A reader sent the following article about IRS scrutiny of the financial management of charters, especially for-profit management companies.
Alert: Increased IRS Scrutiny of Charter Schools Operated by For-Profit Management Companies
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.
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. 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. 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.
Rothgerber Johnson & Lyons LLP has a team of attorneys dedicated to serving all aspects of charter school operations, from formation, to tax qualification, to charter school financing, to personnel and operational issues. For additional information contact:
Eric V. Hall 719.386.3005 begin_of_the_skype_highlighting 719.386.3005 end_of_the_skype_highlighting email@example.com
Christopher Freeman 303.628.9596 begin_of_the_skype_highlighting 303.628.9596 firstname.lastname@example.org
H. William Mahaffey 719.386.2005 begin_of_the_skype_highlighting 719.386.2005 email@example.com
 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.
 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.