Residuary bequests to private foundations are a common form of charitable giving. Typically, a testator's will provides for certain bequests to individuals, and designates a private foundation as a beneficiary of all or a portion of his residuary estate. The advantages of residuary bequests to charity are well-known: The testator's estate is eligible for a charitable deduction, and, if the recipient foundation was created by the testator or a family member during the testator's lifetime or under the will itself, members of the testator's family can retain control over the administration and distribution of foundation assets.

The disclaimer is also a popular tax-planning tool. It's used to provide flexibility and correct mistakes in an estate plan. Expect disclaimers to play an ever more important role in estate planning to cope with changing estate tax rates, estate tax credit amounts and generation-skipping transfer (GST) tax exemption amounts. As estate tax credit amounts increase, for example, a surviving spouse might be more likely to disclaim as part of a post-mortem estate plan, resulting in lower estate tax brackets and passage of more assets to her heirs.

But even with all its appeal, the disclaimer has some inherent risks. Most particularly, the prohibition against “self-dealing” transactions found in Internal Revenue Code Section 4941 can be a significant trap for fiduciaries and their advisors during the course of the administration of an estate in which one or more private foundations is a residuary beneficiary.

If one of an estate's individual beneficiaries is contemplating a disclaimer and it's possible that, as a result, a private foundation could receive a residuary interest in the estate, certain types of transactions between the estate and a disqualified person with respect to the foundation could trigger self-dealing excise taxes. Because of the mechanics of disclaimers under state property law, a transaction with an estate might not be properly classified as a self-dealing transaction until several months after it has occurred. So planners need to know the rules well. That's especially true because the penalties can be steep.

IRC SECTION 4941

IRC Section 4941 imposes an excise tax on acts of self-dealing between a private foundation and a disqualified person. An initial tax of 5 percent of the amount involved in the act of self-dealing is imposed on any disqualified person who participated in the act (and 2 percent on any participating foundation manager, but fines will not exceed $10,000 for each manager).

If the self-dealing act is not corrected in a timely manner as provided by Section 4941(e)(1), a second level of tax equal to 200 percent of the amount involved will be imposed on the disqualified person (and 50 percent on the participating foundation managers, not to exceed $10,000). Under IRC Section 4946, the term “disqualified person” includes: (1) a substantial contributor to the foundation, (2) a foundation manager (that is to say, an officer or director), (3) an owner of more than 20 percent of the total voting power of a corporation, the profits interest of a partnership or the beneficial interest of a trust or unincorporated enterprise that is a substantial contributor to the foundation, (4) a family member (spouses, ancestors, lineal descendants and the spouses of lineal descendants) of any of these or (5) a corporation, partnership, trust or estate in which persons described in (1) through (4) own more than 35 percent of the voting power, profits interest or beneficial interest.

In the context of an estate that has a private foundation as a residuary beneficiary, many of the parties involved will be disqualified, including some of the decedent's family members, testamentary or inter vivos trusts created by the decedent (if one or more of such family members have more than 35 percent of the beneficial interest on an actuarial basis), a family-owned business (if disqualified persons own more than 35 percent of the voting power) and the executors of the estate (if they are family members of the decedent or foundation managers).

Typical self-dealing transactions are detailed in IRC Section 4941(d)(1). (See “Self-Dealing and Exceptions,” p. 24.)

Self-dealing under Section 4941 includes both direct and indirect transactions between private foundations and disqualified persons. The Internal Revenue Service has stated that, “indirect self-dealing occurs when a transaction is entered into between parties, none of which is a private foundation, but to which a private foundation is indirectly a party, and which would constitute direct self-dealing if the private foundation were directly involved.”1

Section 53.4941(d)-1(b)(3) of the Treasury Regulations states that indirect self-dealing could include a transaction affecting a private foundation's interest or expectancy in property held by an estate or a revocable trust.

