Grand Canyon University’s Long Road Home: Non-Profit to For-Profit and Back Again (Or Not), II
Grand Canyon University’s motives seem right, but its process is wrong because it elevates process over mission even if that is not the intention.
From a moral but not legal vantage, I think Grand Canyon University deserves tax exemption from the Internal Revenue Service, and nonprofit status from the Department of Education. They seem sincere enough. But two things can make enemies of friends in this life: sex and money. None of the former, but plenty of the latter is involved in GCU’s demand for tax exempt status from both federal agencies. And despite GCU’s apparent sincerity and altruism, and despite the fact that it spent boatloads of money in a determined effort to be transparent with all involved, GCU is not legally entitled to tax exempt status from IRS nor DOE. I am sorry to say it. Its an easy fix, but one those who gave birth to New GCU seem disinclined to take.
Yesterday, I gave a history of what is now “New GCU.” Old GCU started off as a nonprofit but when it was on the verge of bankruptcy, the Trustees sold Old GCU to a publicly traded company called Grand Canyon Education, Inc. Actually, the for profit buyer was Significant Educations or some such, but it changed its name to GCE. Anyway, GCE restored the university to its former glory and more. At the same time it conducted itself as a model corporate citizen in Phoenix, AZ. But stakeholders longed for the good ol’ days when “Old GCU” was exempt, not just from income tax but from local property taxes amounting to about $10 million a year. So GCE determined to sell its educational assets to “New GCU,” a tax exempt single member LLC. The single member, by the way, was GCU Foundation, an entity controlled by GCE, most likely. So the for-profit stakeholders sold the University to a tax exempt entity controlled by the same for-profit stakeholders. You recognize the problem already.
But look, we shouldn’t get unnecessarily in the way if capitalists evolve into altruists. By that I mean if I give birth, nurture and raise a greedy capitalist entity, and then in my later years decide my entity should sell its possession and follow Jesus (on a tax exempt basis, mind you), the law should not reflexively look askance. If I do it fairly and in the end I pursue the public good rather than private profit, the law should applaud, not condemn me. I have only been reading about New GCU for a few days but I am willing to give New GCU the benefit of the doubt regarding its altruistic motives.
GCU wanted tax exempt status for competitive reasons. In the good, nonprofit sense I mean. It would be able to recruit more students, pay fewer property and income taxes, accept charitable contributions and generate service income. And designation as a nonprofit under DOE rules apparently makes heavy financial aid doors easier to open than if the entity remained a for profit university. Maybe DOE nonprofit status benefits students by making financial aid cheaper at GCU. I don’t question New GCU’s motivations. In any event, tax exempt nonprofit status is all well subsidized upside potential, making any disguised profiteer salivate.
It looks like NEW GCU earnestly sought to do everything right. They hired Barclays, the big multinational investment banking firm to advise it on the economics of the deal. They obtained a fairly sophisticated transfer pricing analysis from Deloitte, the big multinational consulting firm, to justify the price at which for-profit GCE would sell its educational assets to “New GCU.” And they hired Cooley, a big multinational law firm to advise it through the DOE requirements.
You woulda thunk they’d get this right with all that well-paid and well-traveled brainpower. But no. Either they multinational men and women in suits didn’t tell New GCU, New GCU didn’t listen, or New GCU made a deliberate decision to crash and burn on Flanders Fields of Private Inurement. Because that is what happened, they crashed and burned on private inurement. And now they should likely face an IRS examination on top of the Securities Act lawsuit filed (alleging 10b-5 violations because New GCU is not really tax exempt, basically) against “Old GCU,” one that seems likely to prevail. The Securities complaint, by the way, contains a fascinating history of DOE’s policy changes regarding for-profit to nonprofit conversions. The different policy approaches are basically emblematic of most policy differences between the Obama and Trump administrations.
