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George F. Bearup, J.D. Senior Legal Trust Advisor

9-Dec-19

Navigating Self-Dealing Rules and Penalties

Take-Away: The Tax Code’s self-dealing rules are designed to prohibit perceived abuses when financial transactions are entered into between a disqualified person and a private foundation. As a surprise to some, these same self-dealing prohibitions also apply to charitable lead trusts (CLTs) and charitable remainder trusts (CRTs.) The penalties associated with self-dealing transactions are onerous. With those constraints, the IRS recently explained in a private letter ruling how to avoid the self-dealing rules using an LLC wrapper.

Caution: Admittedly, this missive is technical. However, if clients are encouraged to adopt charitable remainder or charitable lead trusts, you need to become familiar with the Tax Code’s private foundation self-dealing rules and the corresponding onerous penalties when those rules are violated, as they also apply to charitable remainder and charitable lead trusts the clients may create.

Background: The self-dealing rules are part of the Tax Code. [IRC 4941.] While normally these self-dealing rules are associated with financial transactions with a private foundation, they also apply to charitable lead trusts (CLTs) and charitable remainder trusts (CRTs.) [IRC 4947(s) (2).] Substantial excise taxes will be imposed where a private foundation (or CLT or CRT) and a disqualified person (a technical term described in the Tax Code- think donors and their family members, broadly defined) engage in a transaction that constitutes an act of self-dealing. The concept of self-dealing is extremely broad. It does not matter if the self-dealing transactions actually provides a financial benefit or advantage to the private foundation (or CRT or CLT.) For ease of reference a private foundation, a CLT and CRT all are collectively referred to as a CRT in this missive.)

  • Financial Transactions: There are only a few exceptions where a financial transaction between a CRT and a disqualified person is not treated as self-dealing. Lending money or other extensions of credit between a disqualified person and a CRT is one of the many enumerated acts of self-dealing. [See IRC 4941(d) (1) (B).] An example of just how broad the scope of a self-dealing transaction is, is when a promissory note is given by a disqualified person to a third-party; normally that will not be subject to the self-dealing rules, yet if that same promissory note is subsequently assigned by that third-party to the CRT, a self-dealing situation arises as a result of the disqualified person being indebted to the CRT. [Treas. Reg. 53.4941(d)-2(c) (1) – ‘an act of self-dealing occurs where a note, the obligor of which is a disqualified person, is transferred by a third party to a private foundation which becomes the creditor under the note.’]
  • Indirect Self-Dealing: A self-dealing transaction is not limited to a direct transaction between the disqualified person and the CRT. It extends to indirect acts of self-dealing, including transactions that are carried out through some form of ‘middleman’ or third party. [See IRC 4941(d) (1), which describes those who are either ‘directors’ or ‘indirect’ ]
  • Example: A CRT owns the controlling interest of the voting stock in CORP. Because of the controlling interest, CRT elects a majority of the board of directors of CORP. A disqualified person with respect to CRT, Alex (assume the son of the donor who created the CRT), requests and receives a loan from CORP.  CORP’s loan to Alex, CORP being controlled by CRT, constitutes an indirect act of self-dealing between CRT and Alex, son of the donor to the CRT. Although there was no direct transaction between Alex and CRT, the loan to Alex results in an indirect act of self-dealing because the loan was made by CORP, which is controlled by CRT, and a loan by the CRT itself to Alex would have been an act of self-dealing. [Regulation 53.4941(d)-1(b) (8). Example 1.]
  • Control: The Regulations provide two alternate ‘tests’ to determine when another organization is ‘controlled’ by a private foundation (or CRT or CLT.) These highly technical ‘tests’ are cumbersome to apply in order to determine if the CRT actually controls through voting power the ‘controlled’ organization, using various stock aggregation Consequently, there lurk possible traps in light of the application these indirect ‘control’ rules to cause a self-dealing situation that involves directly, or indirectly, a CRT and a disqualified person.

Excise Taxes: Two separate excise taxes apply to a self-dealing transaction.

