Private foundations are subject to special rules relating to conflicts of interest. These are called “self-dealing” rules. These rules flatly prohibit transactions between interested persons (known as “disqualified persons”) and the foundation. These transactions are prohibited even if they benefit the foundation. A foundation’s disqualified persons generally include its substantial contributors, directors, officers, family members of these individuals, and certain business entities controlled by these individuals. In the case of a company foundation, the business associated with the private foundation is almost always a disqualified person. There are some important exceptions to the self-dealing rules, such as compensating disqualified persons reasonably for work completed.
Under the self-dealing rules, a private foundation is prohibited from providing goods, services, or facilities to a disqualified person, or allowing foundation assets to be used by or for the benefit of a disqualified person. In most cases, this is logical—the private foundation cannot pay for a disqualified person’s entertainment, for example.
Grants made by private foundations to Section 501(c)(3) organizations usually do not raise an issue of self-dealing. However, when a disqualified person has legally pledged to make a charitable contribution to a Section 501(c)(3) organization, and the private foundation later makes a grant to satisfy this personal pledge, the IRS takes the position that the private foundation’s grant may constitute self-dealing.
Although the grant by the private foundation is made to a charity (and not to the disqualified person), the IRS focuses on the disqualified person’s legal obligation to make the contribution. Before the private foundation’s grant, the disqualified person had the legal obligation to make a gift. But, after the private foundation makes the contribution, the disqualified person no longer has the legal obligation, a result which the IRS considers as having provided a financial benefit to the disqualified person, triggering the self-dealing rules.
If a self-dealing transaction occurs, the disqualified person will be subject to a 10% tax on the benefit, and in most cases, will have to pay back the amount of the benefit. Foundation managers (i.e. directors or officers) may also be subject to an excise tax if they acted willfully.
Importantly, this is only an issue if the pledge is actually binding under state law. Many statements signed by donors are not legally binding – they are simply “statements of intent” or something similar that does not create a binding legal obligation. If this is the case, then the individual or company did not have a legal obligation (at most they had a moral obligation) to make the contribution, and there is no issue if the private foundation makes the contribution.
This issue can be avoided. When directors, officers, or other potential disqualified persons enter into pledges that may be satisfied by a grant from a private foundation, the private foundation itself should enter into the pledge. If the pledge is being made on behalf of the foundation, the individual should be sure to sign in their capacity as trustee or officer of the foundation (simply putting “trustee of XYZ Foundation” or “officer of XYZ Foundation” below the signature line should be sufficient). Although it may be a problem if a private foundation satisfies an obligation of a private individual, it is allowable for a person to make a contribution to satisfy the obligation of a private foundation. Or, the donor may ask the charity to rescind the pledge agreement entirely so that the disqualified person does not have a legal obligation. This must be done carefully so as to not create an argument that the rescission is linked to any later grant made by a private foundation.