The end of the year means a drastic increase in philanthropic gifting.
If any of your clients are considering charitable gifts this month through a private foundation, here are 10 precautions to advise them about:
1. Use Caution when Compensating Family Members Through the Private Foundation
Certain transactions between a PF and a disqualified person are subject to self-dealing rules. The Internal Revenue Code imposes a 10 percent excise tax on the disqualified person for acts of self-dealing between a PF and the disqualified person. A disqualified person includes:
- Officers and members of the PF board
- Substantial contributors to the PF
- Managers of the PF
- Family members of any of the individuals described above
Be aware of the acts that are considered self-dealing between a PF and a disqualified person to avoid penalties, including:
- Sale or exchange of property, or leasing of property, even though the terms are favorable to the PF
- Lending money or other extensions of credit, except on an interest-free basis
- Providing goods, services or facilities
- Paying compensation or reimbursing expenses to a disqualified person
- Transferring PF income or assets to, or for the use or benefit of, a disqualified person
There are some exceptions to these self-dealing prohibitions: The PF can pay compensation to a disqualified person for personal services that are reasonable and necessary to carry out the PF’s purpose and if the total amount of the compensation is reasonable.
- Personal services include PF management and administrative support, real estate management services, investment management services and legal and accounting services, but doesn’t include secretarial services.
- Specific services that a disqualified person can provide include contract and lease negotiation, debt management and budgeting, accounting, supervision of property, operations and inspection, rent collection and supervision of personnel.
2. Don’t Fall into the Ticketing and Fundraising Event Trap
As a general rule, a disqualified person can’t use a ticket to a charitable event receiving support from the PF. This includes attendance by a guest, such as a spouse, of a trustee of the PF.
A trustee can only attend a charitable event if she has responsibility for evaluating and reviewing the activities of the PF.
3. Follow Guidelines for Sharing Office Space, Equipment and Personnel with a Family Office
Office space. The general rule for office space is that it’s an act of self-dealing for an FO to pay the PF for its portion of the lease (the opposite is also true—renting space to a PF). To solve this problem, the FO must enter into its own separate lease, and the landlord can’t be a disqualified person. The common areas should also be allocated to the FO—not to the PF—because the PF can’t pay for such space and then allow the FO to use it. If separate offices and leases aren’t a viable approach to self-dealing, the FO should sign the lease and allow the PF to utilize the space rent-free. Renting to a PF isn’t self-dealing if the lease is without charge. The lease is still considered to be without charge if the PF pays for its own utilities and other maintenance costs to third parties as they occur.
Equipment and supplies. The FO can purchase and provide the supplies at no cost to the PF, or the FO and the PF can enter into separate contracts with a third party to provide the necessary equipment and supplies. If the technology infrastructure can’t be divided between two entities, the FO must pay the expenses and allow the PF to use it free of charge.
Personnel. It may be difficult to separate the time of a shared employee in a shared space, so the safest and best response is always to have the FO pay for these services and not charge the PF. If the employee’s time can be allocated between the two entities, it’s possible for the FO to employ the individual, with the PF providing reimbursement; however, these services must constitute personal services, which aren’t considered secretarial assistance.
4. Avoid Legally Binding Pledges
A member of the board making a personal pledge for a charitable donation, but wishing to have it fulfilled through the PF, rather than through personal funds, causes an issue. This is an act of self-dealing. If an individual, officer, trustee or president of a PF makes a pledge that isn’t legally binding, the PF can assume the pledge. However, the PF can’t assume a legally binding obligation of one of its disqualified persons.
5. Identify any Benefits from Joint Investments and Co-Ownership
A disqualified individual may assume that she can enter into a business proposition with the assistance of her PF, but the Internal Revenue Service has indicated that joint investments could inappropriately benefit the disqualified person and would be considered self-dealing in many circumstances. Depending on the facts, co-ownership of other types of property by a PF and a disqualified person may or may not be considered an act of self-dealing if the PF’s co-ownership confers a significant benefit to the disqualified person as the other co-owner. For example, in Private Letter Ruling 9651037 (1996), the IRS ruled that co-ownership of property by a PF and disqualified person wasn’t self-dealing because the co-ownership was not a sale, exchange or leasing of property. Further, the PF and the co-owner didn’t acquire an interest in the property from the other party; and the PF received its share of rental payments directly from the unrelated third-party tenants.
6. Promptly Address Misuse of Foundation Income or Assets
When family dynamics come into play, there can be liability for a director, so it’s always important to enlist an outside advisor. When there’s misuse of PF’s income or assets, the board will need to reevaluate policies to prevent the transaction from happening again. An example of misuse is a disqualified person displaying a PF’s artwork in his home or office. When a member of the board of the PF has been using PF funds or assets inappropriately, the board should marshal the evidence and retain legal counsel and a forensic accountant. Investigating utilities, furniture purchases, artwork and credit card statements may be a sufficient form of evidence. Legal counsel can then work with the forensic accountant to prepare a full report including all of the self-dealing transactions. If the PF’s directors and officers policy covers excise tax and self-dealing, it should notify the insurance company for possible reimbursements for legal expenses under the policy.
7. A Key Benefit of Seeking Legal Counsel Advice
If any transactions might be considered an act of self-dealing, the PF should seek legal counsel. After full disclosure, if a person relies on written legal advice, indicating that the transaction doesn’t constitute self-dealing, the person won’t be liable for any penalty taxes, even if the transaction is subsequently considered to be self-dealing.
8. Beware the Penalties of Self-Dealing
The PF doesn’t pay self-dealing taxes; it’s the individual who participates in the act who pays the initial tax. The first-tier tax on self-dealing is 10 percent, assessed on the amount that’s involved and will be imposed on the disqualified person. A 5 percent tax is imposed on the PF manager who knowingly and willingly participates in the transaction of self-dealing. A second-tier tax of 200 percent of the amount involved can be imposed on the disqualified person if there’s a failure to correct the self-dealing in a timely manner. According to the IRS, self-dealing taxes can’t be abated for reasonable cause.
9. Exercise Expenditure Responsibility
An excise tax of 20 percent is imposed on a PF for distributions that are classified as a taxable expenditure, which is defined as any amount paid by a PF. If a PF is making a contribution and doesn’t want it treated as a taxable expenditure, it must ensure that it exercises expenditure responsibility. Such responsibility includes:
- Obtaining a written agreement from the grantee
- Ensuring that the grant is spent solely for its intended purpose
- Obtaining reports from the grantee on how the funds were expended
- Recovering the funds if they haven’t been used for the intended purpose
- Reporting such expenditures to the IRS on its Form 990 PF
10. Protect the Founder’s Mission
Many individuals establish their PF with a specific purpose for the use of PF assets through the use of a purpose clause. A charitable trust statement can also be included to provide a stringent interpretation of how funds that are being donated to the PF can be used. Governance structures are also beneficial options. One governance structure is to have outsiders act as individuals or majorities on the board. It can be specified that the PF will terminate in the event that the board tries to make a donation that’s not in line with the original intent. The founder can also sunset the PF to terminate within 10 years after her death so that decades later, the money isn’t at risk of being spent outside of the original intent. A gift document can also be included in the original creation of the PF stating that the gift may only be used for specific, delineated purposes.