Many practitioners and other advisors who have regular dealings with private foundation (PFs) are well aware of the direct self-dealing rules, which severely limit the financial transactions that may occur between a PF and its insiders, technically termed “disqualified persons” (DPs), as defined in Internal Revenue Code Section 4946. Although the direct self-dealing rules are arguably well-defined, the indirect self-dealing rules are fraught with ambiguity. Surprisingly, “indirect self-dealing” isn’t defined by the IRC or the Treasury regulations. Instead, the regulations take the curious approach of providing exceptions1 to this undefined rule. While many practitioners are aware of the potential for indirect self-dealing in connection with transactions between a DP and an estate or trust, transactions between a DP and a PF-controlled intermediary organization likewise can result in indirect self-dealing yet can be easily overlooked. In fact, most of the exceptions and examples2 in the regulations pertain to transactions between a controlled intermediary and a DP, making it critically important for advisors to understand the meaning of control in this context.
Two-Prong Test
A review of such exceptions and examples makes it evident that indirect self-dealing includes a transaction between a DP and a controlled intermediary that would constitute direct self-dealing had it occurred between the DP and the PF (a prohibited transaction).3 An intermediary organization, which may be exempt or non-exempt, will be deemed controlled by a PF under either of the following two prongs if: (1) the PF or one or more of its foundation managers (acting only in such capacity) may, only by aggregating their votes or positions of authority, compel the intermediary to engage in a prohibited transaction (the first prong); or (2) the transacting DP, together with one or more other DPs who are classified as such because of such person’s relationship with the transacting DP4 (the transacting DP, together with such other related DPs, the DP group), may, only by aggregating their votes or positions of authority with that of the PF, compel the intermediary to engage in a prohibited transaction (the second prong).
To illustrate these indirect self-dealing regulations, consider a case in which Luca Jones is a DP because he’s the president of the Jones Foundation, and he and the PF own 90% and 5%, respectively, of the voting stock of Acme Co., the intermediary organization from which Luca wishes to borrow funds. Assume that Luca owns his voting stock personally, rather than in his capacity as a PF manager. Under the first prong, the PF doesn’t control Acme Co. because Luca’s voting stock wouldn’t be taken into account. Additionally, the PF doesn’t control Acme Co. under the second prong because Luca can control Acme Co. without having to aggregate his votes with that of the PF.5
While the first prong may be straightforward, the second prong seems to require the involvement of three parties—the PF, the transacting DP and at least one other DP who’s classified as such because of a relationship to the transacting DP. For example, suppose that Sarah Jones is a DP because she’s married to Luca, the Jones Foundation’s president, making her part of the DP group. Luca, Sarah and the PF own 1%, 5% and 49%, respectively, of Acme Co., from which Luca wishes to borrow funds. Here, Acme Co. wouldn’t be deemed controlled by the PF under the first prong because it lacks sufficient voting power to compel Acme Co. to make the loan. Under the second prong, however, Acme Co. would be considered a controlled organization because, while the DP group, alone, can’t compel Acme Co. to enter into the contemplated loan, Acme Co. can be so compelled by the DP group and the PF acting together.
Given that the indirect self-dealing rules cover a broad range of transactions,6 it seems likely that the Internal Revenue Service would find control under the second prong even if the PF and the transacting DP alone—without the rest of the DP group—could compel the intermediary organization to engage in a prohibited transaction. For instance, suppose that Luca and the Jones Foundation, respectively, own 2% and 49% of Acme Co.7 and that Luca wants to borrow funds from Acme Co. Because Luca and the PF can collectively compel Acme Co. to make the loan, a prohibited transaction, Acme Co. could be deemed a controlled entity, even without the involvement of a related DP, such as Sarah.
Voting Power Less Than 50%
Additionally, under either prong of the control test, even if the aggregate voting power is less than 50%, the regulations provide that an intermediary is controlled if it can, in fact, be compelled to engage in a prohibited transaction by the PF or by the PF together with the DP group.8 This would seem to include, among other things, control resulting from indirect ownership interests. For instance, suppose that the Jones Foundation and Luca, its president, own 48% and 2%, respectively, of Acme Co., from which Luca wishes to borrow funds. Although Sarah, Luca’s wife, holds no direct interest in Acme Co., she owns 100% of Holding Co., which owns 5% of Acme Co. Under a straightforward reading of the second prong, the PF wouldn’t be deemed to control Acme Co. because the PF and the DP group, comprising only Luca and Sarah,9 lack sufficient direct voting power to compel Acme Co. to make the contemplated loan. Nonetheless, it appears that the PF would be deemed to control Acme Co. because Sarah, a member of the DP group, can require Holding Co. to aggregate its voting power with Luca and the PF and compel Acme Co. to make the contemplated loan.
