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The Estate Exception to Self-Dealing Prohibitions Explained

A helpful and powerful tool for charitably inclined clients with complex assets.

The rules governing private foundations are extensive, but the thorniest restrictions are arguably those surrounding self-dealing. Treasury Regulations Section 53.4941(d)-1(b)(3) prohibit PFs from engaging in nearly all direct or indirect transactions with disqualified persons (as defined below).

Clients who wish to leave a portion of their estate to their PFs must carefully consider the self-dealing rules, particularly when a donor carries a great portion of their wealth in illiquid assets, such as family business interests or tangible personal property.

Wise advisors will encourage clients to plan for the disposition of these assets during life. Too often, this doesn’t occur, and PFs receive assets on the donor’s death that present challenges. Fortunately, the Internal Revenue Service has given us a rare gift—the estate administration exception under Internal Revenue Code Section 4941.

Meet the Freeman Family

You represent various members of an influential family known as the Freeman Family. The Freeman Family’s wealth is held primarily in a textile business that’s remained wholly in the family for over 50 years and a collection of preeminent contemporary art.

The senior generation established the Freeman Family Foundation to support economic advancement in underrepresented communities and to provide arts and other cultural education and programming to young people around the country. A member of the Freeman Family has expressed her desire to leave the majority of her assets to the Freeman Family Foundation. She requests your advice on how to proceed.

Self-Dealing Defined and its Consequences

Pursuant to IRC Section 4941(d)(1), self-dealing is any direct or indirect transaction between a PF and a DP.

The IRC provides six technical definitions of direct self-dealing, including: (1) any sale, exchange or leasing of property between a PF and a DP; (2) the furnishing of goods, services or facilities between a PF and a DP; and (3) transfer or use of the income or assets of a PF by a DP. In contrast, Treas. Regs. Section 53.4941(d)-1 explains indirect self-dealing only by way of example and by defining what doesn’t constitute indirect self-dealing.

Though a DP is commonly assumed to be the donor and the donor’s family, under IRC Section 4946, DPs also includes an owner of more than 20% of a business that’s a substantial contributor as well as a corporation, partnership, trust or estate in which DPs own or hold more than 35% of the stock, profits interest or beneficial interests, as applicable.

Clients that are deeply involved with their PFs might find compliance with the self-dealing rules difficult, but it is, nonetheless, critical. Violation of the rules against self-dealing results in a steep excise tax on the DP. This is a two-tiered tax. First, an initial 10% tax is applied to the amount involved in the self-dealing transaction for each year in the tax period. The tax period begins on the date the act occurs and ends on the earliest to occur of: (1) the date a notice of deficiency for the initial tax is mailed; (2) the date the initial tax is assessed; or (3) the date correction of the act of self-dealing is completed (Treas. Regs Section 53.4941(e)-1). A 5% tax may also be imposed on any foundation manager who knowingly participates in an act of self-dealing, unless such participation wasn’t willful or due to reasonable cause.

In addition, if the self-dealing transaction isn’t unwound during the tax period, a 200% tax may be applied to the DP for each full or partial year in the taxable period. An additional 50% excise tax may also be imposed on a foundation manager who refuses to cooperate with undoing the prohibited transaction.

Application of the Rules to the Freeman Family

Textile business. Interests in the Freeman Family textile business could open the door to self-dealing issues for the Freeman Family Foundation. If a member of the Freeman Family contributed their closely held family business interest to the Freeman Family Foundation, the donor’s family members, or, say, a trust for the benefit of those individuals, would own the remaining interests. This would make disposing of the asset complicated, as described below.

More than likely, the Freeman Family Foundation would want to sell this interest and invest in marketable securities, bonds or other assets more in line with its investment objectives. Unfortunately, a family business doesn’t typically welcome outside shareholders. Even if it would, the Freeman Family Foundation would struggle to find a buyer for a partial interest in a family business. The only natural buyer for this asset would be a family member and, therefore, a DP. However, the self-dealing rules would prohibit the PF from selling the interest to a family member who’s a DP.

