Conversions of For-Profit to Nonprofit Colleges Deserve Regulators’ Scrutiny
We trust nonprofits. They heal us, teach us, feed us when we’re hungry. Economists would say that organizations take on the nonprofit form in order to promote trust between donors and the possibly all-too-human managers who decide how donated dollars are spent. Federal law places some faith in the nonprofit form, too. For example, the “gainful employment” rule limits the flow of federally subsidized loan dollars to for-profit educators, unless graduates of the funded programs consistently earn enough to pay off their loans. Nonprofits’ degree-granting programs are exempt.
Federal faith in the nonprofit form will soon be tested by a wave of for-profit colleges aiming to partner with or convert to nonprofits — probably to avoid the gainful employment rule, although some schools have said otherwise. The Department of Education so far seems to have assumed that nonprofits can be better trusted not to exploit vulnerable students or create “diploma mills” for harvesting federal subsidies (though new rules may expand coverage to some nonprofit undergrad programs). In essence, ED relies on the IRS to screen out exploitative firms and ensure that the worst actors don’t get nonprofit status.
That’s a problem. The IRS, as most readers know, is badly underfunded, and TEGE (the tax-exempt and governmental entities unit) has been crippled by the political backlash of the Lois Lerner “scandal.” According to IRS data, from 2009 to 2016, the share of new applications for nonprofit status rejected by the Service plummeted by more than 90%. On top of that, IRS rules make the opposite assumption from DoE: they often presume that a nonprofit with substantial ties to a money-making business can be trusted with nonprofit status, as long as there is another regulator around to police the firm.
Many of us learned not to make that mistake at around nine years old. A ball soars through the air and, uncaught, plops softly to the ground. Two outfielders look at each other. And both say, “I thought you had it.” Sometimes two regulators aren’t as good as one. Before Dodd-Frank, banking regulators competed with one another for an overlapping regulatory portfolio, leading to a race to the bottom in some banking standards. Other times, agencies seem to pass the buck for hard decisions back and forth.
The college conversions deserve a close look. Consider the proposed reorganization of Grand Canyon University (“GCU”). According to securities filings, GCU will split off its real estate and “academic-related” assets to reform as a nonprofit college. The remaining piece of the firm will then contract with the college to provide “recruiting, counseling, human resources and marketing” services; GCU’s recent form 8K also mentions “financial aid.” In exchange, the for-profit will take about a 60% share of the tuition, fees, room, and board revenue earned by the college. The disclosures claim that this split is “comparable to other services agreements currently in the marketplace.”
But wait, that’s not all the for-profit gets! The new nonprofit has no money. How it will afford the $800m purchase price for the existing campus? It will take out a balloon (i.e., interest-only) loan from the for-profit, paying an interest rate of about 6%. Nonprofit GCU can get out of its 60/40 service agreement, but only if it first pays off the entire $800m loan balance, and pays a termination fee of one years’ service fees on top of it.
In short, the agreement allows for-profit GCU to suck out the vast majority of nonprofit GCU’s income. The disclosures are unclear about whether the 60/40 split is of gross or net revenues. Either way, given that the nonprofit would pay $48m in annual interest on top, it is hard to see how nonprofit GCU will have much if any remaining income to set aside as savings. And that means it will be locked forever into its service contract. Not that it would ever seek to escape, because “[nonprofit] GCU would be governed by a board of trustees comprised of the persons who currently serve on the institutional board of trustees of [for-profit] GCU.”
That is not a charity. It is a trustworthy-looking wrapper around a for-profit business.
Put in legal terms, the transaction looks as though it violates federal tax prohibitions on “private inurement.” To qualify for tax-exempt status as a charity or social welfare organization (under sections 501(c)(3) or 501(c)(4) of the tax code, respectively), an entity cannot distribute “net earnings” to its board members, managers, or others with similar influence over the firm. It can’t, in other words, pay out profits. Of course, charities can pay salaries, hire contractors, and even enter into complex service arrangements with outside providers, so long as those agreements are on terms that are fair to the charity. A densely detailed set of regulations and other guidance sketches some rough boundary lines between permissible contracts and those that improperly divert charitable resources to a private purpose.
