A Tax Lesson for Education Law

I. Introduction

Conversions of for-profit colleges into nonprofit entities have prompted concern from policymakers, primarily about the possibly disproportionate and continuing benefit to former owners of the for-profit entities. At the request of several concerned members of Congress, the Government Accountability Office issued a report in December 2020 on these conversions.¹ On April 20 the House Education and Labor Committee held a hearing² to consider the report’s findings. I believe the GAO report does not sufficiently explain the operation and effect of the applicable tax law.³ In particular, it does not distinguish the different tax law definitions of insiders that apply at various points in the life cycle of a tax-exempt section 501(c)(3) organization. Examining the gaps in the report, moreover, highlights the special rules applicable to section 501(c)(3) organizations that also qualify as governmental affiliates. It also exposes uncertainties in the initial contract exception in the intermediate sanctions regime of section 4958. Finally, consideration of the report calls attention to another important but often ignored issue — how agencies other than the IRS should interpret language borrowed from the IRC.

II. Improved Oversight

The GAO report recommends that both the Department of Education and the IRS improve oversight of these conversions. For the IRS, the report recommends that it assess its internal controls for reviewing for-profit college applications for tax-exempt status and that it collect additional information on Form 990, “Return of Organization Exempt From Income Tax,” which most tax-exempt organizations are required to file annually.⁴

Any discussion of the role that the IRS plays in the conversion of for-profit into nonprofit colleges must acknowledge the enforcement challenges facing the IRS in general and its regulation of exempt organizations in particular. As has been much in the news of late, the IRS has become seriously underfunded.⁵ This resource limitation has had an effect on IRS oversight of exempt organizations,⁶ including review of exemption applications⁷ and examination of Form 990.⁸ Thus, although the IRS seeks to ensure compliance with several sets of tax laws addressing self-dealing between exempt organizations and their insiders (and, in some cases, with specific “outsiders” as well), it has only a limited ability to do so.

Conversion transactions involving already established section 501(c)(3) organizations are to be reported on Form 990. Like much else on Form 990, however, those conversion transactions are often not described in detail. And even when an organization fully describes a conversion transaction, the IRS will seldom examine the disclosure. According to the Treasury Inspector General for Tax Administration, the IRS examined only 0.13 percent of Forms 990 in fiscal year 2019, compared with 0.64 percent of corporate returns and 0.44 percent of individual returns.⁹

Moreover, section 501(c)(3) organizations that also qualify as governmental affiliates are exempt from the Form 990 filing requirement.¹⁰ The GAO report’s concern regarding insufficient audits of Forms 990 does not acknowledge that, however many audits take place, they would never involve public universities or colleges because under tax rules, these institutions do not file the form.¹¹

III. Backstopping IRS Limits

These limitations on the IRS underscore the importance of other government agencies undertaking their own examinations when they have oversight responsibilities paralleling and overlapping those of the IRS in regulating exempt organizations. Here, education law, in both the statutory and regulatory language,¹² echoes the requirement of the IRC that “no part of the net earnings” of a section 501(c)(3) organization “inures to the benefit of any private shareholder or individual” (statutory private inurement prohibition).

Although that language closely tracks the statutory private inurement prohibition of 501(c)(3),¹³ it stands as a separate and distinct requirement under education law, independent of a regulatory cross-reference to section 501(c)(3).¹⁴ Moreover, these statutory and regulatory statements in education law define nonprofit. The term is primarily a term of state law,¹⁵ while federal tax law involves tax exemption. Although “nonprofit” is often used as shorthand to describe organizations that are both nonprofit under state law and tax exempt under federal tax law, not all nonprofits are in fact tax exempt.

As the choice of “nonprofit” rather than “tax exempt” in education law suggests, the statutory private inurement prohibition has different purposes and consequences under the two bodies of law. A finding of “inurement” under federal tax law would mean that a higher education institution would not qualify under section 501(c)(3). Lack of section 501(c)(3) status has enormous consequences. It prevents both exemption from income tax and eligibility to receive tax-deductible contributions. Under education law, a determination of inurement means that a higher education organization is categorized as proprietary rather than nonprofit. If a proprietary institution receives more than 90 percent of its revenue from sources receiving federal support, such as Pell Grants, federal work-study, direct loans, and Perkins loans, it becomes ineligible to receive those funds for at least two years.¹⁶ It can, however, continue to operate without them.

Judge Henry Friendly once wrote: “Where the Internal Revenue Code is concerned, no controlling weight can be given to the usual presumption that, when the same words are used in several sections of a statute, they mean the same thing. Rather the Court will look at the Congressional history and purpose in each case.”¹⁷ That must a fortiori be the case when the same words occur in different statutes.

