The IRS recently updated its guidance and resources on how to correct self-dealing transactions under Section 4941, which imposes "a tax on each act of self-dealing between a disqualified person and a private foundation."

Generally, the IRS states that correction is accomplished by undoing, to the extent possible, the transaction that constituted the act of self-dealing, while ensuring that the transaction does not result in the private foundation's being in a worse financial position than it would have been in had the disqualified person (DP) operated under "the highest fiduciary standards."

Background

Section 4941 imposes an excise tax on a DP and each foundation manager who knowingly participates in an act of self-dealing between the private foundation and the DP. Self-dealing includes any direct or indirect:

1. Sale, exchange or leasing of property between a private foundation and a DP
2. Lending of money or other extension of credit between a private foundation and a DP
3. Furnishing of goods, services or facilities between a private foundation and a DP
4. Payment of compensation or reimbursement of expenses by a private foundation to a DP
5. Transfer to, or use for the benefit of, a DP of income or assets of a private foundation
6. Agreement by a private foundation to transfer money or other property to a government official. (Section 4941(d)(1))

Correcting a self-dealing transaction

The IRS emphasizes that as soon as a self-dealing transaction is identified, it must be corrected and Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the IRC, must be submitted to the IRS along with any excise tax due.

Correcting a self-dealing transaction generally means undoing the transaction (e.g., cancelling a sale) or recasting the transaction (e.g., instead of a transaction in which a DP sells property to the foundation, the proceeds of the sale would be returned to the foundation and the transfer would be considered a gift).

Correcting various types of self-dealing transactions

Sales by foundation (Reg. Section 53.4941(e)-1(c)(2)). If a private foundation sells property to a DP for cash, the sale should be rescinded where possible. Further, to ensure that the transaction does not result in the private foundation's being in a worse position than it would have been in absent rescission, the IRS states that the amount returned to the DP cannot be more than the lesser of:

1. The cash that the private foundation received or
2. The fair market value (FMV) of the property that the DP received.

In addition, the DP must remit to the foundation any net profits the DP realized after the original sale with respect to the property.

If the DP subsequently sells the property in an arm's-length transaction to a bona fide purchaser, the IRS does not require the sale to be rescinded. Instead, the DP must remit to the foundation any net profits realized on the property, plus the amount by which the greater of the FMV of the property on the date of correction or the amount the DP realized from the arm's-length resale of the property exceeds the amount that would have been returned to the DP had the arm's-length sale not occurred.

Sales to foundation (Reg. Section 53.4941(e)-1(c)(3)). If a DP sells property to a foundation for cash, the transaction must be rescinded where possible. But, if rescission would put the foundation in a worse position, the DP must remit the greatest of the:

1. Cash the DP received for the property
2. FMV of the property at the time of rescission or
3. FMV of the property at the time of the original sale

The DP must also remit any net profits with respect to the property realized after the original sale.

If the foundation subsequently sells the property in an arm's-length transaction to a bona fide purchaser, the sale need not be rescinded. Instead, the DP must remit to the foundation any net profits realized on the property, plus the excess of the amount that the DP would have paid if rescission were required over the amount the foundation realized on the resale of the property.

Use of property by DP (Reg. Section 53.4941(e)-1(c)(4)). If the act of self-dealing involves a DP using property owned by a private foundation, undoing the transaction means terminating that use of the property, and the DP's remitting to the foundation:

1. The excess of the FMV of the use of the property over the amount the DP actually paid to use it and
2. The excess of the amount that the DP would have paid to use the property on or after the date of termination over the FMV of the use of the property for the same period

Use of property by private foundation (Reg. Section 53.4941(e)-1(c)(5)). Similarly, when undoing a transaction in which a private foundation is using property owned by a DP, undoing the transaction entails terminating that use of the property. The DP must also pay the foundation:

1. The excess of the amount the DP was paid for use of the property over the FMV use of the property and
2. The excess of the FMV use of the property for the period the foundation would have used the property had the use not been terminated over the amount that the DP would have been paid for the use of the property over the same period

Payment of compensation to DP (Reg. Section 53.4941(e)-1(c)(6)). If a private foundation pays a DP to perform personal services that are reasonable and necessary to carry out the foundation's exempt purpose, undoing the transaction means that the DP must pay back to the foundation any amount that was excessive, but the employment or independent contractor relationship does not need to terminate.

IRS issue indicators and audit tips

The IRS lists three fact patterns of particular interest to the agency on audit:

1. A self-dealing transaction has occurred, but no Form 4720 has been filed
2. The foundation made a loan to a DP
3. A DP has been using the foundation's property

Evidence to determine whether any transactions have been entered into between DPs and a foundation "can be obtained from contracts, meeting minutes, interviews, personnel and payroll records," the IRS notes. Further, the IRS recommends that examiners:

• Review balance sheet listing of assets, including depreciation schedules
• Establish the location of all assets, even fully depreciated ones, and identify who is using them
• Determine how fully depreciated assets have been disposed of, including whether they were given to a DP
• Tour the foundation's facilities to assess how the assets are being used
• Review rental agreements, sales contracts, and any "side deals" to determine if any self-dealing transactions exist

Implications

This Issue Snapshot from the IRS provides welcome insight and guidance for private foundations that have engaged in transactions with any individual who could be considered a DP. Self-dealing transactions are common pitfalls for private foundations and correcting these acts upon discovery is required.

Self-dealing transactions continue to be an area of focus for the IRS, as emphasized by the publication of this Issue Snapshot. Private foundations can reduce the risk of being audited by avoiding the fact patterns listed above, taking steps to ensure that all DPs related to the foundation are identified, and analyzing any transactions with DPs before they occur to determine if they are self-dealing transactions.

Specific steps that private foundations can take, both to help prevent self-dealing from occurring and to facilitate the correction of any discovered self-dealing, include:

1. Maintaining a list of known DPs related to the private foundation
2. Establishing internal controls to either flag or prohibit transactions between the foundation and any DPs
3. Keeping detailed records of all transactions and agreements between the private foundation and persons who might meet the definition of a DP

This will enable the organization to systematically review historical transactions if a new DP is identified. It will also assist the organization in calculating the difference between the FMV of the property sold or used and the actual price paid. This is necessary to correct the self-dealing transaction pursuant to the Issue Snapshot and to determine the excise tax assessed on Form 4720.

Please contact your Ernst & Young LLP professional for further information.

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