The private inurement problem takes very few words to describe. The facts are detailed in DOE’s decision letter and a federal district court ruling last December upholding DOE’s findings. For-profit GCU, an educational service company that previously operated Grand Canyon University as its own, sold its educational assets to New GCU, at or below market price. But as part of the deal, For-Profit GCU, whose top dog simultaneously serves as New GCU’s top dog, entered into a management contract giving it exclusive rights over all the non-academic things universities typically do. The management contract gave For-profit GCU an explicit profit split (though the amount was subsequently capped when DOE objected) from food services, housing, IT, bookstores maybe, pretty much all the auxiliary services customarily found around a legit campus. And I think New GCU is legit, its not a stereotypical for profit institution, though its had its share of lawsuits along those lines. Although New GCU obtained an IRS determination letter, no questions asked, from IRS attesting to its 501(c)(3) status, the letter came on the front end of the transaction. That is, the determination letter, like most, was forward looking and based on prospective facts. At best, it determined that New GCU was organized appropriately. It could not have been intended to opine on whether New GCU was then operating as a 501(c)(3), though the form letter stated that “no part of your net earnings inure . . . ” If so it was clearly wrong. That’s the only explanation I can find for why the Service recognized New GCU under 501(c)(3). No doubt, GCU thought that designation would make it ease through the DOE process. A process that requires the absence of private inurement and private benefit.
The thing is, DOE gets far fewer applications for tax exempt status than the IRS, is not chronically underfunded, and is not under any sort of pressure to rule on 1023s within a short period of time. I betcha New GCU’s application to DOE constituted one of a number of applications that on any given day can be counted on one hand, two at the most. DOE obviously had time on its hands that IRS does not have. When DOE saw the management contract, they pretty easily concluded that it constituted private inurement and private benefit, and that New GCU did not qualify under IRC 501(c)(3). They took 18 single spaced pages to say why, so here is the short version.
1. The transaction was conducted in the manner of Smith v. Van Gorkum, except not as quickly and with a lot more paperwork. But Old GCU played the role of Van Gorkum, conceiving, driving, and executing the transaction with New GCU almost entirely without independent review by New GCU. For the nearly $1 billion purchase price, one would think New GCU would have had its own independent advisors. Instead New GCU’s Board was like the Trans Union Board in Van Gorkum, not knowing the critical details, just signing where they were told to sign — maybe sipping champagne while doing so as was the case in Van Gorkum at one point. Ironically, Deloitte’s transfer pricing analysis according to the Court, was an appropriate measure if there is a transfer between related entities. DOE stated as much but didn’t recognize the hidden admission in the use of transfer pricing analysist — that the two entities could not possibly be operating at arms length because they were under a common control. If there is a business judgment rule for nonprofits, it could not possibly apply in this instance.
2. The management services agreement, though ostensibly an arms length contract between two independent contractors, would hardly escape classification as a real partnership agreement under RUPA. Which is to say that there was, in fact if not in law pursuant to an explicit agreement, a partnership between GCE and New GCU (and GCE had voting control as far as I can tell). And it is something closer to a whole hospital joint venture than an ancillary joint venture, the latter of which requires less independent control by the charity, control required in any event lest the profit motivation take precedence over the charitable mission. If New GCU wants to keep its tax exempt status under IRC 501(c)(3), this has to be unwound.
3. The management services agreement creates joint venture private inurement even if the price paid by New GCU is no more than fair market value. The exclusive nature of the contract, one that lasts for years and comes with a right to veto contracts with other service providers, is financial benefit transferred to an insider without commensurate return value. “Old GCU” may not have been an insider through its first bite management contract, but that New GCU’s top dog is also Old GCU’s top dog makes Old GCU an insider other than merely by the management contract.
4. DOE determined that 95% of New GCU’s revenues would be paid to Old GCU pursuant to the management services contract. If that ain’t United Cancer Council private benefit, I don’t know what is.
It appears that GCU doesn’t need DOE’s approval of its nonprofit bona fides. It had enough goodwill and political capital that it likely pays no more property tax. And the federal district court, though upholding DOE’s determination, ruled that GCU could advertise itself as “not-for profit” like most other schools. So there is no sign that New GCU will scuttle the management agreement or that its President will sever ties with the management company. I’d be really careful, though. DOE’s findings aren’t likely to be ignored or disproven over at Service.
darryll jones