Self-dealing exception solves estate settlement woes

By Audrey G. Young, J.D., LL.M., Boston

Editors: Mindy Tyson Weber, CPA, and Trina Pinneau, J.D., LL.M.

Business owners with charitable inclinations often seek to reduce or, in some cases, eliminate estate taxes by bequeathing business interests to private foundations or charitable lead trusts. While such bequests can be effective for estate tax planning purposes, the rules for foundations and trusts make it difficult for a deceased owner's family to conduct business with those entities. More particularly, the so-called self-dealing rules prohibit almost all direct and indirect transactions between a private foundation (which hereinafter includes charitable lead trusts, as they are subject to the self-dealing rules under Sec. 4947(a)(2)) and the owner's family members.

This area of law is fraught with risk: The self-dealing rules include many technical definitions, and indirect self-dealing is defined only by way of example. Compliance is particularly troublesome for any family that interacts with its foundation. Fortunately, there is a key exception to the prohibition on indirect self-dealing that can enable executors and families of decedents to conduct certain transactions with foundations without triggering the onerous penalties otherwise associated with self-dealing.

Definition of self-dealing and its consequences

Self-dealing is defined broadly in Sec. 4941 and includes any direct or indirect (1) sale or exchange of property between a private foundation and a disqualified person; (2) payment of compensation (or reimbursement) by a private foundation to a disqualified person; or (3) transfer to, or use by, a disqualified person of the income or assets of a private foundation. A "disqualified person" includes a substantial contributor to the foundation, a foundation manager, a more-than-20% owner of a business that is a substantial contributor, or a member of the family of any person described above, as well as a corporation or trust in which disqualified persons own or hold a greater-than-35% interest.

Compliance with the statute is essential, as it imposes an excise tax on the disqualified person for any act of self-dealing. The excise tax on self-dealing is twofold: (1) an initial tax of 10% of the amount involved in the self-dealing transaction for each year in the tax period, and (2) potentially a second tier of tax of 200% of the amount involved if the self-dealing act is not unwound during the tax period. The tax period encompasses the time frame beginning on the date of the self-dealing transaction and ending on the earlier of the notice of deficiency mailing date, the initial tax assessment date, or the date the correction to the self-dealing transaction is completed.

Estate administration exception

As noted, there is an exception for self-dealing that occurs during estate settlement. This exception, which is set forth in Regs. Sec. 53.4941(d)-1(b)(3), provides that indirect self-dealing does not include a transaction with respect to a private foundation's interest in estate property, regardless of when title to the property vests under local law, if:

  • The administrator or trustee either possesses a power of sale with respect to the property, has the power to reallocate the property, or is required to sell the property under the terms of any option subject to which the property was acquired;
  • The transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate (or trust) or over the private foundation);
  • The transaction occurs before the estate is considered terminated for federal income tax purposes;
  • The estate or trust receives at least the fair market value (FMV) for the foundation's interest or expectancy in the property; and
  • The transaction results in the foundation's receiving an interest or expectancy at least as liquid as the one it previously had; the transaction results in the foundation's receiving an asset related to the active carrying out of its exempt purposes; or the transaction is required under the terms of an option that is binding upon the trust or estate.

This exception is sometimes referred to as the probate exception or the estate administration exception. Still, compliance with the second and third provisions (probate court approval and the transaction occurs before the estate is terminated for federal tax purposes) often deters families and their advisers from relying on the exception. But as the following rulings and cases make clear, the key requirement is that whenever closely held business interests are changing hands between a disqualified person and a private foundation, it must be done at FMV. Not complying with this rule can result in the IRS's determining that the transaction was a "bargain sale" and, therefore, an act of indirect self-dealing.

IRS Letter Ruling 201446024 offers a road map for successful use of the probate exception in the common scenario where a decedent dies with an outstanding installment note issued by a trust with family members as its beneficiaries. The note was part of the decedent's residuary estate, a portion of which was to be given to the decedent's private foundation. Given the debtor-creditor relationship between the trust (a disqualified person) and the private foundation, an act of self-dealing issue was potentially imminent.

The executor proposed to create a "blocker LLC," which would hold the note and, in exchange, issue voting and nonvoting LLC units. The executor would buy the voting units, while the private foundation would receive the nonvoting units rather than the note. The executor promised that the estate would receive court approval for the sales, and the IRS ruled that the estate administration exception protected the transaction.

