Sale of membership interests in LLC#1. The founder sold membership interests in LLC#1 to an irrevocable trust in exchange for a promissory note (the Note). Her descendants were the beneficiaries of the irrevocable trust. The founder anticipated that any principal and interest unpaid at her death would be used to benefit the PF.
2. Creation of second LLC (LLC#2). The founder created LLC#2, which received the original Note issued by the irrevocable trust. The founder received voting and nonvoting interests in LLC#2.
3. Transfer of interests. The founder transferred her voting and nonvoting interests in LLC#2 to a revocable trust, for which she served as trustee. As grantor, the founder held a power of revocation to direct the trustee to distribute assets of the trust during her lifetime. The beneficiaries of the revocable trust were her descendants, presumably including her sons.
The manager of LLC#2 was one of the founder’s sons who also served as a director of the PF. Holders of voting interests in LLC#2 had the power to remove the manager. The members with nonvoting interests lacked management rights or a right to vote for manager. However, all members, voting and nonvoting, had the power to dissolve LLC#2 if all members approved.
4. Distribution to PF. The revocable trust would distribute to the PF all of the nonvoting interests in LLC#2 that had a 99 percent profit-sharing interest. The revocable trust would maintain its voting interests in LLC#2 with a 1 percent profit-sharing interest.
Analysis and Conclusion
The founder was a disqualified person as she was a “substantial contributor.”8 Other disqualified persons include the revocable and irrevocable trust, whose beneficiaries were the children of the founder.9 Other individuals and entities categorized as disqualified persons include:
• An owner of more than 20 percent of: (1) the total combined voting power of a corporation, (2) the profits interest of a partnership, or (3) a beneficial interest of a trust or unincorporated enterprise that’s a substantial contributor to a PF.10
• A member of the family of any of the aforementioned individuals.11
• A corporation, partnership, trust or estate of which any of the aforementioned individuals own more than 35 percent of the combined voting power, profits interest or beneficial interest.12
The transfer of the promissory note by the founder to the PF would have been a direct act of self-dealing. So, the founder sought to satisfy the prohibition against indirect self-dealing. If the PF controlled LLC#2, there would have been a prohibited transaction. The IRS concluded that because the PF lacked management rights or voting rights on the selection of the manager of LLC#2, it lacked control. Its nonvoting rights merely entitled the PF to a right of distribution if distributions are made or at dissolution. The PF lacked the ability to compel distributions.
The IRS concluded the founder’s proposed transfer from her revocable trust at death of the nonvoting interests in LLC#2 wasn’t a direct or indirect loan or extension of credit between the PF and a disqualified person within the meaning of IRC Section 4941. Interestingly, the IRS wasn’t concerned that the sole asset of LLC#2 was a promissory note.
PLR 201723005 continues the taxpayer-friendly guidance of PLR 201510050 (released March 6, 2015), which held a PF isn’t deemed to control a partnership when lacking more than a 50 percent interest.13 Armed with a working knowledge of the meaning of “control,” the advisor should successfully navigate the landmine of the self-dealing rules to achieve planning goals of the client.
1. See Treasury Regulations Section 53.4941(d)-1(b)(5).
2. See Internal Revenue Code Section 4941(d)(1)(A), (B) and (C).
3. Revenue Ruling 74-600.
4. Treas. Regs. Section 53.4941(d)-2(f)(1).
5. Rev. Rul. 76-158.
6. IRC Section 4941(a).
7. Section 4941(b)(1).
8. IRC Section 4946(a)(1)(A).
9. Section 4946(a)(1)(E), (F) and (G).
10. Section 4946(a)(1)(C).
11. Section 4946(a)(1)(d).
12. Supra, note 9.
13. In Private Letter Ruling 201510050 (released March 6, 2015), the underlying asset of the partnership was 6,000 acres of land subject to litigation and to be sold at a public auction. In PLR 201723005 (released June 9, 2017), we don’t know the value of the note.