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Client Alert

Increased IRS Scrutiny of Charter Schools Operated by For-Profit Management ‎Companies

June 18, 2012

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

Many charter schools are intended to be operated as 501(c)(3) public charities. Historically, the ‎Internal Revenue Service ("IRS") has carefully reviewed other types of charitable organizations ‎operated by management companies to determine whether they qualify as a tax-exempt charities ‎because they are, in fact, operating for the private benefit of the for-profit management company. ‎However, the IRS has not brought a similar focus on this issue to charter schools generally – until ‎now. The IRS is poised to increase its scrutiny of charter school/management company ‎relationships and is now subjecting charter 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 scrutiny of applications for recognition of tax-exempt status ‎will increase. ‎

Charter schools subject to management agreements that are already exempt should be prepared to ‎closely review their management agreements with their counsel to confirm that the management ‎agreement does not violate private inurement and private benefit restrictions applicable to all ‎charitable organizations. ‎

The IRS has thus far refused to disclose the standards and criteria it will employ in reviewing tax ‎exemption applications of charter schools with management companies. It is clear that the IRS's ‎review of charter school management agreements will become more common and burdensome for ‎both existing and new charter schools, and may require amending management agreements – ‎both with respect to their substantive terms and their pricing. ‎

Background

Charter Schools. Most charter schools are nonprofit charities described in Internal Revenue ‎Code Section 501(c)(3). As nonprofits, charter schools often obtain certain benefits including ‎exemption from federal and 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 management company. Generally, these companies ‎are for-profit companies. Typically, a management company assists in establishing the charter ‎school entity and thereafter provides employees, administration and most or all management ‎services. Through its contract, the management company may control all of the public funding ‎provided to the school, and may in fact control all of the charter school operations, staff and ‎activities. In some cases, management companies recruit individuals to serve as charter school ‎board members in their local communities, and enter into agreements with the new school's board ‎of directors significantly limiting their authority to design and implement charter school ‎programs. In other cases, the charter school's local founders may establish their own management ‎entity which manages the school, for a fee set forth in the management agreement with the ‎founders or their affiliates. All of these arrangements have the potential to be fair and reasonable, ‎and not affect a charter school's status. However, these same arrangements can cause the charter ‎school to lose its exempt status, and can expose its board members, as well as the management ‎company, to potential penalties and taxes, if the arrangement demonstrates that the charter school ‎is in fact being operated for the benefit of the management company, or if excessive ‎compensation is being paid to the management company. ‎

The IRS's Role. The IRS's Exempt Organizations Division is charged with overseeing all ‎nonprofit organizations and ensuring that in operation, nonprofits abide by federal statutory and ‎regulatory standards. In the charter school context, tax exemption and, likely, public funding, are ‎conditioned upon schools operating within this complex regulatory regime and achieving their ‎exempt purposes. ‎

The Management Company "Problem"‎

Charter school/management company relationships have long confounded the IRS. The IRS's ‎principal concern is that a nonprofit entity controlled by a for-profit entity may operate to reduce ‎costs and maximize revenue rather than to maximize the delivery of educational services. The ‎perception of a conflict of interest is unavoidable. ‎

Although the IRS has acknowledged these relationships for many years, it has established no ‎defined or consistent approach in analyzing what relationships are permissible for charter schools. ‎Consequently, many management companies have become aggressive in creating and ‎perpetuating relationships with charter schools. The IRS believes that in egregious instances, ‎management companies have so profoundly taken control of charter schools as to vitiate the ‎public benefit the schools are created to fulfill. ‎

In these egregious instances, "private benefit" or "private inurement" concerns arise.[1] As ‎described above, tax-exempt charter schools must operate exclusively for a public benefit - i.e., ‎the benefit of their students. When a management company's control of a school is pervasive, and ‎where there is little transparency in regard to the management company's expenditure of public ‎funds, there exists the potential that the management company could operate the school for its ‎own benefit rather than for the benefit of the school and its students. ‎
For example, a management company having full control over school finances and operations ‎might operate the school in a manner that creates "profit" for the management company resulting ‎from excess funding not spent in operations. Alternatively, such a management company, when ‎determining how to operate, could cause the charter school to further the management company's ‎interest, rather than the interests of the charter school. Examples of this impermissible "private ‎benefit" could include causing or requiring the charter school to purchase or license educational ‎materials from the management company, rather than acquiring materials in the open marketplace. ‎Another example could be payment of excessive compensation to the management company ‎under a management agreement. In such circumstances, the management company may be ‎operating in its own interests rather than in the best interests of students and the community the ‎school serves. ‎

