501(c)(3) Schools: What a Change to For-Profit Status Involves

by: Sabre Linahan
Verified by: CPA

August 1, 2022

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In our recent article here about the court cases involving independent and private schools, Title IX and the threat to a school’s 501(c)(3) status, we stressed two things: 1) the need to avoid panic and 2) a suggestion that boards begin to look at a potential approach for their school’s situation.

While most schools are evaluating the impact of these court decisions, many are weighing the wisdom of continuing to operate a tax-exempt 501(c)(3) organization.

The decision to change tax status to for-profit must be carefully evaluated and should involve considerable input and advice from legal and accounting advisors. Such a change reaches into nearly every aspect of a school’s operations – and not just financial reporting.

In fact, the entire tax picture and reporting structure would change.

How Your Tax Approach Would Change

UBIT to Net Income – Not So Simple

Once no longer a tax-exempt organization, all net income is subject to tax, whereas the 501(c)(3) status allows for only profitable unrelated business income to be subject to tax. Looking at the Form 990 and calculating tax on the net income reported falls far short of the complexities involved in reporting on net income. Schools are currently under GAAP reporting rules; for tax purposes in the for-profit realm, treatment is different. As an example, revenue recognition methods and depreciation expense allowances are different under each.

State Tax Compliance Becomes a Thing

In addition to federal tax reporting considerations, state tax compliance may be required depending on the facts specific to each school.

Net Operating Loss

If a school operating as a for-profit entity generates a loss, it may carry the net operating loss forward to reduce future profits. However, current tax law limits the use of prior net operating losses to 80% of taxable income. Therefore, a school will not be allowed to completely shelter net income in future years by use of losses.

Financial Reporting Considerations

In addition to the tax implications of converting to a for-profit tax status, there are financial reporting considerations that will impact your school as well. Under generally accepted accounting principles (GAAP), for financial statement reporting purposes, you will need to conform to the presentation of financial statements in the same manner as other for-profit entities. This would result in presentation of a balance sheet and income statement as opposed to the required statements of financial position, activities and functional expenses which are currently required by nonprofit financial statement reporting requirements. Additionally, depending upon the tax structure you elect upon converting to a for-profit entity, there could be significant additional disclosure associated with accounting for income taxes among other potential required disclosures.

A Sea-Change in Donor and Supporter Engagement

A change from a 501(c)(3) to a for-profit entity will also affect donors. There is potential for this to make a significant difference in the school’s ability to generate donations from individuals and supporters, especially for independent schools who more often use contributions to “fill the gap” between tuition costs and tuition paid, as well as those who rely on donations for capital campaigns to make significant and usually costly vital upgrades or changes to the school.

Donations received as a for-profit school will be taxable income to the school, but those amounts will no longer qualify as charitable contributions on the donor’s side. Business supporters may be able to deduct their supportive contributions other types of expense on their returns. But for individuals, any contributions to a for-profit school will not be deductible for tax purposes. In addition, donations from foundations may no longer be allowed since the school is not protected by the 501(c)(3) status.

This change will make fundraising for capital campaigns and special events significantly harder because of the loss of the tax benefit. The extra funds schools have relied on to support operations and expansions will be more difficult to secure without the tax benefit received by donors when the schools operate as tax-exempt entities.

Forming a New Entity and Dissolving the Nonprofit

If a school pursues for-profit status, state law will dictate the transaction and if there are any requirements to form a new company. The school will need to determine who will own, direct, and serve as officers of the corporation. There may also be considerations around private benefit as the school exits the nonprofit status and begins its formation as a for-profit. This is a complex change and schools should partner with trusted advisors to navigate this change.

The school also needs to consider how this change may alter the relationships among its related organizations. For example, many schools have related foundations whose sole mission is to hold investments that are used to support the tax-exempt school. With the school now being a for-profit entity, the use of the Foundation funds and endowments may not be allowed to the same degree.

Finally, a question for legal counsel is how the change in federal tax status interplays with the dissolution clause in an organization’s formation documents and state law requirements. If a school becomes a for-profit entity and triggers the dissolution clause, then the school may be required to divest its assets – including any endowment assets – and start over with essentially nothing.

Title IX Requirements and Potential Impact on Private Schools

Title IX requires that no person in the U.S. “shall, on the basis of sex, be excluded from participation in, be denied the benefits of, or be subjected to discrimination under any education program or activity receiving Federal financial assistance.”  Under these recent court rulings, private and independent schools are required to comply with Title IX rules as their federal tax-exempt classification has been ruled to qualify as federal financial assistance. As gender gains a broader legal definition than in the past, it may conflict with deeply held foundational principles of some private and independent schools. Outside of the technical components of maintaining or not maintaining a tax-exempt status, the evolution of the Title IX issue may have additional impact on some schools. This is a matter for legal counsel and should be included in conversations with the board and counsel.

More to Come

We have just scratched the surface of the many issues that school management, boards and advisors should consider when contemplating a change to tax exempt status. Schools thinking about changes to their tax-exempt status should engage experienced financial and legal advisors to navigate these issues and the operational business changes that will come about should a school change its taxable status.

The Smith and Howard independent school team is keeping a watchful eye on developments in this area and will communicate as the situation develops. We regularly partner with other professional advisors such as law firms of our school clients to communicate with school leaders to provide thorough and well-rounded information. If you’d like to speak with us in more detail about this issue, please click the Contact An Advisor button below and we will follow up with you quickly.

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