Veto Power
The regulations also provide that, under either prong, an intermediary will be deemed controlled by a PF or by a PF and the DP group if “one or more of such persons has the right to exercise veto power over the actions of [the intermediary] relevant to any potential acts of self-dealing.”10 For instance, if a PF could veto a prohibited transaction, the PF would be deemed to control the intermediary, despite having only a minority interest. Here, the term “such persons” appears to mean that the PF would be deemed to control the intermediary when veto power is exercisable by (1) the PF and any PF managers acting solely in such capacity; (2) the DP group acting alone; or (3) the PF and the DP group acting in concert. When a PF alone has the power to prevent an intermediary organization from engaging in a prohibited transaction, imputing control to the PF is consistent with the first prong, which focuses solely on the PF’s power to compel the intermediary to engage in a prohibited transaction.
However, when only the DP group has veto power over an intermediary’s prohibited transactions, imputing control to the PF appears inconsistent with the second prong,11 which finds control only when the DP group must act in concert with the PF to require the intermediary to engage in a prohibited transaction. After all, if the regulations don’t impute control to the PF when the DP group, acting alone, can compel the intermediary to engage in a prohibited transaction, then why should control be imputed where the DP group, acting alone, can prevent such a transaction? Finally, when a PF and the DP group acting in concert can veto an intermediary’s prohibited transaction, it seems counterintuitive to impute control to the PF. As evidenced by the second prong, a primary intent of these regulations appears to be to prohibit a DP’s use of the PF to further the DP’s agenda. As such, finding control when a PF might leverage a DP’s veto power to further the PFs agenda arguably goes beyond this primary intent.
Unrelated DPs
Additionally, given the broad reach of these rules, one would expect that the definition of control would take into account the positions of authority and voting power of all DPs. Therefore, it’s surprising that the DP group is limited to the transacting DP and only those DPs that have such status due to their relationship with the transacting DP.12 For example, assume that Luca, Nico Smith (an officer unrelated to Luca) and the Jones Foundation own 1%, 5% and 49%, respectively, of Acme Co. Assume further that, although Nico is a DP, his DP status doesn’t result from a relationship with Luca. In this case, Acme Co. wouldn’t be deemed a controlled organization because Nico would be excluded from the DP group, and the PF and Luca alone would be unable to compel Acme Co. to make the contemplated loan. Perhaps the rationale for excluding unrelated DPs, like Nico, from the DP group is that unrelated DPs are less likely to be influenced by the transacting DP and, therefore, less likely to collaborate with the transacting DP in compelling an intermediary organization to engage in prohibited transactions.
By extension, the IRS might aggregate the interests of unrelated DPs who are, nonetheless, subject to the transacting DP’s influence. For example, assume, as above, that Luca and the PF, alone, can’t require Acme Co. to make a loan to Luca without Nico’s support. Further, suppose that Nico works at Luca’s family business, where Luca sets Nico’s compensation. Under these circumstances, Nico undoubtedly could feel pressured into combining his influence with that of Luca and the PF to compel Acme Co. to make the loan. Even though Nico technically would be excluded from the DP group, the IRS may well find indirect self-dealing here if it subscribes to this approach of combining the interests of unrelated DPs who are subject to the transacting DP’s influence.
Large Range of Transactions
As mentioned above, the possible range of transactions that could trigger an indirect self-dealing violation is so large that the Treasury Department declined to provide a definition even though it was pressed by the sector to do so.13 In fact, the lack of a definition, coupled with the deliberate decision to provide only exceptions to an undefined rule, seems to “imply by negative inference that all other transactions between disqualified persons and controlled organizations are self-dealing.”14 Therefore, being able to identify a controlled intermediary is crucial in figuring out whether a situation fits into a safe harbor exception. Likewise, barring a sham transaction, the absence of control arguably could be used to rule out indirect self-dealing in connection with a prohibited transaction.15
Although the potential reach of these rules can be overwhelming and their application uncertain, let common sense (and paranoia!) be your guide when analyzing cases that don’t fit neatly into the regulations.