For all these reasons, I read the regulations as establishing an independent duty by the Department of Education to ensure that conversion transactions do not result in private inurement. I suggest that this obligation exists even when, as explained below, the intermediate sanctions regime of section 4958, rather than the statutory private inurement provision, applies for purposes of federal tax law.

IV. Applicable Tax Provisions

The GAO report did not identify or analyze all the various tax rules applicable to the conversion structures it describes. The GAO might have made that choice to achieve clarity and avoid complexity. But, as in much of tax law, complexity matters here. The report uses the term “insider” even when a person might not be deemed to qualify as that under the tax provision applicable to conversion transactions by an established section 501(c)(3) organization.

That is, the report relies primarily on the statutory private inurement prohibition of section 501(c)(3). But nowhere does the report cite the private benefit doctrine, which might apply in several conversion structures. And most importantly, nowhere does the report discuss the intermediate sanctions regime of section 4958.¹⁸ The complex rules of section 4958 have largely replaced the section 501(c)(3) statutory private inurement prohibition for transactions in which, for example, a conversion takes the form of a preexisting tax-exempt organization acquiring a previously for-profit college. Of the 20 acquiring nonprofit organizations illustrated in Figure 4 of the GAO report,¹⁹ 14 involve acquisition by an existing nonprofit organization and thus would be tested under the intermediate sanctions regime of section 4958 rather than the statutory private inurement prohibition of section 501(c)(3).

As a leading nonprofit organizations textbook explains the relationship of these doctrines²⁰:

Section 501(c)(3) organizations are prohibited from engaging in activities that result in “inurement” of the organization’s net earnings to insiders, such as founders, directors, and officers. The related “private benefit” doctrine prohibits a section 501(c)(3) organization from providing a substantial economic benefit to individuals who do not exercise control over the organization. The essence of inurement is that a person in a position to influence the decisions of an organization receives disproportionate benefits, such as excessive compensation or rent, a below-market rate loan, or an improper economic gain from sales or exchanges of property with the exempt organization.

Historically, the IRS has invoked the inurement limitation only in the most egregious cases of insider misconduct. Since the only sanction (under the statutory private inurement prohibition) was the ultimate death sentence — revocation of exemption — enforcement was lax. Congress gave the IRS a new and more effective weapon in 1996 when it enacted the section 4958 intermediate sanctions regime. Insiders who receive excess economic benefits are now subject to monetary penalties, as are organization managers who approve of such transactions.

Because of the changes Congress enacted in 1996, tax law now employs different definitions of insiders at different stages of a section 501(c)(3) organization’s existence. Education law does not. Thus, the Department of Education cannot simply rely on the IRS review of conversion transactions that involve established section 501(c)(3) organizations subject to the intermediate sanctions regime. As a result of the intermediate sanctions regime, IRS standards for review diverge from those required of the Department of Education in significant ways that the report does not identify.

V. Overview of Section 4958

When intermediate sanctions apply, excise taxes, rather than revocation under the statutory private inurement prohibition, provide the remedy for self-dealing transactions between the entity and its insiders.²¹ Nowhere does the report recognize, much less discuss, the workings of the intermediate sanctions regime of section 4958, relevant portions of which are discussed below. As noted earlier, the Department of Education’s categories of eligibility for aid require a clear categorization of private institutions as either proprietary or nonprofit. But because they predate the 1996 intermediate sanctions regime, the Department of Education review no longer maps neatly onto tax law.

The intermediate sanctions regime of section 4958 does not apply in every situation. First, intermediate sanctions apply only to organizations already exempt under section 501(c)(3) and (c)(4).²² Second, the intermediate sanctions regime of section 4958 does not apply to entities that qualify under section 501(c)(3) but are also governmental units or affiliates.²³ At least some conversion transactions are likely to involve acquisitions by governmental affiliates. Thus, the implications of this governmental affiliate exception under section 4958 requires scrutiny in the conversion context. The report does not discuss the public university/governmental affiliate issue.

Because of these limits on the reach of section 4958, the statutory private inurement prohibition of section 501(c)(3) continues to apply under the IRC to organizations applying for initial exemption.²⁴ The precise meaning of the statutory private inurement provision is far from clear. As one scholar of the nonprofit sector has noted, the words chosen for the statutory private inurement prohibition must be treated as “evocative rather than precise.”²⁵ For example, based on other authorities, we do know that the “individuals” in the statutory private inurement prohibition are not limited to people but also include corporations, industries, professions, and so on.²⁶ Although private inurement is often described as distributions that are like dividends paid to shareholders, it can occur even without any earnings and profits.²⁷ As a general counsel memorandum has explained,²⁸ the “inurement prohibition serves to prevent anyone in a position to do so from siphoning off any of a charity’s income or assets for personal use.”

