An incisive report published today from the U.S. Government Accountability Office (GAO) provides an in-depth look at the growing trend of for-profit colleges converting to nonprofit — something that The Century Foundation (TCF) has been studying and raising concerns about, for years.
Three core findings stand out in the new report. First, when ownership seeks to preserve some sort of insider role with the nonprofit school, conversions can become compromised, causing leadership and resources to be diverted from the college’s educational mission and instead steered into growing the former owner’s bank account. Of the nearly sixty conversions that GAO examined, insiders continued to play a role in the newly established nonprofit in roughly one-third. The GAO found that, among converted schools, those in which an insider continued to play a role account for the vast majority of federal aid, have worse financial performance, and risk improperly channeling profits to those insiders. Second, IRS tax-exempt status is wholly inadequate for assessing whether a school is actually nonprofit in the way it is operating. And third, neither the IRS nor the Department of Education are doing enough to address the problem.
The GAO report does not name any of the schools, which makes reading the report a bit like playing the board game Clue without the list of characters. Fortunately, lists of conversions are available elsewhere (see TCF’s list here and a federal list here). Bread crumbs dropped throughout the report can lead knowledgeable readers to some conversions that have already made headlines, and some others that have flown under the radar. Schools that have profiles that are consistent with details in the GAO report include Keiser University, Remington Colleges, Independence University and affiliates, Hallmark University, Community Care College, Herzing University, Ultimate Medical Academy, Grand Canyon University, American Academy of Art, Corinthian Colleges (the schools that survived bankruptcy), and the EDMC schools (Argosy, Art Institutes, and South University).
Warning Signs of a Compromised Nonprofit School
At a legitimate nonprofit school, the money earned — whether from tuition, donations, or sales of sweatshirts — must be fully dedicated to the educational or charitable mission of the organization. All revenues are to be reinvested, and no one is allowed to “improperly benefit.” What counts as improper, however, is not always black and white, giving schemers room to maneuver, particularly when robust enforcement is lacking.
GAO helpfully points to three warning signs that a conversion transaction may be suspect. First, the conversion is financed by an IOU to the former owner, rather than with actual money from a third party, such as a bank, thus avoiding independent analysis that might bring a lower price for the school. Second, the transaction is composed largely of intangible assets — things such as the value of a brand name or of accreditation — which are “inherently difficult to value,” according to GAO. Third, the former owner of the for-profit operates as an “insider” of the nonprofit, playing a direct or indirect role that allows them to nudge the school toward decisions that “further their own private financial interests rather than support the college’s mission.”
In a for-profit company, owners can route revenue directly from a school’s profits into their pockets. To make money from a compromised nonprofit, owners style their hoped-for revenue stream as payments on inflated contracts or IOUs; then they continue to shepherd the school in ways that maximize those payments. These types of arrangements contaminate the nonprofit governance of a school with a for-profit incentive structure, which often leads to prioritizing growth over quality and investing more on marketing and less on education, resulting in students with more unmanageable debt and worse job outcomes.
Inflated IOUs Held by Owners
One sign that a for-profit conversion is suspect, according to the GAO, is when a school is sold in exchange for an IOU, especially if the purchase involves intangible assets. Such a transaction can allow a school’s sales price to be inflated — which is most clearly revealed as suspect if the assets that were purchased are later reassessed at a much lower value. This type of later devaluation has happened at three of the four conversions featured in TCF’s 2015 report, The Covert For-Profit, according to the colleges’ subsequent financial statements.
Florida’s Keiser University, for example, was purchased from its owner, Arthur Keiser, with a promissory note for $300 million. Keiser University’s intangible assets at the point of sale were initially valued on the school’s audited financial statement at $535,547,351 in total — enough to justify not only a $300 million IOU, but also a hefty tax-deductible noncash contribution from the owner to the nonprofit equal to the remaining declared value. But, Keiser University later reduced its intangible asset valuation by an eye-popping $250 million. The revision was prompted, according to the college financial statement, by reduced stock prices of for-profit schools and the potential impact of new regulations. The evaluators at GAO may or may not have been pointing to Keiser when they cited a college that “recognized a substantial loss on the intangible assets acquired when the college was purchased from its former owner about 3 years earlier.” Regarding that substantial loss, GAO observed: “While such a loss may arise for unforeseen reasons (i.e. shifting market conditions), it could also indicate that the college and its assets were knowingly overvalued at the time of the sale to improperly benefit insiders.”
Wisconsin-based Herzing University has not revised its asset valuation, according to the financial statements that are currently available. However, the original IOU to the former owner was for $86 million-plus interest, for assets that were about half intangible. A year later, the owner was paid $42 million for the school — less than half the IOU amount — which the school financed with traditional bank loans.
