First, private foundations are subject to tax on their net investment income. In addition, if private foundations do not comply with strict rules, the organizations may be subject to excise taxes on acts of self- dealing, failure to distribute income, excess business holdings, jeopardy investments, taxable expenditures, and lobbying expenditures, to name a few.

One question often asked relates to tax implications of transactions between private foundations and other parties. The correct response to queries requires a study of the acts involved (not all transactions with related parties are prohibited); the parties to the transactions (some parties may be qualified even though they are related); and the propriety of charging fees, commissions, or price for services rendered or goods sold (excessive fees for personal services might pose a problem).

The reason for the caution required in structuring dealings by a foundation is traced back to the Tax Reform Act of 1969. Objectives of the Act were to eliminate certain practices and produce desired results through the imposition of special taxes on organizations classified as private foundations and on certain disqualified persons if they do not adhere to certain statutorily prescribed standards. Congress was concerned that disqualified persons were benefiting at the expense of their foundations and, therefore, at the expense of charity.

Indirect Self-Dealing

As defined in the regulations, the term "indirect self-dealing" does not include any transaction described in IRC Sec. 53.4941(d)-2 between a disqualified person and an organization controlled by a private foundation if -

1. the transaction results from a business relationship that was established before such transaction constituted an act of self-dealing;

2. the transaction was at least as favorable to the organization controlled by the foundation as an arm's-length transaction with an unrelated person; and

3. either (a) the organization controlled by the foundation could have engaged in the transaction with someone other than a disqualified person only at a severe economic hardship to such organization; or (b) because of the unique nature of the product or services provided by the organization controlled by the foundation, the disqualified person could not have engaged in the transaction with anyone else, or could have done so only by incurring severe economic hardship.

A transaction between a private foundation and an organization that is not controlled by the foundation as explained below, and which is not described in other sections mentioning certain persons who own no more than 35% of the total combined voting power or profits or beneficial interest of such organization, shall not be treated as an indirect act of self-dealing between the foundation and such disqualified persons solely because of the ownership interest of such persons in such organization.

An organization is controlled by a private foundation if the foundation or one or more of its foundation managers (acting only in such capacity) may, only by aggregating their votes or positions of authority, require the organization to engage in a transaction that if engaged in with the private foundation would constitute self-dealing. Similarly, an organization is controlled by a private foundation in the case of such a transaction between the organization and a disqualified person, if such disqualified person, together with one or more persons who are disqualified persons by reason of such person's relationship to such disqualified person, may, only by aggregating their votes or positions of authority with that of the foundation, require the organization to engage in such a transaction. The "controlled" organization need not be a private foundation; for example, it may be any type of exempt or nonexempt organization including a school, hospital, operating foundation, or social welfare organization. An organization will be considered to be controlled by a private foundation or by a private foundation and disqualified persons if such persons are able, in fact, to control the organization (even if their aggregate voting power is less than 50% of the total voting power of the organization's governing body) or if one or more of such persons has the right to exercise veto power over the actions of such organization relevant to any potential acts of self-dealing. A private foundation shall not be regarded as having control over an organization merely because it exercises expenditure responsibility as defined in IRC Sec. 4945(d) and (h) with respect to contributions to such organization.

Example 1: Private foundation P owns the controlling interest of the voting stock of corporation X and, as a result of such interest, elects a majority of the board of directors of X. Two of the foundation managers, A and B, who are also directors of corporation X, form corporation Y for the purpose of building and managing a country club. A and B receive a total of 40% of Y's stock, making Y a disqualified person with respect to P under IRC Sec. 4946(a)(1)(E). In order to finance the construction and operation of the country club, Y requested and received a loan in the amount of $4 million from X. The making of the loan by X to Y constitutes an indirect act of self-dealing between P and Y.

Example 2: Private foundation W owns the controlling interest of the voting stock of corporation X, a manufacturer of certain electronic computers. Corporation Y, a disqualified person with respect to W, owns the patent for, and manufactures, one of the essential component parts used in the computers. X has been making regular purchases of the patented component from Y since 1965, subject to the same terms as all other purchasers of such component parts. X could not buy similar components from another source. Consequently, X would suffer severe economic hardship if it could not continue to purchase these components from Y, since it would then be forced to develop a computer that could be constructed with other components. Under these circumstances, the continued purchase by X from Y of these components would not be an indirect act of self-dealing between W and Y.

Case Study

PLR 9325061 (affirmed by PLR 9404032) presented the following facts: Members of one family are considering making gifts to a tax-exempt private foundation of interests in certain partnerships and corporations (owned entities). The owned entities currently, and will continue to, engage in transactions with affiliated entities. Based on the following analysis, the IRS has concluded that providing services between the entities whose ownership interest was given to the tax-exempt organization and the other affiliated entities mostly engaged in real estate and insurance business are indirect acts of self-dealing.

