GAO Says IRS Needs to Improve Handling of College Conversions

By contrast, the large majority of for-profit colleges that converted without insider involvement were in financial distress before their sale. Specifically, 36 of 40 had failing financial responsibility composite scores and 33 were nearing bankruptcy.⁵⁷ After their sales, most of these colleges (26 of 40) had passing financial responsibility composite scores⁵⁸ (See figure 10). None of the colleges with available data had a negative tangible net worth after their conversion, and only one had a failing acid test ratio.⁵⁹

 

According to Education officials, a college's financial condition may decline or improve following its sale depending on factors such as the relative size and financial resources of the college and its purchaser. One Education official stated that if a college's nonprofit purchaser assumes a high level of debt to purchase the college or has limited access to working capital, it could harm the college's financial health. Conversely, another Education official stated that if a college's purchaser is more financially stable than the college it is purchasing, it may strengthen the college's financial health.

We compared the conversion transactions of our five case study colleges to five randomly selected colleges whose conversions did not involve insiders and identified two factors that may have contributed to the case study colleges' generally poorer composite score performance in the year of their conversions.⁶⁰ First, four of the five case study colleges purchased mostly intangible assets — such as goodwill, brand names, accreditation, and established student relationships — from the for-profit college sellers, and two bought intangible assets almost exclusively.⁶¹ By comparison, all five randomly selected colleges purchased mostly tangible assets — such as cash, investments, and property — and two bought no intangible assets at all. Education excludes intangible assets from its composite score, and taking on debt to purchase intangible assets reduces a college's performance along this measure.⁶² Officials from three of our five case study colleges said this exclusion led to an unfair characterization of their colleges' financial conditions. Purchasers may value a college more highly if it has a strong brand name, numerous established student relationships, or other intangible assets expected to yield future value.⁶³ However, intangible assets are also inherently difficult to value. One case study college whose sale price consisted almost entirely of intangible assets later claimed a substantial loss on those assets, citing a less optimistic regulatory outlook than previously anticipated, among other factors.⁶⁴

Second, all five case study colleges financed their conversion transaction entirely with debt, meaning that rather than paying for the college up front, the nonprofit purchasers used borrowed funds — in these cases, from the colleges' former owners. By contrast, in four of the five randomly selected cases, the colleges' nonprofit purchasers paid for the college at the time of sale and did not assume any debt to do so. Debt can reduce a college's ability to weather financial difficulties, and it reduces a college's composite score performance. However, colleges can also reduce their debt over time, thereby improving their composite scores. For example, two of the four case study colleges with conversions involving insiders and failing composite scores in the year of their conversion transaction improved to passing scores in the most recent year available. These colleges both repaid some debt associated with their change in ownership. In addition, former owners forgave a substantial proportion of both colleges' outstanding debt in the years following the sale. This debt reduction had a positive effect on both colleges' composite scores.

While assessing the current financial condition of all converted colleges was not within the scope of our review, it is important to note that a college's financial condition may change over time. A college whose financial condition improves after its sale may ultimately experience declining financial condition, for instance, if it has sustained difficulty attracting and retaining students or its new owners lack expertise needed to successfully operate a college.⁶⁵ Conversely, a college whose financial condition declines after its sale may ultimately experience improved financial circumstances if it improves its ability to attract and retain students or it obtains greater resources through increased charitable contributions or reduced tax liabilities.

IRS Has Not Consistently Identified and Responded to Risks That Insiders May Improperly Benefit from Previously For-Profit Colleges

IRS Staff Did Not Always Seek Information to Assess the Risk of Improper Benefit to Insiders When Reviewing Applications for Tax-Exempt Status

We found that IRS staff reviewing for-profit college applications for tax-exempt status did not always seek information to assess whether insiders would improperly benefit from for-profit college conversions — specifically by being paid more than fair-market value either for the college or for services they provided to the college. According to Treasury regulations, improper benefit would occur if a tax-exempt organization purchases assets from insiders for more than their fair market value. IRS officials stated that doing so would be grounds for IRS to deny an application for tax-exempt status (see sidebar). If an application for tax-exempt status discloses a for-profit conversion, IRS staff training materials instruct staff to carefully scrutinize the application to determine whether the conversion transaction is consistent with fair market value.⁶⁶ Staff training materials also state and IRS officials confirmed that in some cases staff may need to seek additional information to make this assessment, such as copies of draft purchase agreements or independent appraisal reports.⁶⁷ Further, as part of a compliance strategy focused on tax-exempt organizations with a for-profit history, IRS distributed a staff information sheet stating that such organizations, including colleges, are at an elevated risk for improper benefit. Staff training materials also states that relationships between an applicant and a for-profit entity — such as a college and its for-profit service provider — may be vulnerable to abuse and require special attention to assure that transactions between the applicant and for-profit entity do not exceed fair market value.

We found that 10 of the 17 for-profit college conversions involving insiders in our review were disclosed in an application for tax-exempt status by a new nonprofit organization.⁶⁸ An additional planned for-profit college conversion involving insiders was also reported in an application for tax-exempt status, but ultimately did not occur.⁶⁹ In all 11 of the planned or completed conversions, the organization seeking to become tax exempt disclosed plans to purchase a for-profit college and retain former for-profit college owners or other officials in a leadership role in the newly tax-exempt college.⁷⁰ However, IRS staff did not always follow instructions to closely scrutinize the applications to assess whether the conversion transactions were consistent with fair market value. Such scrutiny is important because if the college's sale price was inflated beyond fair market value, then insiders would improperly benefit from the sale.

For nine of the 11 colleges, we found that the public IRS application filed by the college's purchaser either contained information IRS staff could use to assess the transaction (such as the purchase price or a copy of an independent appraisal report) or that IRS staff sought additional information needed to make this assessment before approving the applications. In one case, for example, IRS staff asked the applicant to provide a copy of a proposed purchase agreement and an independent appraisal report estimating the value of property to be included in the transaction.

