Potential IRS Regulations May Affect Public Charter Schools
The Internal Revenue Code treats governmental pension plans differently from private sector pension plans. In some cases, governmental plans are carved out altogether from federal tax rules applicable to private sector plans; in other cases, such rules are tailored to reflect the unique circumstances of governmental plans and the state or local government sector they serve.
To help clarify which governmental plans are eligible for the special tax rules, the Internal Revenue Service has issued an advance notice of proposed rulemaking to solicit feedback as it develops proposed regulations to define the term “governmental plan” under Internal Revenue Code section 414(d). The forthcoming proposed regulations are likely to list multiple facts and circumstances tests—categorized as main factors and other factors—as the means to determine whether an entity is an agency or an instrumentality of a state or political subdivision and thus eligible to have its employees participate in a governmental plan.
At this point, the IRS has yet to officially propose these regulations. An official proposal constitutes one of the first steps in a multi-step federal process that includes a public comment period; further review, analysis and incorporation of the comments; and publication of the final regulations in the Federal Registrar. The official process can span the course of a year or longer.
California Public Charter Schools
CalSTRS has been monitoring the development of the IRS proposal and recently became aware that public charter schools in California operated by nonprofit organizations probably would not be considered agencies or instrumentalities of the state or a political subdivision. Ultimately, this would compel CalSTRS to prohibit the participation of charter schools in its benefit programs so that the CalSTRS programs do not lose their governmental plan status.
Below is a brief summary of the main and other factors the IRS is considering to determine whether employees of an entity are eligible to participate in a governmental plan, and how California public charter school employees might fare when tested against them.
The IRS is considering the following main facts and circumstances to determine whether an entity’s employees are eligible to participate in a governmental plan:
- The entity’s governing board or body is controlled by a state or political subdivision.
- The members of the entity’s governing board or body are publicly nominated or elected.
- A state or political subdivision has fiscal responsibility for the general debts and other liabilities of the entity, including the responsibility for the funding of benefits under the entity’s employee benefits plans.
- The entity’s employees are treated in the same manner as employees of the state or political subdivision for purposes other than providing employee benefits.
- The entity is designated the authority to exercise sovereign powers, which generally means the power of taxation, eminent domain or police power.
Do California public charter schools pass the main facts and circumstances tests?
Most California public charter schools likely would not pass these main tests, primarily because the presence of a nonprofit operator introduces a layer of oversight and management separate from that of the school district which eventually leads to ineligibility under these tests.
For example, a nonprofit corporation typically has and selects its own board and members without public nomination or election, thus disqualifying the school under tests A and B above. Also, nonprofit-run charter schools tend to operate outside the fiscal responsibility of the school district and are solely liable for their debts, so these schools fail test C. These governance and fiscal responsibility tests are likely to be viewed as key by the IRS when it issues the proposed regulations.
A nonprofit-run charter school may pass test D because its teachers are typically required to have a California teaching credential and are subject to California’s education labor relations laws that govern unions and bargaining. However, charter school teachers are exempt from the laws that govern tenure, evaluation and dismissal, which reduces the likelihood that a charter school will pass test D.
Finally, charter schools lack the authority to exercise sovereign powers that are exclusively reserved for school districts, and therefore charter schools cannot satisfy test E.
The IRS is considering a second tier of other facts and circumstances to determine whether an entity’s employees are eligible to participate in a governmental plan:
- The entity’s operations are controlled by a state or political subdivision.
- The entity is directly funded through tax revenues or other public sources.
- The entity is created by a state government or political subdivision pursuant to a specific enabling statute that prescribes the purposes, powers and manners in which the entity is to be established and operated.
- The entity is treated as a governmental entity for federal employment tax or income tax purposes, such as the authority to issue tax-exempt bonds.
- The entity is determined to be an agency or instrumentality of a state or political subdivision for purposes of state laws; for example, the entity is subject to open meetings laws or the requirement to maintain public records that apply only to governmental entities, or the state attorney general represents the entity in court under state statute that only permits representation of state entities.
- The entity is determined to be an agency or instrumentality of a state or political subdivision by a state or federal court.
- A state or political subdivision has the ownership interest in the entity and no private interests are involved.
- The entity serves a governmental purpose.
Do California public charter schools pass the other facts and circumstances tests?
Generally, most California public charter schools may pass tests B, C and H. On the other hand, the presence of a nonprofit organization serving as the school operator may make tests A and G difficult to pass.
The ability of a charter school to pass test D is difficult to determine and will depend on how the IRS applies this test to a conduit financing arrangement. For example, a charter school may participate in a bond offering through a conduit issuer—such as the California School Finance Authority—and receive the proceeds of the bond offering, but not receive the federal tax exemption granted to the issuer.
With regard to test E, while school districts strongly encourage charter schools to comply with open meetings laws and public records laws, these laws do not apply to nonprofit boards operating charter schools, therefore charter schools do not pass this test.
Finally, the ability to pass test F may or may not occur in isolated situations.
- How does passing/not passing the other facts and circumstances tests rank against passing/not passing the main facts and circumstances tests?
The answer is not entirely clear at this point. The IRS has not yet determined the ultimate weight and rank of main factors versus other facts and circumstances. However, if the bulk of the main factors are not met, it may be difficult to overcome that failure by successfully fulfilling the other facts and circumstances.
For example, the IRS is likely to view governance, control and fiscal responsibility factors as key. It is presumed the weight and ranking of the factors will be clarified when the proposed regulations are officially issued.
- What happens if a charter school does not meet the test for its employees to participate in a governmental plan?
Under current federal law, the inclusion of ineligible employees in a governmental plan could disqualify the plan from favorable tax treatment, subjecting CalSTRS and CalSTRS members to current taxation of plan earnings. The IRS does not indicate whether the remedy to correct any errors with respect to the participation of ineligible employees is to:
- Permit existing ineligible employees to continue to accrue benefits under the plan, but prohibit any such employees from becoming members in the future.
- Permit the ultimate payment of benefits already accrued by ineligible employees, but prohibit the accrual of future benefits for such existing or any subsequent ineligible employees.
- Prohibit the payment of any benefits for service performed as ineligible employees.
As a result, it is unclear at this time what the consequences would be if the regulations were implemented in their current form and charter school employees were determined to be ineligible to participate in CalSTRS benefit programs.
To help guide development of the impending proposed regulations, the IRS is accepting written comments from the public until June 18, 2012. Oral comments from the public can be made at a public hearing in Washington, D.C. on July 9, 2012. Town Hall meetings are also planned by the IRS to garner feedback, one of which will be in Oakland-the only session planned in California-on March 15, 2012, and will be attended by CalSTRS.
CalSTRS will communicate its concern about the charter school issue to the IRS through comments developed collaboratively with the National Association of State Retirement Administrators and the National Council on Teacher Retirement. The comments submitted by NASRA and NCTR will also include input from other state plans, many of which have identified similar issues with their public charter schools.