Under the conversion methods shown in the report,²⁹ the statutory private inurement prohibition would apply to the one case of a for-profit reincorporating as a nonprofit and the five cases of a new nonprofit organization purchasing a for-profit college. In those cases, lack of fair market value consideration could be a basis for denying exemption because the statutory private inurement prohibition is absolute; in theory, if not practice, it lacks even a de minimis exception.

However, section 4958 would provide the rules for testing the five purchases by an existing nonprofit college and the eight instances of purchase by an existing nonprofit organization that is not a college, unless the entities involved are governmental units or affiliates. In those cases in which section 4958 does apply, the remedy might be the section 4958 excise tax on the excess benefit. In some cases, the excess benefit transactions may be so pervasive that revocation of exemption is required. However, it is also entirely possible that application of section 4958 would result in no excise tax because any benefit is shown not to be excessive, because of the governmental affiliate exception, or because of the initial contract exception, which is explained below.

VI. Details of Section 4958

A. Disqualified Persons

Intermediate sanctions apply to “disqualified persons.” That is, unlike the statutory private inurement prohibition, section 4958 and the regulations promulgated under it define insiders. Insider for purposes of the statutory private inurement prohibition is entirely a matter of facts and circumstances; no general official IRS guidance exists. The category of insiders under the statutory private inurement prohibition may in some cases be narrower and, in some cases, broader than the category of disqualified persons under section 4958.

For purposes of section 4958, “per se” disqualified persons include officers, directors, trustees, CEOs, CFOs, their close relatives, and specific entities that have more than 35 percent control, going back five years.³⁰ Some will be “disqualified persons” based on a facts and circumstances test showing that they have substantial control.³¹ Some who are not highly compensated are deemed by the regulations as not having substantial enough influence to be a disqualified person; that is, they are per se not disqualified persons.³²

B. Initial Contract Exception

Intermediate sanctions apply only to excess benefit transactions, a transaction in which the disqualified person gains a disproportionate value.³³ Importantly, however, the intermediate sanctions regulations provide that section 4958 does not apply to any fixed payment made to a person in connection with an initial contract, whether or not the payment would otherwise constitute an excess benefit transaction.³⁴

This rule, known as the first bite exception, is based on United Cancer Council,³⁵ a case that the report cites twice in footnotes.³⁶ In that case, the IRS asserted that, because a fundraiser hired by a small charity retained $26.5 million of the $28.8 million it raised, it should be deemed an insider, and the organization’s exempt status should be revoked for violation of the statutory private inurement prohibition. The Seventh Circuit’s opinion, written by Judge Richard Posner, rejected the IRS argument that, by entering a contract for the first time with a charity, an otherwise unrelated person would become an insider for purposes of the statutory private inurement prohibition.

This first bite exception adopted from United Cancer Council will not prevent application of section 4958 unless the transaction involves an initial contract with the amount determined by a fixed formula. The regulations under section 4958 define an initial contract as a binding written contract between a tax-exempt organization and a person who was not a disqualified person immediately before entering into a contract.³⁷ This provision is both important and a bit misleading. Although it is found as part of the regulatory definition of an excess benefit transaction, it follows the lead of United Cancer Council by seeming to provide that no one can become a disqualified person by entering an initial contract.³⁸ This characterization matters for application of the private benefit doctrine, discussed below.

An initial contract consists of a fixed payment only if no person exercises discretion in determining the amount. One aspect of the fixed payment definition in reg. section 53.4958-3(a)(3)(ii) is important enough to be quoted at length:

A fixed formula may incorporate an amount that depends on future specified events or contingencies, provided that no person exercises discretion when calculating the amount of a payment or deciding whether to make a payment (such as a bonus). A specified event or contingency may include the amount of revenues generated by (or other objective measure of) one or more activities of the applicable tax-exempt organization.

The proposed section 4958 regulations included additional guidance regarding revenue sharing, but proposed regulations have no force, and the final regulations reserve guidance on this issue.³⁹ Promulgation of regulations by the IRS on revenue sharing might prove useful in policing some conversion transactions.

