irs scrutiny for for-profit mgrs

7/28/2019 Irs Scrutiny for for-profit Mgrs

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lert: Increased IRS Scrutiny ofCharter Schools Operated by For-

Profit Management CompaniesAuthor(s): Eric V. Hall, H. William Mahaffey, Christopher D.FreemanPublished: 06/18/2012

n some cases, charter schools are managed by for-profit entities(referred to in this article as "management companies"). Themanagement agreements documenting these relationships range fromagreements to provide general administrative support to agreements toprovide virtually every service to be offered by the charter school,including curriculum, payroll, compliance reporting, providing teachersand staff through employee leasing, and the purchase and leasing of

facilities.

Many charter schools are intended to be operated as 501(c)(3) publiccharities. Historically, the Internal Revenue Service ("IRS") has carefullyreviewed other types of charitable organizations operated bymanagement companies to determine whether they qualify as a tax-exempt charities because they are, in fact, operating for the privatebenefit of the for-profit management company. However, the IRS hasnot brought a similar focus on this issue to charter schools generally until now. The IRS is poised to increase its scrutiny of charterschool/management company relationships and is now subjectingcharter schools to more stringent standards defining such relationships.

Certainly, for those charter schools with management companies that

are now seeking or will be seeking tax-exempt status, the level scrutinyof applications for recognition of tax-exempt status will increase.

Charter schools subject to management agreements that are alreadyexempt should be prepared to closely review their managementagreements with their counsel to confirm that the managementagreement does not violate private inurement and private benefitrestrictions applicable to all charitable organizations.

The IRS has thus far refused to disclose the standards and criteria it willemploy in reviewing tax exemption applications of charter schools withmanagement companies. It is clear that the IRS's review of charterschool management agreements will become more common and

burdensome for both existing and new charter schools, and may requireamending management agreements both with respect to theirsubstantive terms and their pricing.

Background

Charter Schools. Most charter schools are nonprofit charities describedin Internal Revenue CodeSection 501(c)(3). As nonprofits, charterschools often obtain certain benefits including exemption from federaland state income taxes, property tax, and sales tax. As nonprofits,charter schools also qualify for federal and state educational funding.

Management Companies. Many charter schools have contracts through

which the school cedes significant control over school operations to a

ATTORNEYSChristopher D. FreemanEric V. HallH. William Mahaffey

AREAS OF PRACTICECharter Schools & School Finance

Page 1lert: Increased IRS Scrutiny of Charter Schools Operated by For-Profit Management Companies

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management company. Generally, these companies are for-profitcompanies. Typically, a management company assists in establishing thecharter school entity and thereafter provides employees, administrationand most or all management services. Through its contract, themanagement company may control all of the public funding providedto the school, and may in fact control all of the charter schooloperations, staff and activities. In some cases, management companiesrecruit individuals to serve as charter school board members in theirocal communities, and enter into agreements with the new school'sboard of directors significantly limiting their authority to design andimplement charter school programs. In other cases, the charter school's

ocal founders may establish their own management entity whichmanages the school, for a fee set forth in the management agreementwith the founders or their affiliates. All of these arrangements have thepotential to be fair and reasonable, and not affect a charter school'sstatus. However, these same arrangements can cause the charter schoolto lose its exempt status, and can expose its board members, as well asthe management company, to potential penalties and taxes, if thearrangement demonstrates that the charter school is in fact beingoperated for the benefit of the management company, or if excessivecompensation is being paid to the management company.

The IRS's Role. The IRS's Exempt Organizations Division is charged withoverseeing all nonprofit organizations and ensuring that in operation,

nonprofits abide by federal statutory and regulatory standards. In thecharter school context, tax exemption and, likely, public funding, areconditioned upon schools operating within this complex regulatoryregime and achieving their exempt purposes.

The Management Company "Problem"

Charter school/management company relationships have longconfounded the IRS. The IRS's principal concern is that a nonprofit entitycontrolled by a for-profit entity may operate to reduce costs andmaximize revenue rather than to maximize the delivery of educationalservices. The perception of a conflict of interest is unavoidable.

lthough the IRS has acknowledged these relationships for many years,it has established no defined or consistent approach in analyzing whatrelationships are permissible for charter schools. Consequently, manymanagement companies have become aggressive in creating andperpetuating relationships with charter schools. The IRS believes that inegregious instances, management companies have so profoundly takencontrol of charter schools as to vitiate the public benefit the schools arecreated to fulfill.

n these egregious instances, "private benefit" or "private inurement"

concerns arise.[1] As described above, tax-exempt charter schools mustoperate exclusively for a public benefit - i.e., the benefit of theirstudents. When a management company's control of a school ispervasive, and where there is little transparency in regard to the

management company's expenditure of public funds, there exists thepotential that the management company could operate the school forits own benefit rather than for the benefit of the school and its students.

For example, a management company having full control over schoolfinances and operations might operate the school in a manner thatcreates "profit" for the management company resulting from excessfunding not spent in operations. Alternatively, such a managementcompany, when determining how to operate, could cause the charterschool to further the management company's interest, rather than theinterests of the charter school. Examples of this impermissible "privatebenefit" could include causing or requiring the charter school topurchase or license educational materials from the managementcompany, rather than acquiring materials in the open marketplace.




