An introduction to the issues encountered by a private foundation and its disqualified persons when they have entered into a self-dealing transaction, as that term is defined in IRC Section 4941, and they seek to correct such transaction. IRC and Treas. Regulation IRC Section 4941(e)(3) Other Definitions - Correction Treas. Reg. 53.4941(e)-1(a) Taxable Period Treas. Reg. 53.4941(e)-1(b) Amount Involved Treas. Reg. 53.4941(e)-1(c)(1) Correction -In General Treas. Reg. 53.4941(e)-1(c)(2) Correction – Sales by Foundation Treas. Reg. 53.4941(e)-1(c)(3) Sales to Foundation Treas. Reg. 53.4941(e)-1(c)(4) Use of Property by a Disqualified Person Treas. Reg. 53.4941(e)-1(c)(5) Use of Property by a Private Foundation Treas. Reg. 53.4941(e)-1(c)(6) Payment of Compensation to a Disqualified Person Resources (court cases, Chief Counsel Advice, Revenue Rulings, internal resources) Rev. Rul. 81-40, 1981-C.B. 508 Du Pont v. Commissioner 74 T.C. 498 (1980) Analysis Generally, IRC Section 4941 imposes an excise tax on certain transactions, acts of self-dealing, between a private foundation and disqualified persons. Once a self-dealing transaction has been identified, the transaction must be corrected, Form 4720, Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the IRC, must be filed and excise tax due paid. Correction Correction shall be accomplished by undoing the transaction which constituted the act of self-dealing to the extent possible, but in no case shall the resulting financial position of the private foundation be worse than if the disqualified person were dealing under the highest fiduciary standards. IRC Section 4941(e)(3); Treas. Reg. 53.4941(e)-1(c)(1). Example: If a disqualified person sells property to a foundation for cash, correction may be accomplished by recasting the transaction in the form of a gift by returning the cash to the foundation. Treas. Reg. 53.4941(e)-1(c)(1). In some instances, correction of the self-dealing transaction can result in another act of self-dealing. In Revenue Ruling 81-40, a disqualified person's attempt to correct an act of self-dealing by transferring real estate to a private foundation, the fair market value (FMV) of which equals the amount of a loan made by the foundation to the disqualified person, is a second act of self-dealing. Sales by Foundation Treas. Reg. 53.4941(e)-1(c)(2) In the case of a sale of property by a private foundation to a disqualified person for cash, undoing the transaction includes requiring rescission of the sale where possible. However, to avoid placing the foundation in a position worse than that in which it would be if rescission were not required, the amount returned to the disqualified person pursuant to the rescission shall not exceed the lesser of the cash received by the private foundation or the FMV of the property received by the disqualified person. FMV property rec’d is lesser of: FMV at time of act or FMV at time of rescission In addition to rescission, the disqualified person is required to pay over to the private foundation any net profits he realized after the original sale with respect to the property he received from the sale. If the disqualified person resells the property in an arm's-length transaction to an independent bona fide purchaser, no rescission is required. Here, the disqualified person must pay over to the foundation the excess of the greater of the FMV of such property on the date on which correction of the act of self-dealing occurs or the amount realized by the disqualified person from such arm's length resale over the amount which would have been returned to the disqualified person. In addition, the disqualified person is required to pay over to the foundation any net profits he realized. Example: On July 1, 1970, private foundation (PF) sold a painting to a disqualified person (DP) for $500 in a self-dealing transaction. The FMV of the painting on that date was $600. On March 25, 1971, the painting is still owned by DP and has a FMV of $720. DP did not derive any income because of purchasing the painting. To correct the act of self-dealing on March 25, 1971, the sale must be rescinded by the return of the painting to PF. However, pursuant to such rescission, PF must not pay DP more than $500, the original consideration received by PF. Sales to Foundation Treas. Reg. 53.4941(e)-1(c)(3) If a disqualified person sells property to a foundation for cash, undoing the transaction includes requiring rescission of the sale where possible. However, to avoid placing the foundation in a position worse than if rescission were not required, the amount received from the disqualified person pursuant to the rescission shall be the greatest of the cash paid to the disqualified person, the FMV of the property at the time of the original sale, or the FMV of the property at the time of rescission. In addition to rescission, the disqualified person is required to pay over to the foundation any net profits he realized after the original sale with respect to the consideration he received from the sale. If the foundation resells the property in an arm's-length transaction to an independent buyer, no rescission is required. In such case, the disqualified person must pay over to the foundation the excess of the amount which would have been received from the disqualified person if rescission had been required over the amount realized by the foundation upon resale of the property. In addition, the disqualified person is required to pay over to the foundation any net profits he realized. Example: DP sells 100 shares of stock to foundation for $2,500 in a self-dealing transaction. The FMV of the 100 shares of stock on that date is $3,200. A year later the 100 shares of stock have a FMV of $2,900. During that time, foundation has received dividends of $90 from the stock, and DP has received interest of $300 from the $2,500 which DP received as consideration for the stock. To correct: the stock must be returned to DP. DP