In such instances, according to provisions of the Internal Revenue Code, Treasury Regulations, ‎prior rulings and jurisprudence, the IRS may penalize the charter school for transgressing the ‎private benefit and/or private inurement prohibitions applicable to all charitable organizations. ‎Further, the management company as a for-profit service provider and, under some ‎circumstances, the charter school's board members, could also be penalized under a separate set ‎of "intermediate sanction" rules adopted by the Congress to punish individuals and organizations ‎that are overcharging for services rendered to a public charity. ‎

Sanctions for private benefit and/or private inurement transgressions can be severe. Certainly, in ‎an instance in which a substantial private benefit or private inurement arises, the IRS would ‎impose tax and penalties for tax years of the charter school currently open under the applicable ‎statute of limitations.[2] In severe cases, the IRS may also revoke the charter school's tax ‎exemption. Additional concerns may arise at the state and local level, not to mention the ‎potential for lawsuits filed against the school by members of the community.‎

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

Despite its belief that egregious charter school/management company relationships are prevalent, ‎the IRS's Exempt Organizations Division, historically, has had no defined or consistent approach ‎in investigating or dealing with these situations. We understand that the IRS has changed course, ‎and is now implementing a plan to deal with charter schools 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 strict standards, and the IRS's enhanced scrutiny, will ‎be imposed on review of all existing and new applications for exemption and will be applied to ‎examine existing relationships. ‎

As the IRS undertakes this effort, the benefit for charter school administrators and boards of ‎directors is that there is time to engage in an internal "audit" to ensure that any management ‎company relationship is appropriate and reasonable. Of the many issues to be aware of and ‎concerned with, it is imperative that charter school administrators and boards of directors ‎understand the following:‎

  • If the IRS enhances its scrutiny as expected, the principal risk is to the charter schools' ‎tax-exempt status. Therefore, significant risk is borne by the charter schools and the ‎students they serve. Very little risk, at this stage, is borne by management companies. This ‎creates a potential conflict of interest between charter school boards of directors and ‎management companies. ‎ 
  • Any charter school with a management company relationship that is seeking tax ‎exemption should expect heavy scrutiny of its application, including significant additional ‎document and information requests. ‎ 
  • Existing charter schools should expect that any management company contracts will be ‎scrutinized by the IRS. We believe that in the future, such contracts could be subjected to ‎more specific and stringent standards governing terms and provisions of the relationship. ‎ 
  • Boards of directors of charter schools with management company contracts in place ‎should consult with counsel to determine the reasonableness of the terms of the contract ‎and the overall management company relationship with the school. ‎ 
  • Specific board procedures should be adopted and implemented for the annual review and ‎evaluation of management contracts. ‎ 
  • Charter schools already under audit by the IRS should contact competent independent ‎counsel as soon as possible, especially when considering any request by the IRS to extend ‎the statute of limitations applicable to any year under audit. Charter schools should be careful to not utilize or rely on counsel provided by the management companies. ‎

The IRS has not issued precise standards, guidelines or requirements for charter ‎school/management company relationships. However, recent questionnaires issued by the IRS in ‎charter school applications this firm is handling illustrate some of the issues the IRS is ‎considering. The treatment of management companies in other charitable contexts is also relevant. ‎We expect the IRS to pay particular attention to:‎

  • The duration of, and ability to terminate, the contract; ‎ 
  • Pricing (including any contracts where pricing is based on a percentage of charter school ‎revenues); ‎ 
  • The provision of staff through employee leasing arrangements; ‎ 
  • The provision of curriculum services; ‎ 
  • The sale or licensing of educational materials to the charter school; and, ‎ 
  • Arrangements which interfere with the independent governance of the charter school by ‎its board of directors. ‎

It is clear that the IRS is poised to deal with the problems it perceives with charter school ‎management companies. Those charter schools that are now parties to a management agreement ‎should contact counsel to review their current arrangements, and to develop a plan of action for ‎these pending IRS changes. ‎


[1] Although a full analysis of these doctrines is beyond the scope of this article, the private ‎benefit and private inurement doctrines broadly prohibit nonprofit organizations from having any ‎relationship in which the organizations provide more than an incidental benefit to private ‎individuals or entities, or pay amounts to private individuals in excess of fair value for services or ‎property. These issues are extraordinarily complex and subjective, and we recommend that as ‎soon as any concern arises in regard to these subjects, that the charter school board seek ‎assistance from counsel.‎

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