Guidance on Revenue Sharing is Forthcoming but Not From Treasury or the Tax Court
I bet we are only about a year or 18 months away from an appellate determination whether private inurement or excess benefit necessarily results when a (c)(3) enters into a revenue-sharing agreement with a management company controlled by its insiders or disqualified persons. I don’t know whether it will be the first since Treasury reserved the issue in the excess benefit regulations issued in the 1990s. Treasury seems to have forgotten about the issue. But the Grand Canyon University case argued last week before the Ninth Circuit Court of Appeals and the OpenAI joint venture with Microsoft are pretty good indications that Treasury oughta reconvene the eggheads about it.
Surprisingly, the ruling will not come in a tax case. We have previously blogged about Grand Canyon University. That is the Arizona nonprofit that converted to for-profit status when it was nearly dead and needed capital from private investors. When it made it through those times, the owners converted back to Arizona nonprofit status and federal tax-exempt status. It was all on the up and up, the for-profit sold itself back for less than FMV by way of an entirely arms-length, conflict-free engineered process. At least that is what it looks like from the record. But then the owners of the former for-profit stayed on as President and other insiders for new nonprofit tax exempt GCU. And in that capacity, those insiders caused GCU to enter into a management agreement with the for-profit company they still owned. The management company will receive a share of tax exempt GCU’s revenues as compensation. The lion’s share, as a matter of fact. The management agreement was not in place when New GCU got its determination letter so they Service has neither condemned nor approved it.
Now GCU seeks “nonprofit” status from the Education Department so that its students have greater and easier access to federal financial aid and no doubt to complete its resurrection as a bona fide educational institution concerned more about education than profit. The relevant Higher Education provision defines “nonprofit” as just that, specifying only that the entity may not engage in private inurement. It does not include any other requirements stated or implied in 501(c)(3). It does not mention political activity or private benefit.
Education department regulations state that a nonprofit must have been determined exempt by Treasury under IRC 501(c)(3), thereby apparently incorporating all of IRC 501(c)(3). Education denied GCU’s application because it concluded that the management agreement results in private benefit, something Treasury could not have determined when it issued the determination letter because the management agreement came later. GCU argues that Education may not incorporate any requirement from (c)(3) other than inurement and that once the Service issued a determination letter, Education could not determine otherwise even regarding inurement, never mind private benefit. The lower court disagreed and upheld the denial of GCU’s HEA “nonprofit” status based the Education Department’s finding of private benefit.
GCU appealed and the Ninth Circuit heard oral arguments last week. You can listen above. The Ninth Circuit panel seemed clearly to agree with GCU. It repeatedly questioned whether Education may incorporate anything other than the prohibition against private inurement into the HEA definition of “nonprofit.” It seemed to appreciate the assertion that until the IRS revokes exemption for private inurement, the Education Department may not make a contrary finding. But it most likely will reject that assertion noting that private inurement is specifically mentioned in the HEA provision so it’s reasonable to think that Education may make an independent determination. It might not be good government, one judge admitted.
The panel gave a pretty clear indication that since Education relied on private benefit – something it is probably not authorized to do according to all three judges – but did not make a finding as to private inurement, the case should be remanded. It’s United Cancer Council in reverse. The Court will say that Education may not withhold “nonprofit status” based on private benefit but may do so based on private inurement. Since Education failed to make findings on the correct issue, the case must be remanded. Remanded to revisit the issue reserved by Treasury nearly 20 years ago, to wit:
Whether a (c)(3)’s revenue-sharing arrangement with a disqualified person – in this case the LLC manager controlled by GCU’s President and other insider/disqualified persons – results in private inurement and excess benefit even if the amount paid thereby is reasonable as determined by an independent analysis.
Its the long way around, but in the absence of a settlement, we might just get a considered judicial discussion about revenue sharing soon.
darryll k. jones