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nother example could be payment of excessive compensation to themanagement company under a management agreement. In suchcircumstances, the management company may be operating in its owninterests rather than in the best interests of students and the communitythe school serves.

n such instances, according to provisions of the Internal Revenue Code,Treasury Regulations, prior rulings and jurisprudence, the IRS maypenalize the charter school for transgressing the private benefit and/orprivate inurement prohibitions applicable to all charitableorganizations. Further, the management company as a for-profit serviceprovider and, under some circumstances, the charter school's boardmembers, could also be penalized under a separate set of"intermediate sanction" rules adopted by the Congress to punishindividuals and organizations that are overcharging for servicesrendered to a public charity.

Sanctions for private benefit and/or private inurement transgressionscan be severe. Certainly, in an instance in which a substantial privatebenefit or private inurement arises, the IRS would impose tax andpenalties for tax years of the charter school currently open under the

applicable statute of limitations.[2] In severe cases, the IRS may alsorevoke the charter school's tax exemption. Additional concerns mayarise at the state and local level, not to mention the potential for

awsuits filed against the school by members of the community.

While the IRS Implements Its Plan, What Can Charter Schools andTheir Boards of Directors Do?

Despite its belief that egregious charter school/management companyrelationships are prevalent, the IRS's Exempt Organizations Division,historically, has had no defined or consistent approach in investigatingor dealing with these situations. We understand that the IRS haschanged course, and is now implementing a plan to deal with charterschools that have contracted with management companies.

We believe that new standards will call for enhanced scrutiny of all

charter schools with management company relationships. These strictstandards, and the IRS's enhanced scrutiny, will be imposed on reviewof all existing and new applications for exemption and will be appliedto examine existing relationships.

s the IRS undertakes this effort, the benefit for charter schooladministrators and boards of directors is that there is time to engage inan internal "audit" to ensure that any management companyrelationship is appropriate and reasonable. Of the many issues to beawareof andconcerned with, it is imperative that charter schooladministrators and boards of directors understand the following:

z If the IRS enhances its scrutiny as expected, the principal risk isto the charter schools' tax-exempt status. Therefore, significantrisk is borne by the charter schools and the students they serve.Very little risk, at this stage, is borne by managementcompanies. This creates a potential conflict of interest betweencharter school boards of directors and management companies.

z Any charter school with a management company relationshipthat is seeking tax exemption should expect heavy scrutiny of itsapplication, including significant additional document andinformation requests.

z Existing charter schools should expect that any managementcompany contracts will be scrutinized by the IRS. We believethat in the future, such contracts could be subjected to morespecific and stringent standards governing terms and provisionsof the relationship.

z

Boards of directors of charter schools with management




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company contracts in place should consult with counsel todetermine the reasonableness of the terms of the contract andthe overall management company relationship with the school.

z Specific board procedures should be adopted and implementedfor the annual review and evaluation of management contracts.

z Charter schools already under audit by the IRS should contactcompetent independent counsel as soon as possible, especiallywhen considering any request by the IRS to extend the statute oflimitations applicable to any year under audit. Charter schoolsshould be careful to not utilize or rely on counsel provided bythe management companies.

The IRS has not issued precise standards, guidelines or requirements forcharter school/management company relationships. However, recentquestionnaires issued by the IRS in charter school applications this firm ishandling illustrate some of the issues the IRS is considering. Thetreatment of management companies in other charitable contexts is alsorelevant. We expect the IRS to pay particular attention to:

z The duration of, and ability to terminate, the contract;z Pricing (including any contracts where pricing is based on a

percentage of charter school revenues);z The provision of staff through employee leasing arrangements;z The provision of curriculum services;

z The sale or licensing of educational materials to the charterschool; and,z Arrangements which interfere with the independent governance

of the charter school by its board of directors.

t is clear that the IRS is poised to deal with the problems it perceiveswith charter school management companies. Those charter schools thatare now parties to a management agreement should contact counsel toreview their current arrangements, and to develop a plan of action forthese pending IRS changes.

Rothgerber Johnson & Lyons LLP has a team of attorneys dedicated toserving all aspects of charter school operations, from formation, to taxqualification, to charter school financing, to personnel and operationalissues. For additional information contact:

Eric V. Hall 719.386.3005 [email protected]

Christopher Freeman 303.628.9596 [email protected]

H. William Mahaffey 719.386.2005 [email protected]

[1] Although a full analysis of these doctrines is beyond the scope of

this article, the private benefit and private inurement doctrines broadlyprohibit nonprofit organizations from having any relationship in whichthe organizations provide more than an incidental benefit to privateindividuals or entities, or pay amounts to private individuals in excess offair value for services or property. These issues are extraordinarilycomplex and subjective, and we recommend that as soon as anyconcern arises in regard to these subjects, that the charter school boardseek assistance from counsel.

[2] We note that in addition to the major issues raised in this briefalert, there are many other complex issues that must be considered inany private benefit or private inurement investigation.


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irs scrutiny for for-profit mgrs

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