To the extent that contracts in connection with a conversion transaction do not qualify for the first bite exception, application of the section 4958 rules would proceed. The section 4958 regulations backtrack from United Cancer Council at this point. Someone who is not a disqualified person before an initial contract can nonetheless become a disqualified person under an initial contract if the amount of the contract is not determined by a fixed formula.⁴⁰

If there is an excess benefit transaction by a disqualified person, an excise tax of 25 percent would apply to the amount of the excess benefit enjoyed by a disqualified person and an excise tax of 10 percent would apply to a knowing manager.⁴¹ Punitive second-tier taxes apply if the excess benefit transaction is not corrected.⁴²

C. Private Benefit Doctrine

If the first bite exception to section 4958 does apply, there is no disqualified person for purposes of section 4958. Given the congressional purpose of intermediate sanctions supplanting the statutory inurement prohibition for an operating section 501(c)(3) organization in all but the most egregious cases, it seems likely that the private benefit doctrine and not the statutory private inurement prohibition would be brought to bear in those cases. Reg. section 1.501(c)(3)-1(d)(2) is the source for the private benefit doctrine. This regulation explains that an organization is not exempt under section 501(c)(3) “unless it serves a public rather than a private interest.” The private benefit doctrine calls for a weighing of private benefit by those who are not insiders against the benefit the organization provides to the public at large by serving its intended beneficiaries.⁴³ (Incidental private benefit, such as payment of reasonable compensation, is inevitable and permitted.) The contours of the private benefit doctrine are amorphous. Whether the IRS will employ the doctrine, how it would do so, and the result when it does are all difficult to predict.

In United Cancer Council,⁴⁴ Posner noted that at trial, the IRS had also argued that the organization’s exemption should be revoked under the private benefit doctrine — that is, that the organization was operating for the benefit of the fundraiser, rather than for those the organization was intended to serve. At trial, the Tax Court gave a “bye” to this ground for revocation of exemption.⁴⁵ Posner observed, “It would have been better had the court resolved that ground as well. . . . But it did not.”⁴⁶ The court of appeals, however, clearly recognized the possibility of finding impermissible private benefit “even if the contracting party did not control, or exercise undue influence over, the charity.”⁴⁷

The road map sketched by Posner could well come into play when the first bite exception is at work; the first bite exception presumes that the party to a first contract with a section 501(c)(3) organization is not a disqualified person. This private benefit road map could also apply in other cases when section 4958 does not apply, as in, for example, situations in which those under scrutiny are not disqualified persons. In those cases, the private benefit doctrine, requiring the difficult determination of whether an exempt organization confers more than incidental benefit on private parties who are not insiders or disqualified persons, would supply the appropriate analytical framework. But, because the report does not discuss section 4958 and the exceptions to the intermediate sanctions regime, it does not discuss how the private benefit doctrine could or should apply in some conversions involving existing tax-exempt organizations.

The reach of the private benefit doctrine is uncertain; further guidance on it from the IRS, both generally and in connection with the initial contract exception of section 4958, would be useful and welcome.

VII. Conclusion

Under tax law, conversion transactions fall into three main categories, some with subdivisions: (1) those involving newly established section 501(c)(3) organizations; (2) those involving established private section 501(c)(3) organizations; and (3) those involving established section 501(c)(3) organizations that also are governmental entities.⁴⁸

The IRS applies different kinds of analyses to each of these categories:

1. Newly established section 501(c)(3) organizations must apply for exemption, and review of those applications includes consideration of the statutory private inurement prohibition.

2. Established private section 501(c)(3) organizations must run the gauntlet of the intermediate sanctions regime. That analysis may result in imposition of an excise tax. In some cases, it could result in revocation of exemption. In yet other cases, the initial contract exception of section 4958 will mean that conversion transactions must be evaluated under the private benefit doctrine.

3. The appropriate analysis for established section 501(c)(3) organizations that are also governmental entities is unclear under current law because they are not subject to section 4958. Their exclusion altogether from section 4958 could make the statutory private inurement prohibition applicable. Past practice, however, demonstrates that the IRS seldom enforces the statutory private inurement prohibition. Its use to revoke the exemption of governmental affiliates seems to me to be particularly unlikely.

The GAO report and any other analysis regarding the tax aspects of for-profit college conversions would benefit from detailed consideration of section 4958 and of the special rules applicable to section 501(c)(3) organizations that are also governmental affiliates. Moreover, addressing the concerns the report expresses calls for additional IRS resources for oversight of tax-exempt organizations⁴⁹ and, especially in the case of governmental affiliates, changes to applicable tax laws.

Perhaps most importantly, an understanding of the regulatory roles that the IRS and the Department of Education play in connection with for-profit college conversion transactions must include recognition of section 4958. The 1996 enactment of the section 4958 intermediate sanctions regime produced a divergence in review of conversion transactions undertaken by each agency, despite identical statutory language forbidding private inurement.