However, for two of the 11 colleges, IRS staff approved the application for tax-exempt status without seeking sufficient information to assess whether the purchaser would pay insiders more than fair market value for the college. Both organizations were created expressly to purchase the college, but neither application included a planned purchase price or an independent appraisal report estimating the college's value. Instead, the applications stated that independent appraisals would be conducted in the future and that the purchase price, once determined, would not exceed fair market value. Each application also disclosed plans for the newly tax-exempt college to purchase extensive services through contractual agreements with its former owners. IRS training materials state that staff should carefully assess whether the contracts exceed the fair market value of the services being provided. However, only one application disclosed how much the college planned to pay for services, and neither provided an independent appraisal report estimating the value of the services.

According to IRS officials, assurances from the applicants that independent appraisals would be conducted and that the eventual transaction prices would not exceed fair market value provided a sufficient basis for the agency's decision to approve these applications. Officials further noted that decisions to grant or deny tax-exempt status are based on representations provided by applicants, and that staff do not audit applicants before making their determination. However, each applicant had a for-profit history, which an IRS staff information sheet says poses a heightened risk of improper benefit. Further, each application disclosed significant planned transactions with insiders, which IRS staff instructions direct staff to assess carefully. Without seeking information recommended in guidance, such as the college's planned purchase price, price of contracted services, or independent appraisal reports establishing the value of the college or contracted services, IRS could not assess whether transactions in these cases would be fair and consistent with the requirements of tax exemption.⁷¹ Ensuring appropriate application review in such cases is critical as it represents the earliest opportunity for IRS to identify and respond to the risk of improper benefit, particularly given that many years may pass before a tax-exempt organization may be selected for an audit.⁷²

IRS officials said they rely on staff expertise to evaluate the unique facts and circumstances of each application for tax-exempt status. However, they also noted that for-profit conversions can raise complex technical issues with which even veteran staff may have limited experience.⁷³ Staff guidance and internal controls, such as manager reviews of staff decisions before they are finalized, are in place to help provide reasonable assurance that staff appropriately assess the risk of improper benefit in applications for tax-exempt status. However, IRS managers told us the depth of their reviews can vary greatly — from cursory to in-depth — depending on factors such as the complexity of the case, a manager's confidence in the staff member's abilities, and the staff member's level of experience. IRS also has a quality assurance group that reviews a random sample of staff decisions to assess their quality. However, IRS officials said that this group has reviewed relatively few cases involving previously for-profit organizations, such as colleges.⁷⁴ This group can also select specific types of cases to review, but officials said they have not focused on previously for-profit colleges.⁷⁵

The complexity of for-profit college conversions that involve insiders and the potential risk they pose heighten the importance of robust quality assurance practices. Standards for internal control in the federal government state that management should mitigate risks by periodically reviewing the effectiveness of internal control policies and procedures.⁷⁶ However, IRS officials stated that they have not assessed whether the agency's internal controls are sufficient to provide reasonable assurance that staff consistently follow guidance to evaluate the risk of improper benefit associated with for-profit college applications for tax-exempt status. Assessing whether internal controls are robust and effectively implemented would better position IRS to assure the quality and consistency of IRS's decisions in such complex cases and improve the review process for conversion applications.

IRS Does Not Collect Sufficient Information to Identify Previously For-Profit Colleges with Tax-Exempt Status for Oversight Purposes

To oversee existing tax-exempt organizations, IRS conducts audits of organizations at risk of noncompliance with tax law.⁷⁷ However, IRS does not collect the information it needs to systematically identify tax-exempt organizations with a for-profit history, such as colleges, for potential audit. Ten of 17 conversions involving insiders in our review were disclosed in an application for tax-exempt status and IRS reviewed the planned conversion transactions as part of its application approval process. However, the other seven of 17 conversions in our review that involved insiders were not reported in an application because the college's purchaser was already tax exempt. As a result, IRS did not have the opportunity to consider these conversions as a part of its decision to grant the purchaser tax-exempt status.

According to IRS officials, the agency could review conversion transactions that involve an already approved tax-exempt organization if the organization is selected for audit. However, to do so systematically, IRS would need to collect information enabling it to identify when an approved tax-exempt organization has engaged in such a conversion transaction. To select organizations for audit, IRS relies to a large extent on information organizations report in their annual filing — specifically information in searchable data fields.⁷⁸ However, this form does not have a data field that asks whether a tax-exempt organization has purchased a for-profit entity or otherwise has a for-profit history. By contrast, IRS's application for tax-exempt status does ask whether an organization has a for-profit history — specifically, the form asks whether the applicant has taken over the assets or activities of a for-profit entity or whether the applicant has converted from for-profit to nonprofit status.⁷⁹ Already approved tax-exempt organizations may disclose that they have purchased a for-profit entity, such as a college, from insiders in narrative fields in their annual filing. However, IRS officials stated that narrative fields are not generally used for audit selection because they are not easily searchable. The lack of information in easily searchable data fields means IRS cannot systematically select for audit tax-exempt organizations whose annual filings disclose purchasing a for-profit college from insiders — such as the organizations that purchased seven colleges in our review.

This lack of information has hampered IRS's oversight efforts. For example, IRS has implemented a new compliance strategy with the goal of identifying tax-exempt colleges and other organizations that have been part of a for-profit conversion, due to their heightened risk of improper benefit.⁸⁰ Because IRS has minimal data on tax-exempt organizations with a for-profit history, it used complex data matching techniques to try to identify them. However, these techniques did not identify any of the existing tax-exempt organizations that purchased the seven for-profit colleges from insiders in our review.⁸¹ IRS officials also said that while it may be possible for them to search narrative fields if necessary, variation in wording used in narrative fields could hamper their ability to identify such cases for audit. Without the ability to easily identify previously for-profit colleges and other tax-exempt organizations with a for-profit history, IRS cannot systematically select them for audit and other compliance activities.