The religious Dream Center Foundation’s acquisition of Argosy, Art Institute, and South University also may have been a case of inflated debt for intangible assets. Dream Center’s purchase was arranged by Jahm Najafi and financed by a loan from Najafi’s company. In reviewing the deal, accreditors expressed concern that the loan value was the product of an insider arrangement (Najafi was friends with Dream Center executives), without a formal and independent review. Within years, the schools ran out of money and argued in court that the schools’ value had been inflated from the start.
Misleading Advertising
Most consumers do not have a sophisticated understanding of what “nonprofit” means, but many of them have heard enough about predatory abuses by for-profit schools that the nonprofit label offers some welcome reassurance. The GAO report noted that several questionable colleges began to market themselves as nonprofits while the Department of Education still viewed them as for-profit entities. While the department has begun to warn schools against this practice, many students have already been misled by premature marketing of nonprofit status.
In February 2019, the CEO of Grand Canyon Education Inc. boasted to shareholders of record new-student enrollments and company profits. “Being out there a million times a day saying ‘we’re nonprofit’ has had an impact,” he said. The prior year the company had transferred some of its Grand Canyon University assets to a nonprofit corporation it had created, in exchange for debt and a long-term services contract. At the time of the call with shareholders, the Department of Education had not yet approved the Grand Canyon nonprofit claim — and ultimately, the agency denied it. If Grand Canyon is the unnamed school in the GAO report, then its students “may have had a mistaken understanding about whether they were pursuing a degree from a college recognized by Education as a nonprofit.” The department, in its denial letter, labeled the school a “captive client” of contractor/former owner, which it calculated was receiving 95 percent of the university’s revenue.
After the owners of online Ashford University announced a plan to convert, the Department of Education warned the company not to advertise the school as nonprofit until the department had cleared the transaction, including the nonprofit designation. As the school was in the process of being acquired by a University of Arizona affiliate last year, however, the “nonprofit” claim was made repeatedly without apparent authorization.
Independence University and other colleges owned by the Center for Excellence in Higher Education advertised as nonprofit long before the schools received approval to use the designation from the Department of Education; the department had initially denied the school the designation, but allowed it only after substantial changes were made to the transaction, as reported in the Chronicle of Higher Education (see “How a For-Profit Tycoon Turned His Colleges Into Nonprofits”).
Similarly, Herzing University started marketing itself as a nonprofit shortly after its tax-exempt scholarship foundation purchased the school from its owner. However, the Department of Education did not approve the nonprofit designation until 2018, after the debt was refinanced at a lower amount through a traditional lender.
Disclosure to the IRS Is Not Approval
GAO found fault with many of the IRS’s processes for reviewing conversions of for-profit colleges. The IRS’s best opportunity to assess the integrity of a for-profit entity’s conversion to nonprofit is when the agency reviews an initial application for nonprofit status, notes GAO. However, the GAO study found that IRS examiners, even when an application revealed a high-risk for-profit conversion transaction, sometimes failed to follow up with a more rigorous review.
Furthermore, the GAO found that for-profit owners can easily bypass IRS review by using an already-tax-exempt entity they or others had created previously. In those cases — which accounted for a majority of the conversions reviewed by GAO — the tax-exempt entity simply notes the acquisition of the college on its annual tax return. GAO found that the IRS does not review the returns, unless an organization is identified for audit. The IRS relies on the tax-exempt organizations themselves, and in particular their boards, to be diligent in ensuring that any transactions are focused on their tax-exempt mission and do not improperly benefit private parties.
For-profit owners who have converted have tried to claim that because they reported the transaction and the IOU, the action was above board. That was how Arthur Keiser defended his nonprofit’s purchase of his for-profit college. He told the New York Times in 2015: “We disclosed everything. There’s nothing wrong with it.” But — as the GAO report makes clear — the IRS does not ratify or even routinely review the information reported on these schools’ tax filing forms.
What Is To Be Done?
GAO credits the Department of Education with improving its review of for-profit colleges converting to nonprofit, by establishing a centralized team of contract, finance, and legal experts. So far, the team has been responsible for reviewing one transaction — a review that GAO says included “a detailed consideration of the fairness of the sale price, a former owner’s continuing role in the college, and the independence of the college’s board, among other things.”
The increased rigor of the Department of Education’s reviews of college conversions needs to continue in the Biden administration and should be applied to conversions that were approved earlier. Furthermore, the question of whether there has been for-profit capture of nonprofit higher education should be extended to the examination of any college that exhibits signs of improper benefit to private parties, including contracts with online program managers and other service providers or lenders.
Solving the problems at the IRS is going to be more difficult. The agency’s response to GAO’s findings (published at the end of the report) does not inspire confidence that the agency will take the recommendations seriously. Congress needs to hold the IRS’s feet to the fire. Furthermore, the Department of the Treasury must take a leadership role in rebuilding the oversight capacity of the IRS’s tax-exempt division.
The problem of covert for-profit colleges is real, but the scope is still relatively small in the universe of nonprofit higher education. Acting now to restore the integrity of nonprofit colleges is critical to maintaining our country’s leadership in quality higher education.
