This is Leaffer Law Group’s third in a series of posts addressing nonprofit issues that have been in the headlines due to the 2016 Presidential Election. As with our previous posts, and all posts in this series, our goal is to use the recent headlines as a teaching tool to inform our clients and the larger nonprofit sector on these important, much publicized topics. In past posts, we’ve addressed the importance of charitable solicitations registration, which was in the headlines recently when the Attorney General of New York prohibited the Donald J. Trump Foundation from making charitable solicitations in the state of New York, and the potentially devastating impact that a scandal—or even just the appearance of impropriety—can have on a charity, which has been in the headlines recently with respect to the Clinton Foundation. This post will focus on the allegations of self-dealing with respect to some of the Donald J. Trump Foundation’s expenditures, as reported by David Fahrenthold in the Washington Post last month.
Pulled From the Headlines Part III – The Prohibition on Self-Dealing for Private Foundations
As a starting point, private foundations and public charities are both considered tax-exempt charitable organizations under Section 501(c)(3) of the Internal Revenue Code. They have certain tax benefits in common, namely a federal tax-exemption for their income and the ability to receive tax-deductible charitable donations. With these benefits come IRS regulation and oversight.
Regulation of Private Foundations. Decades ago, Congress decided to impose greater regulatory burdens on private foundations than public charities, given the more limited public involvement in their activities. At the time, public involvement was believed to serve, to some extent, as a surrogate for government oversight (e.g., through the power of the purse). Most public charities fall into two categories: 1) charities that are public in nature (i.e., churches, hospitals and schools); and 2) charities that rely on significant public support (either earned income or donations from the general public). By contrast, private foundations typically have a smaller base of support and are controlled by a narrower group of people. Congress believed the lack of public involvement made private foundations more susceptible to abuse by insiders, justifying greater regulation and oversight.
To put things in perspective, the Donald J. Trump Foundation is a private foundation. Initially, it was funded primarily, if not solely, by the Trump family. In more recent years, it has accepted some donations from other sources as well, but has remained under the Trump family’s control. The Clinton Foundation, on the other hand, is a public charity and has always relied extensively on public support. Thus the Donald J. Trump Foundation is subject to the additional regulatory burdens imposed on private foundations, whereas the Clinton Foundation is not.
As mentioned, the additional regulations imposed on private foundations were designed to ensure proper operation and prevent potential abuses. The regulations often prohibit private foundations from doing something that a public charity can do. The regulations are enforced through penalty taxes imposed on the private foundation, those who improperly benefit from foundation transactions, and those who manage the foundation. The penalty taxes escalate for any failure to unwind or “correct” the violation. Repeated, willful or flagrant violations can also lead to the revocation of the private foundation’s tax-exempt status, which triggers an additional private foundation termination tax.
Self-Dealing Prohibition. One of the special rules that apply to private foundations is the prohibition on “self-dealing” transactions between a private foundation and its insiders and related persons, also known as “disqualified persons.” The self-dealing rules, found in Section 4941 of the Internal Revenue Code and related Treasury regulations and IRS rulings, are quite detailed and complex, and are often counter-intuitive. They prohibit the private foundation from engaging in any transaction with, or using foundation income or assets to benefit, disqualified persons, even when the transaction is beneficial to the foundation. There are limited exceptions to the prohibition, and those exceptions are strictly interpreted and narrowly applied.
Take, for example, a director, officer or substantial contributor of a private foundation (each a disqualified person) who owns a building and leases that building worth $100 per square foot to the private foundation for the bargain price of $10 per square foot. Although this transaction clearly benefits the private foundation to the tune of $90 per square foot, this is a prohibited self-dealing transaction. An exception to self-dealing rules would, however, allow the disqualified person to make the space available to the private foundation rent-free.
The self-dealing prohibition can also apply to transactions that a private foundation enters into for the benefit of a disqualified person. Thus, even if a disqualified person is not a direct participant in the transaction, if the transaction is undertaken by the foundation for the benefit of a disqualified person, the transaction is prohibited, unless one of the self-dealing exceptions applies.
This prohibition on self-dealing is a significant departure from the rules governing public charities. The public charity rules allow a charity to enter into transactions with disqualified persons, so long as the transaction is at fair market value.
Donald J. Trump Foundation. Circling back to the Donald J. Trump Foundation, Donald Trump is a disqualified person with respect to the Foundation by virtue of his management control over the organization and the fact that he was once a substantial contributor to the Foundation. His family and any businesses in which he or his family owns a 35% interest are also disqualified persons. Thus any transaction between the Foundation and these persons, or any use of Foundation assets for their benefit, is prohibited under the self-dealing rules, unless one of the self-dealing exceptions applies.