INDIRECT SELF-DEALING

There are several types of transactions between an estate and a disqualified person that have been classified as indirect self-dealing. For example, a sale of assets by an estate with a private foundation as a residuary beneficiary to a disqualified person is an act of self-dealing.2 Settlement of a probate litigation or litigation involving a trust may be a sale or exchange that constitutes self-dealing.3 Also, a distribution to, and receipt and holding by, a private foundation, of a note, the obligor of which is a disqualified person, as part of a residuary bequest to a private foundation may also be deemed to be indirect self-dealing.4

Even certain investment decisions made by an executor could be viewed as self-dealing. For example, if a decedent's will provides that a portion of the residuary estate will be paid to the decedent's spouse and the remaining estate assets will go to a private foundation, the IRS might classify the executor's investment of estate assets in municipal bonds as self-dealing because the investment benefitted the disqualified person by providing her with tax-exempt income.5

Things get even more complicated when one of the beneficiaries of an estate disclaims a portion of his interest in the estate, and under the terms of the will (or revocable trust agreement) the disclaimed property is to be distributed directly to a private foundation.

Consider this example: Suppose the decedent's will provides that after making certain specific distributions to family members and certain charities, the residue of the estate (which includes a collection of antique pottery) will be paid in equal shares to the decedent's sons: X, Y and Z. If any of the sons predecease the decedent, his share will be given to a private foundation created and funded by the decedent during his lifetime. Y wants to buy the pottery collection and is willing to pay the full fair market value. X has been contemplating making a qualified disclaimer, within the meaning of IRC Section 2518, of his interest in the decedent's residuary estate.

This case presents a timing conundrum. Y is a disqualified person with respect to the private foundation, because he is the son of the substantial contributor to the foundation. As a result, a sale of the collection to Y would be self-dealing if the private foundation were in fact a residuary beneficiary of the decedent's estate. However, the private foundation's interest in the residuary estate is a contingent one unless and until X renounces his interest in the residue. Consider this conclusion: Y purchases the collection from the estate four months after the decedent's death. Several months later, X disclaims his entire interest in the decedent's residuary estate. X's disclaimer satisfies the requirements of IRC Section 2518. Under state law,6 once X disclaims his interest in the residue, he will be treated as having predeceased the decedent with respect to the disclaimed property. Under the terms of the will, one-third of the residue must be distributed to the foundation.

Because X is treated as having predeceased the decedent, X's disclaimer would relate back to the date of the decedent's death. The private foundation would be deemed to be a residuary beneficiary of the estate as of the decedent's date of death.

If Y purchases the collection and then, three months later, X disclaims his entire residuary interest, could that earlier purchase have been an act of self-dealing? Does the foundation have an interest or expectancy in the estate at the time of the sale of the collection to Y solely because it may receive assets after a disclaimer by a beneficiary?

There is no discussion, either in IRS rulings or court cases, regarding the interaction of the disclaimer rules with the self-dealing rules pertaining to estate administration transactions.7 The IRS has issued a few private letter rulings that examine what it means for a private foundation to have an “interest or expectancy” in an estate. In these rulings, the IRS indicated that the mere possibility a foundation might at some point in the future receive property from an estate or revocable trust is not sufficient to make the self-dealing rules apply to transactions affecting the property. For example, in PLR 9222057,8 the IRS ruled that a foundation's interest or expectancy did not include a bequest of stock under the will of a living person. In addition, the IRS in PLR 90470549 held that a foundation that was the residuary beneficiary of a decedent's estate did not have an interest or expectancy in certain stock owned by the decedent that, under the terms of the decedent's will, could be acquired by the decedent's children in exchange for other stock, until the children's right to acquire the stock expired.

In our example, at the time of the sale of the collection it was hardly a certainty that the foundation would be entitled to the estate's assets. As in the case of PLR 9047054, the foundation would have no interest in the estate at the time of the sale transaction between the estate and Y, were it not for the intervening act of a third party (in this case, X's disclaimer). If we apply the principles discussed in this ruling to the conclusion of our example, an argument could be made that the indirect self-dealing rules should not apply at all, because at the time of the sale, before the disclaimer, the private foundation had no vested interest in the estate.

On the other hand, state law will treat X as having predeceased the decedent, even though the disclaimer occurs up to nine months after the decedent's death. The federal transfer tax treatment of qualified disclaimers itself is based on this legal fiction. Under IRC Section 2518, no gift tax will be imposed on a disclaimant if he makes a qualified disclaimer (within the meaning of that section) of an interest in a decedent's estate. The tax law re-characterizes the entire transaction as a transfer of the disclaimed property from the decedent directly to the recipient of the disclaimed funds. In other words, the tax law creates a transfer that never actually happened. That prompts this question: If IRC Section 2518 works to retroactively create transfers by a decedent that may not have even been contemplated by the decedent, can estate planners, in the absence of clear authority, advise clients that there is no risk that the IRS will retroactively apply the self-dealing rules of Section 4941 in the context of transactions occurring during the administration of an estate?