  • 10% Tax: An initial 10% excise tax is imposed on the disqualified person, not the CRT. [IRC 4941(a).] This excise tax is imposed each calendar year until the transaction is rectified. As a result, a self-dealing transaction that is not fixed could attract multiple 10% excise taxes for the number of years that the self-dealing transaction remains outstanding.
  • 200% Tax: A second tax of 200% of the amount that is involved in the self-dealing transaction is imposed on the disqualified person if the self-dealing act is not ‘corrected’ during the taxable period. Corrected means ‘undoing’/reversing the transaction to the extent possible. This ‘undoing’/reversing standard is stringent: it requires placing the CRT in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards. [IRC 4941(e) (3).]

How to Avoid Self-Dealing Rules: A creative way to avoid the self-dealing rules was recently outlined in an IRS Private Letter Ruling.

  • PLR 201907004 (not binding precedent)
  • Facts: Dad transferred business interests to several non-charitable trusts that he established for the benefit of his descendants (for simplicity, collectively the Beneficiary Trusts.) In exchange, Dad received promissory notes that will pay interest only for 30 years, with the total principal amount due at the end of the 30-year note term. The beneficiaries of each Beneficiary Trust are Dad’s descendants.
  • Notes Assigned: Dad then assigns these promissory notes received from the Beneficiary Trusts to LLC #1. Under the LLC #1, Dad holds all the non-voting LLC #1 membership interests. The LLC #1 voting membership interests are held in another LLC, called LLC #2. The members of LLC #2 are Dad’s descendants, each of whom holds a membership interest in LLC #2 individually, and not through any trust device.
  • Dad’s Non-voting LLC Units: Consequently, LLC #1 holds all of the promissory notes from the Beneficiary Trusts and it receives all interest payments on those promissory notes. LLC #1 also holds a small amount of cash, which was contributed to LLC #1 by LLC #2 for the voting interests acquired by LLC #2 in LLC #1. In sum, Dad’s non-voting interests in LLC #1 represents virtually the entire ownership interest in LLC #1, although Dad’s membership interest in LLC #1 has no voting rights.
  • Dad’s CLAT: Dad creates a CLAT. Dad funds the CLAT with his non-voting interests in LLC #1. IRC 4941 applies to Dad’s CLAT. [IRC 4947(a) (2).] Therefore, Dad’s CLAT is treated as a private foundation subject to the self-dealing The charitable interest in Dad’s CLAT is the right to a guaranteed annuity payment, distributed annually to a public charity. Dad’s daughter, Diane, is named the trustee of Dad’s CLAT. The remainder interests in Dad’s CLAT are his descendants.
  • Diane: The management of LLC #1 is vested in a manger who is selected and may be removed by a vote of the members who hold at least a majority of the voting interests in LLC #1. The voting members selected Diane to be LLC #1’s manager. (I made up Diane’s name so it is easier to follow the facts.) Diane is also the sole trustee of the Beneficiary Trusts. Diane is also the trustee of a charitable lead annuity trust (CLAT) that Dad created. Diane therefore holds interests in LLC #1 only a voting interest indirectly through her own membership interest in LLC #2. [Diane is a busy girl: trustee of the Beneficiary Trusts that gave the notes to Dad; trustee of Dad’s CLAT to which LLC #1 non-voting interests, which LLC holds these notes, is transferred; manager of LLC #1; and direct owner of some LLC #2 membership units. As I said, Diane is busy and on multiple sides of these financial transactions.]

PLR Question: Dad intends to transfer his non-voting interests in LLC #1 to Dad’s CLAT. The annual annuity amount paid to the public charity would be from Dad’s CLAT’s income, including distributions from LLC #1 to Dad’s CLAT. If that income were insufficient, the annual annuity amount would then be satisfied using Dad’s CLAT’s principal. Thus, the question asked in the PLR is if the transfer of the LLC #1 non-voting units to the CLAT a self-dealing transaction?