When a charity engages in what amounts to a joint venture with a for-profit firm, the private inurement rules require that the agreement satisfy what is sometimes known as the “control test.” The control test derives from a revenue ruling, RR 98–15, as well as a series of federal appellate decisions upholding and applying the revenue ruling. The ruling is unfortunately typical of IRS guidance in its reliance on a long list of factors, or “facts and circumstances,” without clear statements about which factors are the most important.
Still, GCU’s proposal pretty clearly fails the control test. To be sure, one central factor in the test is whether the venture agreement provides for “reasonable compensation,” and GCU has been careful to state that both the $800m sale price and the 60/40 split are based on market comparables. GCU will still be an educational institution. But there are no assurances that the new organization will prioritize its charitable mission over profit. Under the control test, overlapping boards between the for-profit and nonprofit are a serious red flag. So, too, is the inability of the nonprofit to escape its management agreement. And, as in the situation ruled impermissible in the revenue ruling, for-profit GCU will “have broad discretion over [nonprofit]’s activities and assets that may not always be under the [nonprofit] board’s supervision.” Nor are those activities peripheral to the college’s mission — certainly recruitment and financial aid are central components of how a college builds its student community.
Even if the arrangement isn’t considered as a joint venture, it would still violate the more general prohibition on private inurement. Private inurement rules govern not only those with current positions of power, but also those who within the past five years held such a position, so for-profit GCU certainly fits that description. The private inurement rules don’t outright forbid incentive pay, but profit-sharing or other contracts that would incentivize managers to favor revenue over nonprofit mission are extremely disfavored. A manager that earns 60% of revenues has obvious incentives to maximize them. Even the nonprofit’s officers would have powerful incentives to ensure enough cash flow to service the massive $800m loan, forcing them to constantly scramble for dollars at the expense of educational quality. A finding of private inurement might not outright prohibit nonprofit status, but it would trigger penalty taxes that would make conversion economically infeasible.
We don’t know yet how the IRS will rule on GCU’s application, but two factors worry me. One is just the current depleted and demoralized state of the TEGE unit. The other, as I mentioned at the top, is the language appearing in some descriptions of the control test suggesting that the presence of another regulator can serve to assure that a joint venture will avoid excess private inurement. That is a mistake, in my view. Let’s put aside the current views of the DeVos-led Department of Education. Regulators should be on guard for the human tendency to hope the other outfielder will catch the ball. Double vigilance, not free riding, is the wiser course.
We could say the same to ED and state regulators who may assume that IRS review will protect the interests of students and donors. All of these have to sign off on the majority of the proposed conversion transactions. They should give a long, careful consideration before they do so, and not assume that a firm’s ability to slip through the porous IRS net is a meaningful signal of nonprofit quality.
This post is already too long, but let me mention two other deep structural problems with the law of nonprofits that make these cases harder than they need to be. Many private inurement questions are unpredictable and resource intensive because they come down to battles of the experts: was the price the charity paid really a fair market price? Matters are much simpler in the special case of “private foundations,” or organizations whose funding comes from just a handful of donors. Private foundations can’t engage in most transactions with their insiders, whether “fair” to the charity or not: the law presumes that these deals are so likely to be unfair, and will be so hard to police, that none are permitted (I have much more to say about private foundations here).
It’s not clear why the law is so much more generous to inside dealing at other charities. Even if deals with insiders weren’t totally prohibited, they could still be limited to, say, those where the insider is earning zero profits. Certainly, that rule make rarer the already-rare beneficial deal between charity and insider. But that seems a minor price to pay for simplifying the law, making it more predictable, and protecting charitable dollars from abuse. Alternately, we might reconsider the statutory exception that makes all “schools” exempt from private foundation status. Students and faculty are not in a good position to monitor self-dealing between a college and its management company (though better disclosures could help). We shouldn’t presume schools are mostly safe from the private inurement problem.