Furthermore, notwithstanding PLR 9222057 and PLR 9047054, the IRS in at least one other instance has stated that a private foundation's contingent interest in a trust was indeed an interest or expectancy in the trust's assets within the meaning of Treas. Reg. Section 53.4941(d)-1(b)(3).

In PLR 9724018,10 A created a revocable trust (Trust Y), the terms of which provided that at A's death, after the payment of certain obligations, expenses and transfer taxes on A's estate, and after the payment of five specific distributions to various charities including X (a private foundation created by A), the trustee of Trust Y would establish Trust Z for the benefit of B and distribute to Trust Z all of the property of Trust Y not otherwise distributed. The trustee of Trust Z would distribute to B all of Trust Z's income and as much principal as the trustee determined would be necessary for B's support, maintenance and health. B would have the right to withdraw as much of the principal of Trust Z as he chose. B also would have a general testamentary power of appointment over Trust Z. At B's death, from any property B failed to appoint, the trustee would be required to distribute a specific sum to charity X. A distribution committee then would have the power to direct the trustee to distribute the remainder of the unappointed property to such charitable purposes as the committee specifies within nine months of B's death. Any property not distributed by the distribution committee would be distributed to X.

The IRS commented that in this case, X would be a default taker in Trust Z and would have “an interest or expectancy in its assets.” This was true even though, as a result of B's exercise of B's power of appointment, X could have been entitled to none of Trust Z's assets. If a sale had occurred between a disqualified person and Trust Z while X's interest was contingent upon the actions of a third party, would the IRS have considered that transaction to be a self-dealing transaction?

Given the lack of authority on the issue, and given the inconsistencies in the Service's rulings in similar situations, the prudent course for the family in our example would be for Y to wait until the nine-month time limit for disclaimers has passed before purchasing the collection held by the estate. If X decides against a disclaimer, Y's purchase could never be classified as a self-dealing transaction. If Y cannot wait the nine months, or if X does disclaim a portion (or all) of his interest in the estate, the estate's attorney could structure the sale between the estate and Y so that it qualifies for the estate administration exception of Treas. Reg Section 53.4941(d)-1(b)(3).

SAFE HARBOR

The Treas. Regs. offer fiduciaries a way to engage in such transactions without incurring liability for the self-dealing excise tax. Treas. Reg. Section 53.4941(d)-1(b)(3) provides that indirect self-dealing does not include a transaction with respect to a private foundation's interest or expectancy in property held by an estate or a revocable trust if the following conditions are met:

  1. The executor (or trustee in the case of a revocable trust) has the power to sell the property or re-allocate it to another beneficiary, or the terms of any options subject to which the property was acquired by the estate (or trust) requires them to sell it.

  2. The transaction is approved by the court having jurisdiction over the estate, trust or private foundation.

  3. The transaction occurs before the estate is treated as terminated for income tax purposes pursuant to Treas. Reg. Section 1.641(b)-3.

  4. The estate (or trust) receives a payment that equals or exceeds the fair market value of the foundation's interest in the property at the time of the transaction, taking into account the terms of any option to which the property was subject when acquired by the estate or trust.

  5. The transaction results in the foundation receiving property that is at least as liquid as it gave up, property related to its charitable activities, or the property specified by the option.

The IRS has issued numerous PLRs in which, because the parties have satisfied all of the requirements of the safe harbor, transactions between an estate with a private foundation as a residuary beneficiary and a disqualified person that would otherwise be self-dealing have been permitted.

A COMPARISON

For some clients, this safe harbor is a relatively easy way to avoid self-dealing excise taxes. But others may find it difficult to satisfy all of the safe harbor requirements, especially that a court approve the proposed transaction. Getting court approval may be unpalatable because of timing or privacy issues.

Another possible solution, at least prospectively, might be to draft the will or revocable trust agreement so that only a pecuniary amount could be renounced in favor of the private foundation. While there are several rulings in which a private foundation that received only a pecuniary bequest during the estate administration period was treated as potentially violating the self-dealing rules,11 a strong argument can be made that the self-dealing rules should not be implicated if the pecuniary bequest is small relative to the size of the estate. In this instance, a transaction between the estate and a disqualified person should not affect the foundation's interest or expectancy in property held by the estate.