Though IRS could require tax-exempt organizations to report the purchase of a for-profit college or other for-profit entity in a data field on the annual IRS filing, it has not done so. IRS officials stated that doing so was unnecessary since the agency's application form for tax-exempt status asks applicants whether they have a for-profit history. However, an existing tax-exempt organization does not need to submit a new application form when it purchases a for-profit college. As a result, IRS lacked information about the for-profit history for seven of the 17 colleges in our review because they were purchased by an existing tax-exempt organization. Standards for internal control in the federal government state that agencies should use quality information to make decisions.⁸² Improving IRS's ability to identify previously for-profit colleges and other tax-exempt organizations with a for-profit history could enhance its oversight and reduce the risk that potential improper benefit and other tax noncompliance may go undetected.

While Education Is Reviewing Nonprofit Applications More Closely, It Has Not Taken Steps to Assess the Risk of Improper Benefit among Newly Converted Colleges

Education Has Enhanced Its Reviews of For-Profit College Applications for Nonprofit Status

In recent years, Education has enhanced its process for reviewing applications from for-profit colleges seeking to convert to nonprofit college status.⁸³ According to agency records, from November 2010 through August 2020, 59 for-profit colleges, which were part of 20 separate conversion transactions, applied to Education for nonprofit college status.⁸⁴ As of August 2020, Education has approved 35 of these 59 colleges for nonprofit status and denied two.⁸⁵ The remaining applications are still under review or no longer require action because the colleges have closed (see figure 11). According to agency officials, Education's earlier reviews of for-profit college applications for nonprofit status involved ensuring that the college had the appropriate approvals from IRS, state oversight agencies, and accreditors, and that the college was financially responsible. While improper benefit is prohibited under the Higher Education Act for nonprofit colleges, agency officials noted that Education's earlier reviews did not focus on assessing the risk of improper benefit.⁸⁶ Officials told us that Education strengthened its approach in response to an application that raised agency concerns about the risk of improper benefit.⁸⁷ Our group of five case study colleges included two colleges that Education approved for nonprofit college status prior to this change and one college approved after it.⁸⁸

Education officials explained that prior to 2016 the agency did not have well-developed guidance or a specialized work group to evaluate complex changes in ownership and nonprofit conversions. In line with this observation, we found that staff did not identify or follow up on potential risks of improper benefit in either of the case study colleges whose conversions Education approved prior to 2016.⁸⁹ In both cases, former for-profit owners held leadership roles in the college's tax-exempt purchaser both before and after selling the college, putting them in a position to possibly influence the sale and the college's subsequent financial decisions for their own improper benefit. However, Education staff did not focus on assessing the risk of improper benefit in either case. Education staff familiar with both reviews noted that leadership continuity following a change in ownership can enhance a college's operational stability and suggested they did not see leadership by former owners as a source of risk. Further, Education staff did not request or review independent appraisal reports or thoroughly assess purchase and sale agreements to determine whether former owners were paid more than fair market value for either college. For one of these cases, Education staff told us that they would not have questioned whether the college sale price was fair. For the other case, staff said they had no process to assess the fairness of the college sale price nor a way to assess whether the former owner had improperly influenced the price.

According to Education officials, under the new process the agency began developing in 2016, Education started requesting copies of documents, such as a list of the new tax exempt college's board of directors, purchase and sale agreements, and independent appraiser reports, to assess whether the sale price was fair and did not improperly benefit insiders. According to officials, Education also began requesting copies of other agreements between the college and its former for profit owners, including employment contracts and lease agreements to determine if the college employed, or leased property from, insiders and to assess whether the terms of these transactions were reasonable. Education reviewed the application for one of our case study colleges after 2016 and obtained additional information, such as lease and debt terms, during the course of the review. According to an official involved in the review, Education used this information to assess whether the former owners were benefitting improperly from those agreements. More recently, Education officials told us that the agency has started to use templates to standardize its document requests and help ensure that staff consistently collect information needed to assess the risk of improper benefit.

Education took additional steps to improve its processes when it created a centralized team composed of Education staff with contract review, finance, and legal expertise. According to officials, the agency created this team in September 2018 to help staff review applications from for-profit colleges seeking nonprofit status and identify risks of improper benefit.⁹⁰ Officials noted they are also working to obtain contractor assistance to assess valuation reports provided by applicants. Officials further explained that the team has begun to work closely with staff in regional offices to review for-profit college applications for nonprofit status and draft decision letters, which are then finalized by the regional director. Officials stated that the team is currently involved in all ongoing agency reviews of pending for-profit college applications for nonprofit status and that since this centralized team started reviewing applications, the agency has issued one decision regarding a for-profit college's application to convert to nonprofit status. Education's review of this application included a detailed consideration of the fairness of the sale price, a former owner's continuing role in the college, and the independence of the college's board, among other things.⁹¹ As a result of these actions, Education may be better positioned to thoroughly evaluate for-profit college applications for nonprofit status and mitigate the risk of improper benefit.