According to news reports, the Foundation has been involved in several potential self-dealing transactions over the years. These reports indicate Foundation funds were used to pay for a painting of Donald Trump and a football helmet signed by Tim Tebow acquired by Mr. Trump and his wife at charity auctions. This is problematic from a self-dealing perspective because Foundation funds cannot be used to satisfy a pre-existing obligation of a disqualified person. If the Trumps bid on items at an auction and were obligated to pay for them, and Foundation funds were used to satisfy the obligation, the rules are clear—it is self-dealing. Apparently, in one case, the items purchased were also displayed in Trump’s for-profit businesses. This could be considered an additional act of self-dealing, even if the Trump business paid for the use of the items or purchased them from the Foundation.
Other news reports revealed that the Foundation made payments to settle lawsuits against Trump businesses. One case related to a dispute between the Mar-a-Lago Club and the town of Palm Beach over a flag pole that violated township ordinances. The Club settled the lawsuit by agreeing to make a $100,000 donation to a veteran’s charity in lieu of paying assessed fines to Palm Beach. The amount was paid by the Foundation. Presumably, the Trumps own at least 35% of the Club, making the Club a disqualified person as well. If so, this also looks to be self-dealing—either Foundation funds were used to satisfy a pre-existing obligation of the Club, or Foundation funds were used for the benefit of the Club to help it settle a lawsuit.
What’s not clear is whether anyone at the Foundation or other Trump entities knew these transactions could be violations of the self-dealing prohibition. In fact, the in-house accountant to the Trump entities stated he had standing orders to pay any and all expenditures to tax-exempt organizations from Foundation’s funds, regardless of the expenditure’s purpose. This is an indefensible and dangerous practice for any private foundation!
If the IRS audits the Foundation and finds these transactions, or others like these, to be self-dealing, there will be serious consequences for everyone involved. The persons who improperly benefited will be required to make the Foundation whole, i.e., by restoring the funds to the Foundation with interest. They will also have to pay substantial penalties to the IRS. The Foundation may be subject to substantial penalties for violating other tax rules, such as the prohibition on use of Foundation funds for non-charitable purposes. The Foundation managers who participated in the transactions may also be subject to personal penalties, which can’t be indemnified by the Foundation. Last, it’s possible under circumstances as egregious as these, the IRS could find the violations to be repeated, willful and flagrant, justifying revocation of exemption and confiscation of Foundation assets.
Lessons Learned. This headline is shaping up to be a cautionary tale to private foundations who might try to operate without adequate knowledge of, or respect for, the special tax rules that govern them. The self-dealing rules are expansive, complex and often counter-intuitive, so it is extremely important for private foundations, large or small, with or without dedicated staff, to maintain a clear understanding of what constitutes self-dealing. They should maintain a list of all disqualified persons relative to the organization, and any transaction with these persons, or use of foundation income or assets that benefit them, should be carefully evaluated under the self-dealing rules. They should also be mindful of situations that come up for them, that might represent traps for the unwary. For example, use of foundation assets to pay a charitable pledge made by disqualified person is generally considered self-dealing, as is the purchase or sale of supplies or equipment. Use of foundation funds to pay membership dues, to make donations that result in tangible benefits to a disqualified person (e.g., premium tickets at a sporting event), or to purchase a table a charity event, can also be problem areas. We’ve blogged about these things in the past.
The consequences for a misstep in this area are severe, both in terms of the financial penalties that can be assessed against everyone involved, and the reputational harm that can result once self-dealing is reported on the foundation’s Form 990-PF or is picked up by the media. Foundations should train employees on compliance, as well as institute adequate procedural safeguards, to prevent violations at best, or quickly identify them at worst, so that they can be corrected with minimal harm. We’ve only scratched the surface of self-dealing here. Since compliance should never be taken lightly, we also wanted to offer additional resources for those wishing to dig deeper into the topic.
For more information on the private foundation prohibition on self-dealing, see:
Leaffer Law Group’s blog “Private Foundations and Self-Dealing: Avoiding the Danger Zone”
The Internal Revenue Service summary of Taxes on Self-Dealing: Private Foundations
Exponent Philanthropy Self-Dealing FAQs
Council on Foundations link about Self-Dealing
For more on the purchases of items at charity auctions, see:
The Washington Post article “Trump boasts about his philanthropy. But his giving falls short of his words.”
The Washington Post article “Donald Trump used money donated for charity to buy himself a Tim Tebow-signed football helmet.”
For more information on the Donald J. Trump Foundation’s accounting practices, see:
The Washington Post article “Trump pays IRS a penalty for his foundation violating rules with gift to aid Florida attorney general.”