Consider our example with a slightly different set of facts:

Assume that the decedent's will provides for a bequest of $2,000,000 to each of his sons, X, Y and Z. If one of his sons disclaims any portion of this bequest, the will provides that a foundation created and funded by the decedent during his lifetime will receive the disclaimed funds. The residue of his estate (which includes the decedent's pottery collection) will be paid in equal shares to those of the decedent's grandchildren who survive the decedent. Four months after the date of the decedent's death, Y purchases the decedent's collection from the estate. Several months later, X disclaims his entire interest in his $2 million bequest. Under the terms of the will, the disclaimed assets pass to the decedent's private foundation.

Once again, the private foundation has an interest in the assets held by the estate and the sale of the collection by the estate to Y precedes X's disclaimer. As in our example's earlier configuration, if, as a result of the disclaimer, the foundation were a beneficiary of the decedent's residuary estate, the IRS would have a strong argument that the sale of the collection to Y was, in retrospect, a self-dealing transaction. The IRS could argue the disclaimer related back to the decedent's date of death and, therefore, the sale transaction affected the foundation's interest or expectancy in the property. The IRS might even argue that, even if X never actually disclaimed his interest in the bequest, the private foundation had an interest or expectancy in such property until the disclaimer period ended.12

The two versions of our hypothetical differ because, although the foundation might have an interest or expectancy in the estate's assets, this interest or expectancy may not be affected by the sale, particularly if the size of the foundation's interest is relatively small in relation to the size of the entire estate. The foundation's potential interest is valued at $2 million. If the collection being sold is worth $2 million but the decedent's total estate is worth $50 million, the IRS would be hard-pressed to argue that the sale of the collection could have any effect on the foundation's interest in the estate. If the value of the total estate were much less than $50 million, assets equal in value to the value of the collection might be necessary to fund the specific bequests to X and Y. A sale of the collection to Y would be more likely to affect the foundation's interest (or possible interest) in the estate.13

SOLUTIONS?

The estate administration exception set forth in the Treas. Regs. is only one way around the potential excise tax issues. Drafting the testamentary instrument to appoint a private foundation as default beneficiary only in the event of a disclaimer of a pecuniary amount is another possible solution.

The Services ruling in PLR 9724018 is troubling, even outside the context of disclaimers during estate administration. It is common for wills and revocable trusts, as well as irrevocable inter vivos trusts for that matter, to name a private foundation created by the decedent (or the settlor in the case of an inter vivos trust) as a contingent remainderman. Does this mean that the fiduciaries of every such estate or trust need to avoid engaging in any transaction that would affect the foundation's interest or expectancy in the property held in the trust? While this seems far-fetched, PLR 9724018 implies that this is the Service's position.

To avoid confusion, a self-dealing de minimis rule might be in order. Such a rule could provide, for example, that the self-dealing rules would not be implicated when the actuarial value of the private foundation's contingent remainder interest was less than 5 percent of the value of the assets held in the estate or trust. In addition, an extension of the estate administration exception found in Treas. Reg. Section 53.4941(d)-1(b)(3) to irrevocable inter vivos trusts would be helpful.