Education Is Taking Steps to Ensure That Colleges That Submit an Application for Nonprofit College Status Do Not Advertise as Nonprofit While the Decision Is Pending

We found that for-profit colleges advertised as nonprofit colleges while Education was reviewing their applications for nonprofit college status; however, according to agency officials, Education is in the process of communicating newly developed instructions to colleges with such pending applications to prohibit advertising that could be confusing to students. A for-profit college seeking to convert to nonprofit status must have IRS tax-exempt status prior to obtaining nonprofit college status from Education.⁹² Education considers the college to be a for-profit college until it has reviewed and approved the college's application for nonprofit college status. A college with a pending application must continue to meet all Education requirements applicable to for-profit colleges.⁹³ Some experts on student college choice suggest that students may want to consider whether a college is a nonprofit, for-profit, or public institution when choosing a college to attend, because a college's status can have different implications in terms of cost, perceived reputational benefits, and transfer of credits, among other things. If a tax-exempt college advertises as nonprofit without being clear as to what this means, students may erroneously believe that the college is approved by Education as a nonprofit college — and, as a result, they may not have accurate information upon which to make their decision.

We found that the nine for-profit colleges with pending applications for nonprofit college status at the time of our review all advertised as nonprofit colleges before Education decided whether to approve or deny their applications. In addition to the colleges with pending applications, we also reviewed past advertising for three additional colleges with available information — one of our three Education case study colleges and both colleges whose applications Education later denied — and found that all three had advertised as nonprofit before Education had made a decision on their applications.⁹⁴ For instance, one college issued a press release the day after it obtained tax-exempt status from IRS, stating that it was now a nonprofit tax-exempt educational institution and that its conversion had been conducted in accordance with “the requirements of the U.S. Department of Education.” The college issued the press release more than 3 years before it obtained nonprofit status from Education, an extended period during which students enrolling in the college may have had a mistaken understanding about whether they were pursuing a degree from a college recognized by Education as a nonprofit.

Education officials have acknowledged concerns about unclear language in colleges' advertisements while their applications are under review. One official noted that it is fair for a college to advertise that it has tax-exempt status, but broader statements about a college having nonprofit status can make it unclear whether or not the college has Education's approval.⁹⁵ In a denial letter to one for-profit college seeking nonprofit status, Education noted that the college's advertisements referring to itself as a nonprofit college are confusing and could cause students and others to incorrectly assume that the department considered it to be a nonprofit college. Education instructed the college to stop advertising as a nonprofit.

Education recently developed instructions to prohibit for-profit colleges with pending applications from advertising as nonprofit colleges⁹⁶ (see text box). Agency officials said they plan to provide these instructions to all for-profit colleges that apply for nonprofit college status. Specifically, they explained that the agency would include the advertising instructions in its document request and decision letters for nonprofit status, as well as in the temporary program participation agreements that allow colleges with pending applications to continue to receive federal student aid while Education reviews their applications. To ensure that schools that currently have pending applications for nonprofit college status are aware of the new advertising instructions, Education officials told us that they intend to send a separate letter with the instructions to these colleges no later than October 15, 2020. Providing these advertising instructions to colleges should help Education curtail this type of potentially confusing advertising and ensure that students have clear and accurate information upon which to base their educational decisions.

Source: Education document; language in brackets added by GAO. | GAO-21-89

After Approval, Education Does Not Review College Financial Statements to Identify Potential Risk Indicators for Improper Benefit among Converted Nonprofit Colleges

Some indicators of potential improper benefit may surface in a college's audited financial statements after Education has approved the college for nonprofit status; however, Education does not use its existing reviews of college financial statements to assess this risk. The Higher Education Act requires all colleges to submit their audited financial statements to Education on an annual basis, and Education uses information in those statements to calculate the colleges' financial responsibility composite score, a measure of college financial health.⁹⁷ According to Education officials, while a contractor reviews the financial statements of all colleges to calculate the composite score, Education staff conduct audited financial statement reviews only for certain colleges, such as colleges with a failing score, as well as colleges overseen by Education's multiregional division (typically large for-profit colleges). Further, even when staff review a previously for-profit college's full audited financial statements, they do not assess whether the statements contain indicators of potential improper benefit.

Colleges are required to disclose information in their audited financial statements that could provide Education with important insights into possible improper benefit. For instance, in accordance with accounting standards, colleges must disclose losses on intangible assets they purchased and related-party transactions.⁹⁸ These could include transactions such as leases or contracts with insiders, as well as related-party debt.

We reviewed audited financial statements for each of our three case study colleges approved by Education for nonprofit college status. In two cases, we found information in the colleges' audited financial statements that could raise concerns about possible improper benefit.⁹⁹ For example, one college advanced funds to another business controlled by its former owner and later purchased assets from that business, all while the former owner continued to lead the college as its president. Although transactions between a nonprofit college and related parties (such as companies controlled by the college's president and former owner) are not prohibited, they can indicate a risk that a college's resources may have been improperly used for the former owner's benefit. This college's financial statements also showed that the college recognized a substantial loss on the intangible assets acquired when the college was purchased from its former owner about 3 years earlier.¹⁰⁰ While such a loss may arise for unforeseen reasons (i.e., shifting market conditions), it could also indicate that the college and its assets were knowingly overvalued at the time of the sale to improperly benefit insiders. Education staff in the region that managed this case told us that they were aware that the college had recognized a loss on intangible assets (as it had affected the agency's evaluation of the college's financial condition).¹⁰¹ However, staff also said that they had not considered whether the loss reflected a risk of improper benefit. Further, a staff person involved in the review said that he believed the former owner was mostly retired and uninvolved in college operations, but we found the former owner was still the college president at the time of our review.

According to Education officials, the agency has not developed plans to assess the financial statements of newly approved nonprofit colleges for indicators of possible improper benefit, even though we found they may contain new and relevant information about potential risks. One official stated that reviewing financial statements to assess such risk is not required in regulation and that all nonprofit colleges should be treated equally once they obtain Education's approval. However, according to procedures, after Education's approval newly converted nonprofit colleges are provisionally authorized to receive federal student aid funds generally for a period of 1 to 3 years, during which time colleges should be monitored more closely. Further, unlike colleges with a long history of nonprofit status, audited financial statements submitted by newly nonprofit colleges may contain important information about potential risks of improper benefit in the early years of its nonprofit operation.

