IRS Raises Questions as Charter Schools Mature

Published March 1, 2001

After almost a decade of growth, the charter school movement has produced more than 2,000 new public schools across the country that serve more than a half-million students.

That growth has attracted the approval of many school choice advocates, the opprobrium of many public school officials . . . and the attention of the Internal Revenue Service of the U.S. Department of the Treasury.

As a result, many charter school boards are re-examining contracts with management companies, and some charter school sponsors are being forced to reconsider what they are asking of charter school boards.

It is a sign of the coming of age of charter schools that the IRS now has a separate division for charter schools in the section addressing not-for-profit exemptions under section 501(c)(3) of the Internal Revenue Code. Since most charter schools are sponsored by not-for-profit organizations that either have or are seeking 501(c)(3) status, the IRS is becoming intimately involved with the charter school movement.

For-Profit Partners Raise Concerns

One area of particular concern to IRS agents is the partnership of some not-for-profit charter school operators with for-profit companies that manage charter schools. The IRS requires an “arm’s length” arrangement between the not-for-profit and the management company to qualify for 501(c)(3) status. If the arrangement is not “arm’s length” and the management contract cedes too much decision-making power, the not-for-profit may lose its 501(c)(3) exemption.

“When considering exemption with respect to charter schools that have contracted with for-profit entities for management services, the Service is particularly interested in whether the charter school board remains in control and continues to exercise its fiduciary responsibility to the school,” explains a six-page IRS document called “Charter Schools.” The document defines and clarifies elements of the charter school movement, explains what charter schools are, and describes the requirement for a 501(c)(3) exemption.

“The board may not delegate its responsibility and ultimate accountability for the school’s operations to a for-profit management company without raising the issue of whether the organization is operating for the private benefit of that company,” states the IRS document.

Many charter school boards opt to contract with educational management companies for a very good reason: The companies bring skills in proposal and contract development, curriculum guidance, staff procurement and development, and business and finance savvy–skills often absent in an organization that has never started or operated a public school before. The management company brings aid and comfort to a group of founders who have plenty of drive and vision but sometimes little experience operating a school.

The partnership of vision and experience also is growing in popularity with the local and state organizations that sponsor charter schools. The collaboration of not-for-profit and for-profit elements often convinces the sponsor of a greater likelihood of project success. Sponsors also are comforted by the prestige and venture capitalization that management companies can bring to the partnership.

But sometimes, the very thing that comforts charter school sponsors and boards draws the suspicion of the IRS. For example, “name branding”–the practice of requiring the management company’s name be attached to the school–helps a new charter school attract students and provides parents with a measure of quality and continued existence. But to the IRS, the same name branding “has no clear exempt purpose”; requiring it “may be an indicator of private benefit,” allowing a management company to build name recognition without additional expense.

Oversight Must Remain with Non-Profit

What particularly concerns the IRS in this marriage of for-profit and not-for-profit entities is independent leadership. In keeping with both the intent of charter school legislation and with IRS regulations, the not-for-profit directorship of the charter school must retain “active oversight” as an independent board of directors. A charter school board of directors is expected to be “composed of parents, teachers and community leaders.” Dominance of the board by a management company “raises questions as to whether the school will be operated for the benefit of the management company” instead of the not-for-profit.

A board that “delegates its duties and responsibilities to the management company” may forfeit its exempt status, warns the IRS. To avoid that situation, the board must retain oversight responsibility for “school policies such as the budget, curriculum, admissions procedures, student conduct, school calendars, and dispute resolution.” The board also must “have the responsibility and take appropriate action to ensure the fiscal health of the school.”

But the charter school sponsor may want the management company in control rather than the charter school board. The University of Missouri-St. Louis, for example, is attempting to nullify its contract with one of its sponsored charters after the not-for-profit board changed management companies. Under the first contact, the management company had responsibility for all development and operational decisions; under the revised contract, the board took back those responsibilities. Although the IRS would clearly prefer the second arrangement, the University declared it did not trust the not-for-profit organization to make its own decisions in school management.

According to Andrew Megosh, a tax law specialist with the IRS, a charter school that surrenders too much authority to a for-profit manager could be denied tax-exempt status. Denial of that exemption–which, for example, is required of all Missouri charter schools–could close a charter school. To be 501(c)(3) exempt, a charter school must “be organized and operated for the benefit of the public and not for the benefit of any private person, such as a service provider.”

The IRS participated in the U.S. Department of Education’s 1999 Charter Schools National Conference, and it offers training to school district personnel and charter school developers. The Service plans to continue its educational outreach efforts.

Paul H. Seibert is the editor of The Illinois Charter School Facs, which is published by Charter Consultants, a division of The Governor French Academy, Inc.

For more information . . .

Two undated chapters of an Internal Revenue Service publication–“H. Private Benefit Under IRC 501(c)(3)” and “J. Charter Schools”–are available through PolicyBot, The Heartland Institute’s free online research service. Point your browser to and click on PolicyBot. Search for documents #2111802 (18pp.) and #2111801 (6pp.) Adobe Acrobat’s PDF format.