must pay foundation $3,200, the FMV of the stock on the date of sale. DP also must pay foundation $210, the amount of income derived by DP during the correction period from the $2,500 received from foundation, which is $300, minus the $90 income derived by foundation during the correction period. Use of property by a disqualified person Treas. Reg. 53.4941(e)-1(c)(4) In the case of the use by a disqualified person of property owned by a private foundation, undoing the transaction includes terminating the use of such property. In addition to termination, the disqualified person must pay the foundation: The excess of the FMV of the use of the property over the amount paid by the disqualified person for such use until such termination, and The excess of the amount that would have been paid by the disqualified person for the use of the property on or after the date of such termination, for the period such disqualified person would have used the property if such termination had not occurred, over the FMV of such use for such period. The FMV of the use of property shall be the higher of the rate (that is, fair rental value per period in the case of use of property other than money or fair interest rate in the case of use of money) at the time of the act of self-dealing or such rate at the time of correction of such act of self-dealing. The FMV of the use of property shall be the rate at the time of correction. Example: On January 1, 1972, private foundation rented an office building to DP for one year at an annual rent of $10,000, in a self-dealing transaction. The fair rental value of the building for a one-year period at that time is $12,000. On June 30, 1972, the fair rental value of such office space for a one-year period is $13,000. To correct on June 30, 1972, DP must terminate his use of the property. In addition, DP must pay foundation $1,500, the excess of $6,500 (the fair rental value for six months as of June 30, 1972) over $5,000 (the amount paid to foundation from January 1, 1972, to June 30, 1972). Use of property by a private foundation Treas. Reg. 53.4941(e)-1(c)(5) In the case of the use by a private foundation of property owned by a disqualified person, undoing the transaction includes terminating the use of such property. In addition to termination, the disqualified person must pay the foundation: The excess of the amount paid to the disqualified person for such use until such termination over the FMV of the use of the property, and The excess of the FMV of the use of the property, for the period the foundation would have used the property (without regard to any further extensions or renewals of such period) if such termination had not occurred, over the amount that would have been paid to the disqualified person on or after the date of such termination for such use for such period. The FMV of the use of property shall be the lesser of the rate (that is, fair rental value per period in the case of use of property other than money or fair interest rate in the case of use of money) at the time of the act of self-dealing or such rate at the time of correction of such act of self-dealing. The FMV of the use of property shall be the rate at the time of correction. Example: On July 1, 1972, private foundation leases a building owned by DP for one year at an annual rent of $6,000. The fair rental value of the building for a one-year period on that date is $4,200. As of January 1, 1973, the fair rental value of the building for a one-year period is $5,400, and as of June 30, 1973, the fair rental value of the building for a one-year period is $4,800. To correct on June 30, 1973, DP must terminate foundation's use of the property. DP also must pay foundation $1,500, $900 (the excess of $3,000, the amount paid to DP from July 1, 1972, through December 31, 1972, over $2,100, the fair rental value for six months as of July 1, 1972) plus $600 (the excess of $3,000, the amount paid to DP from January 1, 1973, through June 30, 1973, over $2,400, the fair rental value for six months as of June 30, 1973). Payment of compensation to a disqualified person Treas. Reg. 53.4941(e)-1(c)(6) In the case of the payment of compensation by a private foundation to a disqualified person for the performance of personal services that are reasonable and necessary to carry out the exempt purpose of such foundation, undoing the transaction requires that the disqualified person pay to the foundation any amount that is excessive. However, termination of the employment or independent contractor relationship is not required. Issue indicators or audit tips Issue indicators Self-dealing transaction occurred but no Form 4720 filed. Evidence of loans from the foundation to disqualified persons. Use of foundation’s property by disqualified persons. Audit tips Examiners will need to investigate to identify the disqualified persons with respect to the private foundation and review if any transactions have been entered between the disqualified persons and the foundation that might warrant further review. Evidence can be obtained from contracts, meeting minutes, interviews, personnel and payroll records. Review balance sheet listing of assets, including depreciation schedules. Establish location of all assets, even fully depreciated ones, and identify who is using them. For instance: real property acreage owned by the PF the DPs might be using it for hunting or other personal uses. a fully depreciated vehicle may be driven by a DP. artwork owned by the PF may be listed in the books as in “storage” but really hanging in a DPs residence or business. How were fully depreciated assets (which still may have value) disposed of? Were they just given to a DP? Tour the assets. Be aware that just because a building is not generating rental income that someone, such as a DP, is not using it. Review rental agreements, sales contracts, agreements, side deals. Additional information and links to guidance on self-dealing excise tax.