Education officials stated that it would be reasonable for the agency to assess the risk of improper benefit as a part of its annual audited financial statement review process after it has approved a college for nonprofit status. Officials said that they could develop relevant procedures to ensure that its reviews of audited financial statements looked for potential improper benefit by former college owners and that they could refer any concerns identified to Education's centralized review team for further review. Until such procedures are in place and are implemented for all newly converted nonprofit colleges, Education lacks reasonable assurance that staff will review the financial statements of newly converted nonprofit colleges following their approval to assess risks of improper benefit. As a result, Education may miss opportunities to more effectively monitor such colleges after their approval.

The Higher Education Act prohibits the revenues of nonprofit colleges that receive federal student aid funds from being used to improperly benefit private individuals.¹⁰² Standards for internal control in the federal government state that agency management should design control activities to achieve objectives and respond to risks.¹⁰³ Without procedures in place for reviewing audited financial statements to look for indicators of improper benefit at converted nonprofit colleges, Education lacks reasonable assurance that federal student aid funds are used appropriately and do not improperly benefit insiders.

Conclusions

If a nonprofit college's revenues are diverted to improperly benefit insiders, funds available to support the college's educational mission would be reduced, potentially harming the college and violating federal requirements. IRS has stated in a staff information sheet for a compliance strategy that tax-exempt organizations with a for-profit history, such as colleges, may pose a heightened risk of improper benefit. While IRS provides staff with guidance to assess the risk of improper benefit by evaluating whether transactions reported on applications for tax-exempt status are consistent with fair market value, we found that IRS staff did not always seek the information to thoroughly assess this risk when reviewing for-profit college applications for tax-exempt status. Further, IRS has not assessed its internal controls to assure that staff consistently evaluate for-profit college applications for tax-exempt status to determine whether their conversion transactions are consistent with fair market value and do not improperly benefit insiders. Assessing and, as applicable, improving these controls could help IRS assure that any improper benefit is detected and prevented prior to granting tax-exempt status. Once tax-exempt status is granted, however, IRS does not have the information it needs to systematically identify and monitor previously for-profit colleges' compliance with the requirements of that status. Collecting such information — for instance, on annual filings required for tax-exempt organizations — could help IRS respond proactively to risks that some insiders could improperly use the resources of a tax-exempt college for their own personal benefit.

Education has recently enhanced its scrutiny of previously for-profit college applications for nonprofit status and improved its oversight of for-profit college conversions. However, until Education extends its review beyond the initial approval of nonprofit applications, the agency may miss indicators of improper benefit that surface in audited financial statements after a college's nonprofit approval. As for-profit colleges continue to convert to nonprofit status, Education has the opportunity to better assure that converted colleges continue to act in accordance with the requirements of their nonprofit status.

Recommendations for Executive Action

We are making a total of three recommendations, including two to IRS and one to Education. Specifically:

• The Commissioner of Internal Revenue should assess the agency's internal controls for reviewing for-profit college applications for tax-exempt status and improve the review process to ensure that staff appropriately apply agency guidance on assessing potential improper benefit to insiders. (Recommendation 1)

• The Commissioner of Internal Revenue should collect information, for instance on the annual IRS filing tax-exempt organizations are required to submit, that would enable the agency to systematically identify tax-exempt colleges with a for-profit history for audit and other compliance activities. (Recommendation 2)

• The Secretary of Education should develop and implement monitoring procedures for staff to review the audited financial statements of all newly converted nonprofit colleges for the risk of improper benefit.(Recommendation 3)

Agency Comments and Our Evaluation

We provided a draft of this report to IRS and Education for review and comment. Their comments are re-produced in appendix II and appendix III, respectively, and summarized below. IRS also provided technical comments, which we incorporated as appropriate. We also provided relevant information to representatives of the five case study colleges for their technical review and incorporated their technical comments as appropriate.

In response to the first recommendation, IRS stated that it would assess its internal controls for reviewing applications for tax-exempt status from organizations with a for-profit history and make improvements to those controls, as appropriate. In addition, IRS stated that it would continue to educate staff on application review procedures, emphasize staff discretion to request additional information from applicants, and provide staff with sample questions about transactions with for-profit entities. IRS also noted that we reviewed 11 applications for tax-exempt status that disclosed plans to purchase a for-profit college from insiders between January 2011 and August 2020, while over the same time period IRS processed over 700,000 applications for tax-exempt status. We acknowledge that applications for tax-exempt status stemming from a for-profit college conversion represent a very small proportion of IRS's total caseload. However, as acknowledged by IRS, such conversions pose a heightened risk of improper benefit. Further, in two of the 11 cases we reviewed, applicants did not provide sufficient information for IRS staff to determine whether the transactions were consistent with fair market value so that staff could assess the risk of improper benefit to insiders, as instructed in IRS guidance. While this guidance gives staff discretion to determine whether additional information is needed to assess if an applicant will pay more than fair market value to purchase assets from insiders, we continue to believe that without knowing the prices the applicants planned to pay insiders in these high risk cases, IRS staff were not well positioned to assess whether the prices were consistent with fair market value. We believe that a broader review of IRS's internal controls would help assure that staff appropriately apply guidance in these high-risk cases.