Endnotes
1. See Treasury Regulations Section 53.4941(d)-1(b)(2) (grants to intermediaries), -1(b)(3) (transactions during the administration of an estate or revocable trust), -1(b)(4) (transactions with certain organizations), -1(b)(6) (certain transactions involving limited amounts) and -1(b)(7) (applicability of statutory exceptions to indirect self-dealing).
2. Three out of the five listed exceptions to indirect self-dealing and four out of seven of the examples focus on the presence or lack of control over an intermediary organization. See also Treas. Regs. Sections 53.4941(d)-1(b)(2), -1(b)(4), -1(b)(6) and -1(b)(8)(Exs. (1), (2), (6) and (7) (involving loans and purchases between a disqualified person (DP) and an intermediary organization)).
3. See Shearn Moody, Jr. v. Commissioner, T.C. Memo. 1995-195, at 2529 (1995).
4. See Internal Revenue Code Sections 4946(a)(1)(C) through (G).
5. Treas. Regs. Section 53.4941(d)-1(b)(5) specifies in part that “an organization is controlled by a private foundation in the case of a transaction between the organization and a disqualified person, if [the transacting DP] together with one or more [related DPs], may, only by aggregating their votes or positions of authority with that of the foundation, require the organization to engage in [a prohibited transaction].” (emphasis added) See also Revenue Ruling 76-158 (determining that the intermediary organization wasn’t controlled when the DP owned 65% and the private foundation (PF) owned 35% because the DP could control the intermediary without aggregating his votes with that of the PF).
6. General Counsel Memorandum (GCM) 039445 (July 11, 1985) (citing to T.D. 7270, LR-1611, indicating that the Treasury regulations provided no definition of “indirect self-dealing” because it wasn’t felt feasible to draft a comprehensive definition due to “the great variety of possible situations which could be called ‘indirect self-dealing.’”) See also Private Letter Ruling 8942054
(July 25, 1989) (reasoning that case law supports the notion that IRC Section 4941 is construed broadly in certain cases).
7. This example assumes that an exception applies under the excess business holdings rules of IRC Section 4943, making the PF’s holdings permissible. Additionally, note that although the intermediary in this example isn’t a DP, the indirect self-dealing rules would apply even if the intermediary were a DP. While the direct self-dealing rules would prohibit certain transactions between the PF and the DP intermediary, such rules wouldn’t reach transactions between the transacting DP and the DP intermediary.
8. See Treas. Regs. Section 53.4941(d)-1(b)(5).
9. While Holding Co. would be a DP by virtue of its relationship to Sarah, it would be excluded from the DP group because its status as a DP derives from Sarah rather than from Luca under Section 4946(a)(1)(E).
10. Treas. Regs. Section 53.4941(d)-1(b)(5) (emphasis added).
11. Note that the first prong is inapplicable here because it takes into account the voting power of the PF only and not that of the DP group.
12. Presumably, the DP group would include a person who’s a DP not only because of his relationship to the transacting DP but also who’s a DP in his own right. For instance, when the related DP is a family member of the transacting DP and a PF officer, one would expect that the related DP would still be included in the DP group. Notably, the regulations don’t require that one be a DP only by reason of a relationship with the transacting DP; rather, the language simply requires that one be a DP “by reason of such person’s relationship” to the transacting DP.
13. See GCM, supra note 6.
14. Alvin J. Geske, “Indirect Self-Dealing and Foundation’s Transfers for the Use or Benefit of Disqualified Persons,” 12 Hous. L. Rev. 379, 398 (1975).
15. See supra note 3. Although the Internal Revenue Service asserted that a DP had engaged in indirect self-dealing with an intermediary organization, the court held that self-dealing hadn’t occurred after concluding that the intermediary wasn’t controlled under either prong of the control definition. However, the court also noted that “[t]he failure of an organization to come within the ‘control’ tests of section 53.4941(d)-1(b)(5) Foundation Excise Tax Regs., may not be determinative [in ruling out indirect self-dealing]. There may exist other ways to engage in self-dealing through organizations that are related to the private foundation.”