Earlier this month, we learned that the Donald J. Trump Foundation admitted to acts of self-dealing in its most recent IRS filing.
But what is self-dealing and, more significantly, what does it mean for the president-elect as he deals with his many conflict of interest issues when he runs the country?
The potential of these conflicts to become problems surfaced recently as the president-elect began discussions with foreign leaders. As illustrated by his conversations with Japan’s prime minister, Indian business partners and Argentina’s prime minister, his vast global business holdings suggest his decision-making could be influenced by his financial interests.
As researchers who have examined the filings and activities of foundations for years, we see this high-profile case as an opportunity to explain self-dealing, its consequences, how it can be avoided and what it may mean for the incoming administration.
What is self-dealing?
Though the intrepid reporting of David Fahrenthold of the Washington Post brought questions of self-dealing at the Trump Foundation forward months ago, this is the first admission by the foundation itself.
These issues provide a backdrop to the broader discussion of conflicts of interest the president-elect faces, an issue he had planned to address but has since postponed. This is particularly true if early reporting that he intends to keep financial interests in his various businesses materializes.
Self-dealing refers to a class of transactions between a private foundation and a person who exercises control over it because of official authority or because of large contributions. Such individuals are referred to in the statute as “disqualified persons.”
There are precise definitions for the different types of transactions (e.g., sales, loans, use of facilities, transfer of assets, etc.) that fall under this classification. But the gist of the rule is that an activity conducted by the private foundation that could benefit a person who has substantial influence over the foundation’s decisions is generally viewed as prohibited self-dealing.
In the Trump Foundation case, the potential self-dealing transactions are many: from buying a painting at a charity auction that was displayed at Trump-owned properties and using a foundation grant as a means to settle a lawsuit to using foundation funds in promotion of “Celebrity Apprentice.”
Because the foundation has not made the details public, we cannot say for sure which, if any, of these is the source of the admission, but they all have a similar flavor: the foundation spends funds in a way that can benefit Trump himself.
Why is the rule in place?
Congress grants charitable organizations both exemption from income tax and the ability to accept tax deductible contributions. In exchange for this subsidy, Congress views these organizations as holding money for public charitable purposes and insists funds are used accordingly.
Private foundations are in a particularly delicate position in this regard because they are typically established and controlled by one wealthy family. In a report from the U.S. Treasury Department in 1965, its legal counsel indicated concern that a small group of founders of private foundations were using charities as their private piggy banks. They might make their private foundation lease or buy property from themselves for too much money. In response to these concerns, Congress included a tax on all self-dealing in the 1969 Tax Act to reduce the potential for abuse.
The Trump Foundation’s recent admission that it engaged in self-dealing is uncommon in the private foundation world. Over the most recent 10-year period for which IRS data is available (2004-2013), fewer than 0.25 percent of returns filed by private foundations entailed recognized acts of self-dealing.
This is consistent with the findings of the Treasury Department in its 1965 report, which focused on a small number of violations and has led Congress to continue to find ways to rein in abuses in the broader charitable sector.
What are the consequences?
The legislation prohibiting self-dealing did not criminalize this activity. Thus, the fact that the Trump Foundation admitted self-dealing is not an admission that it engaged in an illegal act.
However, there are two primary consequences that result from a self-dealing transaction. First, the disqualified person who engaged in a self-dealing transaction must pay a tax equal to 10 percent of the greater of the amount paid or the fair market value of the transaction. For instance, if a disqualified person sold a building to a private foundation in a self-dealing transaction for $100,000, the disqualified person would owe an excise tax of $10,000 (assuming the fair market value is also $100,000).
Secondly, the charity must seek to correct the transaction, meaning it must reverse what took place. The disqualified person must return the money or thing he or she received. If the disqualified person does not correct the transactions after the IRS assesses the self-dealing excise tax, other more significant taxes can apply.
Self-dealing rules were written to address situations that are ethically difficult. When a private foundation and its founder engage in a transaction, it can be hard to tell whether the foundation got the bad end of the stick or not.
The Trump Foundation, however, seems to have engaged in some transactions where there may be more clear benefits to the disqualified person, for example, when the foundation acquired paintings of its founder. Such instances could also violate a charity law called inurement, which prohibits a charitable organization from providing its earnings to its founders or those who control it. If the IRS were to determine that the Trump Foundation violated the inurement prohibition, the IRS could revoke its tax exemption.
Finally, and least likely, there could be criminal consequences for Trump or others if they were found to have willingly and knowingly filed false returns. It is highly unlikely that the IRS would bring such a case. Typically, the IRS only brings such cases when it finds a pattern of egregious conduct.
How do organizations prevent self-dealing?
While the penalties associated with self-dealing are real, the bigger picture is that self-dealing is a symptom of a governance failure.
Self-dealing arises when a governance system fails to adequately separate the interests of influential individuals from the mission of the institution they serve. Such failings permeate the institution well beyond the isolated acts of self-dealing to the point of threatening the organization’s credibility.
The principles of effective governance that shield against self-dealing and build public trust for foundations are arguably universal in that they form the hallmark of effective governance for a variety of institutions. In particular, foundations that instill public trust:
Develop a culture that makes clear distinctions between the institution and the individuals who run it. This can be achieved by putting rules in place that no single individual has excessive authority for decision-making or receives outsized pay;
Remove potential conflicts of interest, both real and perceived. Foundations can ensure this by establishing a policy that activities are not approved unless it is first concluded that they will not benefit insiders or could even be perceived as such; and
Establish and respect layers of independent review. This is assured in foundations by segregating duties so that decisions must be reviewed and/or approved by those without connections, familial or otherwise, to those who are most influential.
Preparing to lead a much larger organization
The principles of private foundation governance surely could help prevent self-dealing at the Trump Foundation moving forward; however, they may also represent much more than that.
Given Trump’s substantial conflicts of interest created by his international business holdings, self-dealing at the Trump Foundation should serve as a warning bell for the president-elect – and the rest of us – as he prepares to take the reigns of a much larger taxpayer-subsidized institution.
Self-dealing at a relatively small foundation should be an affront to taxpayers, albeit one with limited repercussions. Self-dealing when you’re the president with an obligation to put the public trust ahead of your own personal and business interests could be calamitous.
Philip Hackney, James E. & Betty M. Phillips Associate Professor of Law, Louisiana State University and Brian Mittendorf, Fisher College of Business Distinguished Professor of Accounting, The Ohio State University