In response to the second recommendation, IRS stated it would evaluate the benefits and burdens of collecting information about the for-profit history of tax-exempt organizations, including colleges. IRS noted that it already asks tax-exempt organizations to report whether they have engaged in transactions with insiders. However, responses to this question do not allow IRS to isolate organizations that have engaged in conversion transactions with insiders. As a result, IRS does not have the information it needs to systematically identify and audit approved tax-exempt organizations with a for-profit history — in particular, those that have engaged in for-profit conversion transactions with insiders. IRS's compliance strategy acknowledges that these transactions pose unique risks. However, the matching techniques IRS used in the strategy to identify tax-exempt organizations that were involved in a for-profit conversion did not identify any existing organization that purchased a for — profit college from insiders. Although IRS states that its techniques were not designed to identify for-profit college conversions specifically, they were the original impetus for IRS's strategy and were included in the scope of its review. We continue to believe that IRS should collect additional information to enable it to systematically identify organizations with a for-profit history — organizations that the agency acknowledges pose a heightened risk of improper benefit — for oversight purposes.

In its written comments, Education agreed with the recommendation to develop and implement monitoring procedures for newly converted nonprofit colleges and noted the need to closely monitor such colleges for the risk of improper benefit during their provisional certification period. The agency stated that it will develop new financial analysis procedures to ensure that staff review audited financial statements submitted by newly converted colleges after Education's approval. Education also stated that it will include additional reporting requirements for newly converted colleges as a condition in their provisional program participation agreements and it will closely monitor newly converted nonprofit colleges for the risk of improper benefit until the school receives its first recertification after the nonprofit conversion. For example, newly approved colleges will be required to report relevant IRS actions, changes to any existing service agreements between insiders and the college, and any new servicing or contracting agreements, among other things. Once implemented, we believe that Education's planned actions will help it identify indicators of potential improper benefit that can surface in audited financial statements after a college's nonprofit approval.

In its written comments, Education also provided several clarifications. Education observed that, in some cases, multiple colleges with a single owner were sold to the same nonprofit organization in a single conversion transaction. Education noted that while our analysis focused on the 59 colleges that converted to nonprofit status, the agency reviewed fewer than 59 transactions. In our draft report, we used colleges as our unit of analysis, but we did include information on the number of nonprofit organizations that acquired these 59 colleges. In response to Education's comments, we have clarified how college groups are treated in Education's application process and have included additional information to make it clear that Education did not review 59 separate conversion transactions. We have also added supplemental information on the number of unique conversion transactions associated with the colleges we report on in some sections of the report. Education also noted, in regards to our analysis of financial responsibility composite scores, that in the case of a group of colleges with the same owner, the agency only conducts one financial review for the group. We have added this information to the report. Finally, Education pointed out that two colleges in our review were purchased by existing nonprofit colleges and became an additional location of those colleges, rather than applying to be recognized as nonprofit colleges themselves. We believe that these colleges belong in our universe of for-profit college conversions, as they become part of a nonprofit college through a change in ownership and had to meet similar requirements to obtain Education's approval. We have clarified the information regarding these two colleges in the report and the applicable regulations for these colleges.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies of this report to the Commissioner of Internal Revenue and the Secretary of Education, congressional committees, and other interested parties. In addition, this report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (617) 788-0534 or emreyarrasm@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix IV.

Melissa Emrey-Arras
Director, Education, Workforce, and Income Security Issues

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Appendix II: Comments from the Internal Revenue Service

November 6, 2020

Melissa Emrey-Arras
Director, Education, Workforce, and Income Security Issues
United States Government Accountability Office 441 G Street, NW
Washington, DC 20548

Dear Ms. Emrey-Arras:

Thank you for the opportunity to review the draft report of the Government Accountability Office entitled “Higher Education: IRS and Education Could Better Address Risks Associated with Some For-Profit College Conversions” GAO-21-89, (Job Code 103006). We appreciate your recognition that IRS collects information and maintains procedures to assess whether organizations attempting to convert to tax-exempt status comply with the applicable requirements of Internal Revenue Code (I.R.C.) section 501(c)(3). We share the goal of ensuring that applicants and staff appropriately apply these rules and procedures in every case.

GAO identifies 11 applications for recognition of tax-exempt status including the conversion of a for-profit college that involved “insiders” over the period from January 2011 through August 2020. During this period, IRS processed over 700,000 applications for recognition of I.R.C. section 501(c)(3) tax-exempt status. In two of the identified cases, GAO questions whether IRS sought “sufficient information to assess whether the nonprofit organization would pay insiders more than fair market value for the college.”

As noted in the report, IRS complied with applicable procedures to make a determination in these cases based upon the “facts, attestations, and representations contained in the administrative record” under Section 3.05 of Rev. Proc. 2020-5, 2020-1 I.R.B. 241 (updated annually). IRS guidance also instructs staff to closely scrutinize significant transactions between an applicant and its insiders to assure that they are consistent with fair market value, providing staff with the discretion to request an independent appraisal, where warranted. However, there is no requirement that specific information, such as an independent appraisal, be submitted during the determination process because every case rests on its own facts. In the two cases in question, the applications represented that an independent appraisal establishing a fair market value would be undertaken.

We believe our procedures were followed in the identified cases. Nonetheless, we appreciate GAO's study of this issue and constantly seek to improve our determinations process. We will continue to educate agents on the rules and procedures applicable to for-profit conversions involving “insiders”, which, in particular, may raise questions as to whether the organization is complying with the requirement of Section 501(c)(3) that “no part of [its] net earnings . . . inures to the benefit of any private shareholder or individual.” In addition, our training will emphasize to agents their discretion to request additional information from applicants, such as an independent appraisal, when indicated by the particular facts of the application. To support our agents in this regard, IRS has provided determinations agents with 70 pages of selectable paragraphs with questions on topics as varied as functional integration to fundraising and has included questions about transactions with for-profit entities. We will continue to train agents on the proper use of this resource.

