Family foundation funding relatives' research

[John Levine]

A guy I know has this bright idea: set up a non-profit, presumably
501(c)(3), make tax deductible contributions to it, and pay grants out
to fund research being done by a relative. The relative's research is
legit, she's gotten a Fullbright to support part of it, but this
strikes me as transparently illegal.

He argues that it's fine, or alternatively that if done at small scale
the IRS will never notice. Advice welcome, particularly with
citations.

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[Sandy]

A 501(c)(3) non-profit funded by a single person or family would be considered a private foundation. [Section 509 of the Internal Revenue Code] Private foundations that make grants of this kind must submit their "grant-making procedures" to the IRS in advance of making any grants. If they do not, there is a 20% excise tax (basically, a penalty tax) imposed on the foundation, and a 5% excise tax imposed on foundation managers that go along with it. [Section 4945 of the Internal Revenue Code] Private foundations are also subject to a tax on "self-dealing." Whether this tax applies would depend on whether the relative is a close enough relative to fall into one of the categories of "disqualified persons." The excise tax for self dealing is 10% on the self-dealer and 5% on foundation managers. [Section 4941 of the Internal Revenue Code]