Endnotes

  1. Private Letter Ruling 9040063 (July 12, 1990).
  2. See, for example, Rockefeller v. Comm'r, 572 F.Supp. 9 (D.C. Ark., 1982), aff'd, 718 F.2d 290 (8th Cir. 1983), cert. denied, 466 U.S. 962, (1984); Rev. Rul. 76-18, 1976-1 C.B. 355; PLR 200224033 (Mar. 19, 2002); PLR 200207028 (Nov. 21, 2001); PLR 200124029 (Mar. 22, 2001); PLR 200148080 (Sept. 5, 2001); PLR 200024052 (Mar. 9, 2000); PLR 9818063 (Feb. 4, 1998); PLR 9839029 (June 29, 1998); PLR 9752071 (Oct. 1, 1997); PLR 9739033 (June 27, 1997); PLR 9724018 (Mar. 17, 1997); PLR 9421005 (Feb. 14, 1994).
  3. See PLR 200519082 (Feb. 17, 2005); PLR 200219036 (Feb. 11, 2002); PLR 200132037 (May 15, 2001); PLR 199917078 (Jan. 28, 1999); PLR 9839028 (July 24, 1998); PLR 9734020 (May 19, 1997); PLR 9709028 (Nov. 27, 1996); PLR 9525056 (March 27, 1995); PLR 9438045 (June 30, 1994).
  4. See PLR 200124029 (March 22, 2001); PLR 200024052 (March 9, 2000); PLR 199924069 (March 23, 1999); PLR 9818063 (Feb. 4, 1998); PLR 9724018 (March 17, 1997); PLR 9501038 (Oct. 6, 1994); PLR 9434042 (June 3, 1994).
  5. For a discussion of this and other types of executor actions during the course of estate administration (such as decisions regarding asset and expense allocation) that might be classified as self-dealing transactions, see M. Antoinette Thomas, “Private Foundations Breed
    Estate Planning Complexities,” 62 Practical Tax Strategies 17 (1999); Jonathan Blattmacher, “Something Pretty Scary: Application of Certain Private Foundation and UBTI Rules in Estate Planning and Administration,” Institute on Estate Planning (Chap.10 1992).
  6. New York Estates Powers and Trusts Law Section 2-1.11.
  7. There is a PLR in which an estate's residuary beneficiaries disclaimed a portion of their interests in the residue. The will provided that disclaimed assets were to pass to a private foundation. This ruling is not particularly helpful, because the proposed transaction that might have been classified as a self-dealing transaction took place after the disclaimer, when the private foundation's interest in the residue was no longer contingent. See PLR 200148080 (Sept. 5, 2001).
  8. March 6, 1992.
  9. Nov. 23, 1990.
  10. March 17, 1997.
  11. See PLR 199924069 (March 23, 1999); PLR 9739033 (June 27, 1997); PLR 9501038 (Oct. 6, 1994).
  12. Cf. PLR 9724018.
  13. The IRS has examined whether a foundation's interest in an estate would be affected by a particular transaction during the course of estate administration in determining whether indirect self-dealing had occurred. For example, in a Field Service Advisory (1997 WL 33314899 (Oct. 31, 1997)), the decedent's revocable trust agreement provided that certain shares of stock held in the trust were to be transferred to a private foundation, subject to a stock purchase option which gave three disqualified persons the option to purchase all of decedent's shares at a set price. The options were exercised, which meant that the foundation had the right only to the cash provided by the option price. Prior to the exercise, the estate sold other assets to two of the disqualified persons. The IRS indicated that this sale of assets did not give rise to self-dealing under IRC Section 4941 because the amount of cash the foundation was entitled to receive “was unaffected by the asset sale and loan that are the subject of this case since this option price was determined as of a date prior to these transactions.”

SELF-DEALING AND EXCEPTIONS

It pays to know the rules

Typical self-dealing transactions, subject to certain exceptions, include:

  • Sale or exchange of property — The sale or exchange of property between a private foundation and a disqualified person is an act of self-dealing. This will be the case even if the private foundation benefits from the transaction.

  • Leases — A lease between a private foundation and a disqualified person is an act of self-dealing, unless the lease is a lease to the private foundation and the lease is without charge.

  • Loans — A loan between a private foundation and a disqualified person is an act of self-dealing, unless the loan is a loan to the private foundation and it bears no interest.

  • Furnishing goods, services or facilities — The furnishing of goods, services, or facilities between a private foundation and a disqualified person is an act of self-dealing.

  • Payment of compensation — The payment of compensation by a private foundation to a disqualified person is an act of self-dealing. Unless the recipient is a government official, payment of compensation and reimbursement of expenses for personal services performed by the disqualified person is not an act of self-dealing if the services are reasonable and necessary to carry out the purposes of the foundation and payment is not excessive.

  • Transfer or use of the income or assets of the private foundation — The transfer to, or use by or for the benefit of a disqualified person of the assets of a private foundation is an act of self-dealing unless the benefit to the disqualified person is incidental and tenuous (that is to say, small in relation to the broader exempt purpose of the activity). Prohibited uses of a foundation's assets for the benefit of a disqualified person includes guarantees of loans made by disqualified persons and the use of foundation funds to satisfy charitable pledges made by disqualified persons.
    Elyse G. Kirschner