GAO also suggests that IRS collect information on the Form 990-series annual information return that would identify whether an organization has a for-profit history to “help IRS respond proactively to risks that some insiders could improperly use the resources of a tax-exempt college for their own personal benefit.” We agree that there may be increased risk of inurement where an I.R.C. section 501(c)(3) organization, including but not limited to a tax-exempt college, engages in transactions with insiders. In fact, the Form 990 does ask whether the organization is a party to a business transaction (including a contract of sale) with certain interested parties, including current and former officers, directors, trustees, key employees, creators or founders, or substantial contributors. See Form 990, Part IV, line 28. Organizations answering yes then must provide additional information on Schedule L (Transactions with Interested Persons). The Form 990 also asks whether the organization owns a disregarded entity or is related to any taxable or tax-exempt entity in Part IV, lines 33 and 34, in which case additional information on Schedule R (Related Organizations and Unrelated Partnerships) is required. These questions assist in identifying organizations engaged currently in transactions or relationships with insiders that may indicate increased risk of inurement in the year for which the return is filed. In view of the entire population of 300,000 filers, the IRS will evaluate the benefits and burdens of adding a question explicitly about the for-profit history of an organization.

GAO's recommendation on information collection seems to be informed by a concern that IRS “data matching techniques . . . did not identify any of the existing tax-exempt organizations that purchased the seven for-profit colleges . . . to select them for audit.” To be clear, the techniques described in the report were not intended to identify those purchasers of colleges. Instead, the data matching techniques were part of a compliance strategy on conversion to exempt status by organizations of all sorts. While this particular strategy is still in process, the results will inform future compliance efforts. Moreover, IRS has the capability to research various sectors as exemplified by reports on colleges and universities (2013) as well as hospitals (2009) posted on IRS.gov. On both the application and return, colleges file a separate schedule that identifies them as such, namely Form 1023, Schedule B, Schools, Colleges & Universities, and Form 990, Schedule E, Schools. Annually, we process thousands of internal and external referrals alleging malfeasance by specific organizations including colleges. IRS continually strives to improve the selection of cases for exam.

We share GAO's interest in ensuring compliance in this area and appreciate having the opportunity to review and comment on the draft report. Responses to your specific recommendations are enclosed. If you have any questions, please contact Margaret A. Von Lienen, Director, Exempt Organizations and Government Entities at 513-975-6562.

Sincerely,

Sunita B. Lough
Deputy Commissioner for Services and Enforcement

Enclosure

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Enclosure

GAO Recommendations and IRS Responses to GAO Draft Report “Higher Education: IRS and Education Could Better Address Risks Associated with Some For-Profit College Conversions”

Recommendation 1:

The Commissioner of IRS should assess the agency's internal controls for reviewing for-profit college applications for tax-exempt status and improve the review process to ensure that staff appropriately apply agency guidance on assessing potentially improper benefit to insiders.

Comment: IRS will assess its internal controls, including its review process, for reviewing applications for tax-exempt status from organizations with a for-profit history and will make improvements to those controls including the review process, as appropriate.

Recommendation 2:

The Commissioner of IRS should collect information, for instance on the annual IRS filing tax-exempt organizations are required to submit, that would enable the agency to systematically identify tax-exempt colleges with a for-profit history for audit and other compliance activities.

Comment: Form 990 currently includes questions that allow for systematic identification of organizations that have undertaken transactions with insiders that may indicate an increased risk of inurement. Nevertheless, IRS will evaluate the benefits and burdens of collecting information about the for-profit history of an organization, including colleges.

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Appendix III: Comments from the Department of Education

October 30, 2020

Ms. Melissa Emrey-Arras
Director, Education, Workforce, and Income Security Issues
Government Accountability Office 441 G Street, NW
Washington, DC 20548

Dear Ms. Emrey-Arras:

Thank you for providing the U. S. Department of Education (Department) with the opportunity to respond to the draft Government Accountability Office (GAO) report, IRS And Education Could Better Address Risks Associated with Some For-Profit College Conversions (GAO-21-89).

The Department agrees with GAO that it is important to identify and respond to the risks that former owners or other insiders could improperly benefit from the conversion of a for-profit college to nonprofit status under Department regulations. In addition to responding to the recommendation in the draft GAO report, the Department would like to provide additional clarifications.

Specifically, GAO's reference to “59 final for-profit conversions from January 2011 through August 2020” (GAO draft report p. 3) and related references to “59 colleges” could potentially lead a reader of the draft report to conclude that the Department has evaluated and approved more nonprofit conversion transactions than it actually has reviewed. This concern was raised during the exit conference and subsequent correspondence with GAO. Additionally, it is the Department's understanding that when GAO uses the term “college,” it is referring to a single postsecondary institution and all the institution's additional locations. The main campus of each college is identified by an OPE ID number, which is assigned by the Department. The college's additional locations are assigned sub-numbers. The Department considers a “school group” to be a group of colleges (i.e., each college consists of its main campus and any additional locations) under single ownership.

When a school group undergoes a change of ownership, several colleges may be sold, but it only involves one transaction. The Department reviewed fewer than 59 individual transactions, because several of the conversion transactions involved school groups that owned multiple colleges. On page 13 of the draft report GAO clarifies that “ [t]he 59 colleges in our review were acquired by 20 separate tax-exempt organizations. In a few cases, the tax-exempt organization acquired more than one college—up to 20 colleges in one case.” The Department requests that those numbers be clarified at the very beginning of the report, as well as that a distinction be made between “colleges” and groups of colleges involved in individual transactions. The potential for confusion continues in footnote 80 where GAO refers to “3 5 approved conversions” which again is a reference to individual OPE ID numbers, and not 35 transactions. The references to the number of “insider transactions” suffers from the same lack of clarity (unique transactions vs. number of OPE ID numbers in a single transaction).