  • IRS Analysis: The IRS noted that Dad is a disqualified person with respect to Dad’s CLAT because he is a substantial contributor to the CLAT having created and funded the CLAT. [IRC 4946(a) (1) (A).] Diane, as the CLAT trustee, is also a disqualified person with respect to Dad’s CLAT because she is a ‘foundation manager.’ [IRC 4946(a) (1) (B).] The Beneficiary Trusts are also disqualified persons with respect to Dad’s CLAT because they are trusts in which Dad’s descendants are beneficiaries, i.e. family members of Dad, who hold more than a 35% beneficial interest in the trusts [this one of those many broad indirect control rules that apply to expose transactions to the excise taxes.] [IRC 4946(a) (1) (D).]
  • No Direct Self-dealing: Initially the IRS noted that had Dad transferred the Beneficiary Trusts’ promissory notes directly to Dad’s CLAT, an act of self-dealing would have occurred because Dad’s CLAT would have become the creditor of those promissory notes, i.e. a direct act of self-dealing, because the debtor, the Family Trusts, are disqualified persons, and the creditor would be Dad’s CLAT, with payment to be made under the notes by disqualified persons directly to Dad’s CLAT. However, because the promissory notes themselves were not assigned by Dad to Dad’s CLAT, just the non-voting LLC #1 membership units, a direct act of self-dealing was avoided.
  • No Indirect Self-dealing: The question was then whether an indirect act of self-dealing occurred, specifically if Dad’s CLAT was considered to ‘control’ LLC #1. If that were the case, then Dad’s CLAT would be the creditor, indirectly, under the promissory notes because of its ownership interest in LLC #1. The IRS found that neither Dad’s CLAT, nor its ‘foundation manager’, aka, Dad’s CLAT trustee (Diane) possessed any ‘control.’ Since Dad’s CLAT was the holder of only non-voting membership interests in LLC #1, and LLC #2 held all of the voting interests in LLC #1, only LLC #2 possessed the right to select and remove the manager of LLC #1. Moreover, as the non-voting member in LLC #1, Dad’s CLAT had no ability to vote to dissolve LLC #1 nor any right to compel distributions from LLC #1: “Only LLC #2, as the holder of the voting interests which may elect or remove the manager of LLC #1, and such manager will have the sole power to manage the affairs of LLC #1 and determine the timing and amount of distributions….The CLAT and the CLAT trustee, a foundation manager acting only in such capacity will not have sufficient votes or positions of authority to cause LLC #1 to engage in a transaction…The CLAT will not have the power to compel dissolution of the LLC #1 since LLC #1 may only be dissolved with the written approval of all members, including LLC #2.”
  • No Power with Non-voting LLC Interests: With regard to the proposed assignment by Dad of his non-voting membership units in LLC #1 to Dad’s CLAT, the IRS observed: “[The] power associated with non-voting interests of LLC #1 as a necessary party to vote on the liquidation of LLC #1 is not considered equivalent to a ‘veto power’ within the meaning of Treas. Reg. 53.4941(d)-1(b)(5).” [Yet another one of the vague ‘control’ tests under the Tax Code.]
  • Summary: In sum, the IRS held that Dad’s CLAT’s receipt of Dad’s non-voting interests in LLC #1 did not constitute a loan or extension of credit between a private foundation (Dad’s CLAT) and a disqualified person (the Beneficiary Trusts.) That is because Dad’s CLAT did not acquire an interest in the promissory notes. Rather, Dad’s CLAT acquired only non-voting interests in LLC #1 (which held the promissory notes from the Beneficiary Trusts.)

Conclusion: While the facts of the private letter ruling are a bit tedious, its key message is the importance of remembering that the self-dealing rules, along with their bewildering ‘control’ rules to find a disqualified person, and the confiscatory self-dealing penalty provisions, apply to CLATs and CRTs along with private foundations. In this PLR, but for the use of an intermediary, i.e. LLC #1, that was not controlled by the CLAT to hold the promissory notes issued by the disqualified person-Beneficiary Trusts, an act of self-dealing would have occurred upon the direct transfer of the promissory notes by Dad to the CLATs. By Dad using an LLC ‘wrapper,’ the CLAT was not considered to ‘control’ the promissory notes, and thus the promissory notes could be used as the CLAT’s funding source.

When working with the transfer of assets to a CRT, its best to stay away, whenever possible, from business interests that might be ‘controlled’ indirectly by the CRT settlor’s family members or business entities that they may directly, or indirectly, control.