The Acts. The affiliated entities were engaged in providing the following services:

1. Management of real properties controlled indirectly by the private foundation;

2. Brokerage services for sale and leasing of real properties indirectly owned by the private foundation through owned entities;

3. Construction work or mill work in connection with interior renovation and performance of leasehold improvements;

4. Marketing and advertising services with respect to real property in order to facilitate sales and leasing; and

5. Insurance brokerage services to the owned entities in connection with purchase of property and liability insurance.

All of the above transactions constitute the furnishing of goods, services, or facilities and could potentially be classified as acts of self-dealing if further tests are met.

The Parties to the Acts. Transactions involving private foundations, directly or indirectly, could not be acts of self-dealing if, at least, some of the parties to the dealings were not "disqualified persons." IRC Sec. 4946(a)(1) includes many categories of persons that are considered disqualified. The private foundation, in our analysis, did not participate in most of the transactions. The members of the family who made a donation to the private foundation were ruled as disqualified pursuant to IRC Sec. 4946(d), either because they were related to the substantial contributors to the foundation, or because they were family members of the foundation managers. If they had more than 20% control of any entity that was a substantial contributor, the members of the family could also be considered as disqualified persons. (The specific reason for classifying the family members as disqualified is not mentioned in the ruling.)

The second group of players in the acts were the owned entities, whose interest was donated to the foundation. In fact, these entities were controlled corporations and partnerships. Apparently, certain owners or certain foundation managers owned more than 35% interest, and thus the entities became controlled for purposes of the self-dealing code sections.

The third group consisted of seven disqualified entities, that provided to the second group services in the real estate industry that could not fall into the exceptions to acts of self-dealing.

Although the presence of a disqualified person is required to the presence of an act of self-dealing, it should not be concluded that every transaction with a disqualified person is an act of self-dealing.

Exceptions to Self-Dealing

The following discussion demonstrates a few exceptions:

Compensation for Services. None of the transactions between the owned entities and disqualified entities was free of charge. Management fees were based on revenues from managed properties. Brokerage fees were based on sales price paid for the properties. Construction costs were paid to the disqualified contractors, marketing and advertising fees were paid on an hourly-fee basis for services rendered, and the insurance broker was paid commissions and renewal commissions.

The fact that all services were compensated was one step forward (but not the crucial one) in concluding that the transactions were acts of self-dealing. Free-of-charge transactions could exclude them from the defInition of a self-dealing act. However, the compensation was not excessive and was within a range considered reasonable and customary in the industry in the geographical area (initially a factor in favor of the foundation).

Transactions with Controlled Organizations. In the case study, the owned entities were not only affiliated with the private foundation but also controlled by it. Reg. Sec. 53.4941(d)-1(b)(i) provides that indirect self-dealing does not include a transaction between a disqualified person and an organization controlled by the private foundation.

The taxpayer, therefore, has to show that the foundation, its managers, or disqualified persons were able to require the organization to act or refrain from acting in a manner that would not constitute an act of self-dealing.

In our case study, the next step was to show that the controlled organization could have engaged in the transaction with someone other than a disqualified person only at a severe economic hardship. The IRS ruled that hiring unrelated parties to render real estate services would not cause severe economic hardships to the owned entities.

Payments for Personal Services. Payments to disqualified persons for personal services will not be an act of self-dealing if the amounts are reasonable and for services that are necessary to carry out the exempt purpose of the private foundation.

The IRS ruled that the services performed by the disqualified entities for the owned entities were not performed exclusively for IRC Sec. 501 (c)(3) purposes. All the services mentioned above were in the commercial real estate business context. Some services (e.g., construction) were payments for properties, not for personal services. The exception that requires necessity to carry out the tax-exempt purpose does not apply to payments for properties.

The IRS conclusion is that the case study is one of indirect self- dealing.

The Tax Consequences May Be Severe

Caution must be exercised in structuring transactions in which the foundation is involved even indirectly. The taxes on acts of self- dealing may be severe and are imposed on disqualified persons who participate in self-dealing and on foundation managers in certain instances. The initial tax is at a rate of 5% of the amount involved and is imposed on the disqualified person who participates. Additional taxes may be imposed on the foundation manager who knew that the act was an act of self-dealing. Much more severe second-tier taxes may be imposed if no corrections are made.

The facts and conclusions described in this article refer to a private- letter ruling. The possibilities of interpretation are broad, and the ruling's conclusions are not binding.