As recognized in the GAO draft report, the Department's review of nonprofit conversions has strengthened overtime. Of the 20 separate conversion transactions, seven (comprising 30 of the 59 OPE ID numbers) were reviewed and approved by the Department before it began its heightened level of review of conversion transactions in 2016. Moreover, in a post-2016 review for a single transaction comprising 13 OPE ID numbers, the Department denied the approval for a change of ownership and conversion to nonprofit status for one of the OPE ID numbers, and eight of the 13 colleges (each with a separate OPE ID number) closed before a final decision was made. The four remaining OPE ID numbers are pending review in a second, separate transaction. Five of the 20 separate transactions (each with only a single OPE ID number) are also still under review by the Department.

In addition, two of the 20 transactions did not involve a change of ownership and conversion to nonprofit status. Rather, in each of these two transactions, an existing proprietary institution was acquired by, and became an additional location of, an established and approved nonprofit institution. As a result, the former proprietary college relinquished its individual OPE ID number when it became an additional location of the nonprofit college. Therefore, the requirements of 34 C.F.R. § 600.32 applied, instead of the requirements of 34 C.F.R. § 600.20 and 34 C.F.R. § 600.31.

The GAO draft report also includes a discussion of financial performance before and after change in ownership transactions based on whether insiders remained involved following the change of ownership. The Department conducts financial responsibility reviews at the highest level of ownership, and only one review is conducted per combined school group under single ownership. Accordingly, to the extent that “Figure 9: Financial Responsibility Composite Score of For-Profit Colleges Whose Conversion Involved Insiders, Year before and Year of Their Conversion Transactions” refers to “ 16 colleges,” financial statements for only nine entities were reviewed for nine separate school/school group transactions. Moreover, the Department understands the term “conversion” in the title of the graphics to refer to the closing of the change of ownership transaction itself — not the Department's decision on the requested conversion to nonprofit status. Of the nine separate transactions involved, five of those transactions have been subject to the heightened level of review that the Department has conducted since 2016. Only one of those transactions was reviewed in the year following the change of ownership, and that request to convert to nonprofit status was denied. Of the remaining four transactions, the heightened reviews were conducted more than a year following the change of ownership. One of those four reviews resulted in an initial denial of the request to convert to nonprofit status. Following a significant restructuring of the financial terms of that transaction, the Department approved the request to convert to nonprofit status. The second of the four transactions reviewed more than a year following the change of ownership was approved only after significant restructuring of the financial terms of the transaction. The third and fourth transactions remain under review.

“Figure 10: Financial Responsibility Composite Score of For-Profit Colleges whose Conversion Did Not Involve Insiders, Year before and Year of Their Conversion Transactions” refers to “36 of 40” colleges that changed ownership without insider involvement and had failing financial responsibility scores prior to the change in ownership. The Department notes that the 36 “failing” colleges involved only five separate school groups. Two of those five school group transactions (one involving 20 schools in the group) were reviewed prior to the Department's heightened review. The third transaction (involving 13 schools in the group) resulted in the Department's denial as to one school, the closure of several other schools in the group before the Department completed its post-closing review of the change of status, and the subsequent resale of the remaining schools in the group (and that subsequent second transaction is currently still under review). The fourth and fifth transactions were not 'changes of ownership'; rather, they involved an acquisition of an additional location by an existing nonprofit institution. The four colleges with passing composite scores involved three separate school transactions. One of those transactions was reviewed and approved prior to 2016, and the other two were reviewed and approved after 2016.

The 33 colleges that were described as “nearing bankruptcy” involved two separate school group transactions. The “nearingbankruptcy” schools are also included in the “36 of 40” with failing composite scores in the year prior to the change of ownership. One transaction (the 20-school group referred to above) was reviewed and approved prior to 2016. The other school group transaction (the 13-school group) is described above (denial as to one school, closure of other schools in the group, and the subsequent sale of the remaining schools).

The GAO draft report also refers to “26 of 40” colleges without insider involvement that had passing financial composite scores in the year following the change of ownership. These schools involved six separate school/school group transactions. Three transactions were reviewed and approved prior to 2016 (including the 20-group transaction), and three were reviewed and approved after 2016 (one of which was the acquisition of an additional location by an existing nonprofit).

Our response to the one recommendation for the Department in the GAO draft report is set forth below.

Recommendation 3: The Secretary of Education should develop and implement monitoring procedures for staff to review the audited financial statements of all newly converted nonprofit colleges for the risk of improper benefit.

Response: The Department concurs with this recommendation. As such, the Department will develop modifications to existing decision letter templates to include additional reporting requirements for newly converted nonprofit colleges (e.g., reporting of any IRS issues impacting the nonprofit status of the institution or IRS actions with related parties that involve the conversion, any changes in status with the institution's accrediting or state licensing agencies, and changes to existing service agreements, if any, between insiders and the institutions). Additionally, institutions will be required to report promptly any new or amended servicing or contracting agreements, and when another entity assumes any of responsibilities associated with the functional components of the institutions (in addition to the regulations requiring an institution to report changes related to third-party servicers). As appropriate, the decision letters may also direct the schools to provide additional financial reporting, including projected cash flow statements, which include information about their current operations and future plans, as well as enrollment monitoring reporting. Requirements for additional reporting will also be included as a condition in the provisional program participation agreement for Department review during the provisional period. The Department anticipates the need for closely monitoring newly converted nonprofit colleges for the risk of improper benefit until the school receives its first recertification after the change in ownership with nonprofit conversion.

The Department will develop new financial analysis procedures to ensure that all conversions are reviewed after the change in ownership by monitoring the additional reporting and subsequent financial statement submissions.

Thank you for the opportunity to respond to the recommendation outlined in this GAO draft report. We appreciate the time and the effort auditing this issue, as well as the opportunity to comment on the GAO draft report.

Sincerely,

Mark A. Brown
Chief Operating Officer
Office of Federal Student Aid

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