Contemporary art collection. As a general rule, a member of the Freeman Family may leave their art collection (and any other tangible personal property) to the Freeman Family Foundation without triggering self-dealing rules. However, given the value of the client’s collection, advisors should review the provenance of the art to confirm that the client is indeed the sole owner of the works. If owned by more than one family member, there would then be practical concerns regarding where the artwork was stored and/or displayed. If the artwork continued to hang in the home of such family member, that family member would be using PF property for their own enjoyment — an obvious concern. As the PF couldn’t lease the artwork to the family, the co-owner would instead be forced to lease the artwork, free of charge, to the PF.

In both scenarios, the client should be advised to dispose of troublesome assets during life or at least plan for disposition to non-charitable recipients. But, as all advisors know, many clients put off action until it’s too late. So, when a member of the Freeman Family dies, how can the self-dealing penalties be avoided?

Estate Administration Exception to Self-Dealing

Fortunately, the IRC provides some exceptions to the self-dealing rules.  The most relevant exception, and the focus of this article, is the estate administration exception.

IRC Section 4941 states that indirect self-dealing doesn’t include a transaction involving a PF’s interest in estate property, regardless of when title to the property vests under local law, if the following requirements are satisfied:

  1. Power of sale– Executor has the power to sell the property, power to reallocate the property or is required to sell the property pursuant to an option;
  2. Court approval– The transaction must be approved by the probate court. This will likely also involve the state Attorney General and public disclosure of the transaction;
  3. Timeliness– The transaction must occur before the estate is considered terminated for federal income tax purposes. In the case of a revocable trust, the transaction must occur before the trust is subject to IRC Section 4947;
  4. Fair market value (FMV)–The estate or trust must receive at least the FMV for the PF’s interest in the property. As relevant case law demonstrates, the valuation rules must be strictly followed to avoid a potential bargain sale situation; and
  5. Nature of consideration–Consideration must be at least as liquid as the assets being given up. The transaction must result in the PF receiving an asset related to its charitable purpose, or it must be required under the terms of a pre-existing option (Treas. Regs. Section 53.4941(d)-1(b)(3)).For many clients, the implicit difficulties in adhering to these rules is enough motivation to plan ahead for disposition. However, this isn’t always practical, or even possible. The estate administration exception is a powerful tool when reallocation of assets doesn’t occur during a client’s life.

Exception Complexities

The most complex requirements of the estate administration exception rules are that the transaction be done at FMV and that the PF receive an interest or expectancy at least as liquid as the one it previously had. As relevant case law demonstrates, the IRS’ rules of valuation surrounding these sales must be strictly followed.

An often-overlooked component of the estate administration exception is the sale under the option agreement. For this unique exception to apply, the donor can provide heirs with an option agreement that would allow them to purchase the property at FMV. On the donor’s death, the property will transfer to the estate subject to the option, the executor (or trustee, as the case may be) is then obligated to sell the assets to the heirs if they exercise the option. Of course, FMV must be determined by a third-party appraisal, and court approval is necessary to avoid the self-dealing rules.

Importantly, the option must be considered when determining the FMV of the asset. The value of the asset under the option shouldn’t vary too greatly from the FMV. If it does, the estate risks being subject to a valuation mismatch — when the value for inclusion and deduction purposes disconnect. In that unfortunate instance, additional estate tax could be due.

Let’s apply this to the Freeman Family textile business. As a closely held family business, the shareholders (all disqualified persons) would enter into an agreement, for nominal consideration, giving the other shareholders an option to purchase interests in the textile company. If a family member exercises the option, an appraisal should be obtained, and court permission timely sought. Following the sale, the PF could then receive cash or cash-equivalents, rather than the family business, and avoid any self-dealing (or excess business holding) issues.

Ultimately, the estate administration exception to self-dealing prohibitions is a helpful and powerful tool for charitably inclined clients with complex assets. Advisors should continue to encourage clients to plan around these assets during life, but clients and advisors alike should take comfort in the backstop provided by Section 4941.

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