This ruling is illuminating for several reasons. It implies that the IRS concluded that the nonvoting units were at least as liquid as the note. Another key takeaway is the need for the foundation to receive nonvoting units rather than voting units, as Regs. Sec. 53.4941(d)-1(b)(5) provides that indirect self-dealing will occur if a private foundation controls the organization that is a party to the transaction with a disqualified person.

Letter Rulings 200635016 and 201145026 offer other pathways for successful use of the estate administration exception. In the earlier letter ruling, the IRS ruled that a nonexempt trust treated under Sec. 4947(a)(2) as a private foundation that owned nonvoting interests in an entity and had engaged in a transaction with one or more disqualified persons did not engage in indirect self-dealing. In Letter Ruling 201145026, the IRS concluded that the sales of limited partnership interests between a marital trust and a testamentary charitable lead unitrust met the requirements of the estate administration exception.

While the letter rulings provide examples of thoughtful planning that successfully deploys the estate administration exception, a recent Tax Court case, Estate of Dieringer, 146 T.C. No. 8 (2016),demonstrates the pitfalls of settling an estate without complying with Regs. Sec. 53.4941(d)-1(b)(3). In Dieringer, the decedent made a specific bequest of voting and nonvoting stock in a closely held corporation to a private foundation she created during her lifetime. At the time of her death, the decedent owned 81% of the voting stock in the corporation and 84% of the nonvoting shares. One son, who wore many hats within the family, including trustee, corporation president, and private foundation trustee, owned the balance of the voting shares and co-owned, with his brother, the balance of the nonvoting shares. For estate tax purposes, the decedent's voting stock was valued without discounts, and the nonvoting stock was valued with a 5% discount for lacking voting rights. The estate tax return reported a charitable deduction for the appraised value of the stock on the decedent's date of death. However, the IRS determined that due to significant events that occurred after the decedent's death and the time the estate transferred the property to the private foundation, the value of the stock had changed.

During the estate administration period, the sons engineered the corporation's full redemption of the voting stock and partial redemption of the nonvoting stock. The corporation issued promissory notes to the decedent's trust as payment. The redemption of the decedent's voting shares was valued by the same appraiser using a 15% discount for lack of control, as well as a 35% discount for lack of marketability. At the same time, the sons entered into a subscription agreement with the corporation and purchased minority interests in the shares, using the second appraisal. Without the protection of the estate administration exception, this was clearly an act of self-dealing, as the sons were disqualified persons who, in essence, purchased shares belonging to the private foundation. Moreover, following the redemption, one son owned 38% of the corporation, which would make the corporation a disqualified person as well.

Belatedly, the executor went to probate court, ostensibly to rely on the estate administration exception and avoid Sec. 4941. The probate court's blessing of the transaction might have stopped the IRS from pursuing the excise tax against the sons. However, it is doubtful that Regs. Sec. 53.4941(d)-1(b)(3) was complied with, given that the court blessed the transaction 20 months after it occurred and the Tax Court found that the private foundation did not receive FMV. However, the Tax Court sided with the IRS that the estate's charitable contribution deduction should reflect the events that occurred after the decedent's death and substantially reduced the deduction, causing an estate tax deficiency in excess of $4 million as well as a substantial accuracy-related penalty.

As Dieringer shows, where a private foundation or charitable trust is included in the estate plan of a business owner, transactions must be carefully scrutinized to ensure taxpayer accountability. Even transactions that may seem routine can trigger the Sec. 4941 tax.

Strict compliance is essential

As the rulings show, the probate exception is an excellent lifeboat. Using a checklist that tracks the requirements will ensure that the provisions of the estate administration exception are adhered to precisely. It is preferable for the estate planning documents to include provisions that require the executor or trustee to follow the terms of the exception. For example, the trust grantor and foundation founder can provide heirs with an option to acquire business holdings, real estate, or other assets that the founder would otherwise leave to his or her foundation. Upon the founder's death, the executor can sell the designated assets to the heirs based on an FMV appraisal that is timely approved by a probate court. The heirs end up with the property, while the foundation will be funded with the equivalent value. If a promissory note is needed to facilitate the transaction, then a blocker LLC can be established as set forth in Letter Ruling 201446024.

In an effort to protect the charitable beneficiaries and the public interest, the self-dealing rules for private foundations and charitable trusts prohibit family members from conducting virtually all transactions with the foundation, both directly and indirectly. Where a decedent names a private foundation as a beneficiary, challenges arise as to how best to administer the estate while also avoiding the Sec. 4941 tax. The estate administration exception offers an escape route, but the requirements must be strictly followed.


Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.

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Unless otherwise noted, contributors are members of or associated with RSM US LLP.

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