IRC Section 4941(d)(2)(E) – Taxes on Self-Dealing, Special Rules

Section 4941(d)(1) generally provides that self-dealing means any direct or indirect (A) sale or exchange, or leasing, of property between a private foundation and a disqualified person; (B) lending of money or other extension of credit between a private foundation and a disqualified person;(C) furnishing of goods, services, or facilities between a private foundation and a disqualified person; (D) payment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person; (E) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and (F) agreement by a private foundation to make any payment of money or other property to a government official.

Section 4941(d)(2)(E) provides an exception regarding payment of compensation. The payment of compensation and the payment or reimbursement of expenses by a private foundation to a disqualified person for personal services which are reasonable and necessary to carrying out the exempt purpose of the private foundation shall not be considered an act of self-dealing if the compensation is not excessive. Treas. Reg. Section 53.4941(d)-3(c)(1). This exception to self-dealing is referred to as the personal service exception. The exception does not apply in circumstances where the disqualified person has such status because they are a government official.

IRC Section and Treas. Regulation

  • Section 4941 Taxes on Self-Dealing
  • Section 4941(d)(1)(D) Self-Dealing, Payment of Compensation
  • Section 4941(d)(2)(E) Special Rules, Payment for Personal Services
  • Section 53.4941(d)-3 Exceptions to self-dealing
  • Section 53.4941(d)-3(c)(1) Payment of compensation for certain personal services, in general

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

Madden v. Commissioner, T.C. Memo 1997-395. The Tax Court ruled that maintenance, janitorial, and security services provided by a disqualified person to a private foundation are not "personal services" for purposes of the exception to self-dealing.

Kermit Fischer Foundation v. Commissioner, TC Memo 1990-300. A private foundation's sole trustee received compensation from the foundation irregularly, and the amounts appeared to be related more to his need for funds than to his duties and responsibilities. Additionally, the court found added weight in the fact that the foundation paid cash compensation to the trustee of over 47 times the amount donated to charity. The court held that the disqualified person, the trustee of the foundation, was liable for tax under Section 4941(a) for receipt of excessive compensation.

Rev. Rul. 73-613,1973-2 C.B. 385. The payment of legal fees on behalf of a director-manager of a private foundation relating to the filing of a lawsuit arising out of his duties as a director did not constitute an act of self-dealing by virtue of the exception provided by Section 4941(d)(2)(E).

IRM 7.27.15.4.1.4 Payment of Compensation
IRM 7.27.15.4.2.2 Reasonable Compensation

Exceptions - Self Dealing by Private Foundations: Paying compensation or reimbursing expenses by a private foundation to a disqualified person

Analysis

Section 4941 imposes an excise tax on acts of self-dealing between a private foundation and a disqualified person. Furnishing of services between a private foundation and a disqualified person are acts of self-dealing under Section4941(d)(1)(C). And payment of compensation (or payments for reimbursements of expenses) by a private foundation to a disqualified person are acts of self-dealing under Section 4941(d)(1)(D). However, Section 4941(d)(2)(E) and 53.4941(d)-3(c) provide an exception to application of  these rules. Payment of compensation to a disqualified person by a private foundation for the performance of personal services which are reasonable and necessary to carry out the exempt purpose of the foundation will not constitute self-dealing if the compensation is not excessive.

Treas. Reg. Section 53.4941(d)-3(c)(1) provides that “personal services” includes the services of a broker serving as an agent for the private foundation, but not the services of a dealer who buys from the private foundation as principal and resells to third parties. Treas. Reg. Section 53.4941(d)-3(c)(2) provides four examples regarding personal services. The examples show that the providing of legal services, investment counseling services, and commercial banking services are personal services that are reasonable and necessary to carry out the exempt purpose of a private foundation, but that manufacturing goods is not. A summary of each of the four examples follows:

  • M, a partnership, is a law firm. A and B are partners of M and serve as trustees to a private foundation and therefore are disqualified persons. Also, A and B own more than 35 percent of the profits interest in M, thereby making M a disqualified person. M performs various legal services for foundation. The payment of compensation by the foundation to M shall not constitute an act of self-dealing if the services performed are reasonable and necessary for carrying out the foundation’s exempt purposes and the amount paid by the foundation for such services is not excessive.
  • Manager of foundation owns an investment counseling business. Acting in his capacity as an investment counselor, Manager manages foundation’s investment portfolio for which he receives an amount which is determined to be not excessive. The payment of such compensation to Manager shall not constitute an act of self-dealing.
  • A commercial bank services as trustee for foundation. In addition to bank’s duties as trustee, the bank maintains foundation’s checking and savings accounts and rents a safety deposit box to foundation. The use of the funds by the bank and the payment of compensation by foundation to the bank for such general banking services shall be treated as the payment of compensation for the performance of personal services which are reasonable and necessary to carry out the exempt purposes of foundation if such compensation is not excessive.
  • A substantial contributor to a foundation (and thus a disqualified person) owns a factory which manufactures microscopes. The disqualified person contracts with foundation to manufacture 100 microscopes for the foundation. Any payment to the disqualified person under the contract shall constitute an act of self-dealing since the payment does not constitute the payment of compensation for the performance of personal services.

In Madden, supra, the IRS argued that the services the disqualified person provided were not personal services because the services were different from the legal, investment management, and general banking services described in the regulations. The disqualified person argued that personal services were any activity that did not include the sale of goods and that "assisted the private foundation in carrying on its legitimate business." The Tax Court rejected the disqualified person’s broad interpretation because it nullified Section 4941(d)(1)(C)'s prohibition against the "furnishing of goods, services, or facilities" for a charge. According to the Court, "personal services" are services that are essentially professional and managerial in nature such as legal services, investment management services, and general banking services. Furthermore, the Court determined that "any exceptions to the self-dealing transactions rules should be construed narrowly." Therefore, the Court ruled that general maintenance, janitorial, and custodial services were different in nature from the professional and managerial services found in the examples in the regulations and, therefore, would not meet the definition of personal services.

Cash Advances. The making of a cash advance to a foundation manager or employee for expenses on behalf of the foundation is not an act of self-dealing, so long as the amount of the advance is reasonable in relation to the duties and expense requirements of the foundation manager. Treas. Reg. Section 53.4941(d)-3(c)(1) provides that generally, cash advances shall not ordinarily exceed $500, unless there are extraordinary expenses to be incurred in fulfillment of special assignment. 

Reasonable Compensation. Treas. Reg. Section 53.4941(d)-2(e) provides in general that the payment of compensation, or payment or reimbursement of expenses, by a foundation to a disqualified person shall constitute an act of self-dealing. However, Section 53.4941(d)-3(c) provides for an exception for the payment of compensation by a foundation to a disqualified person for personal services which are reasonable and necessary to carry out the exempt purposes of the foundation is not considered self-dealing if the compensation or reimbursement is not excessive. Treas. Reg. Section 53.4941(d)-3(c) points to Treas. Reg. Section 1.162-7 for the determination of whether compensation is excessive. Reasonable compensation is defined in Treas. Reg. Section 1.162-7(b)(3) as the amount like organizations would ordinarily pay for like services in like circumstances.

Issue Indicators or Audit Tips

Review 990PF Part 1 regarding compensation of officers and directors.

Review the type of service when a personal service exception is claimed.

Review organizing documents such as by-laws, minutes of the meetings of the board and committees to determine if;

  • the compensation was approved and authorized;
  • the nature of services to be rendered if they satisfy the personal services exception and related to the organization’s exempt purpose;
  • the basis for rate of payment for services to determine if they are reasonable.

Review books and records such as general ledger and payroll records to determine if services were rendered.

Review expenditure journals for any payments to disqualified persons.