On November 8, 2011, the IRS and Treasury Department published an Advance Notice of Proposed Rulemaking (“2011 Advance Notice”) that posed a threat to charter school participation in public pension plan systems. The 2011 Advance Notice stated that the Treasury Department intended to issue regulations on when a retirement plan would constitute a “governmental plan” for qualified retirement plan purposes, and when a governmental affiliated employer, such as a charter school, would be considered an “instrumentality” of state or local government and therefore be eligible to participate in a public pension plan.
On February 9, 2015, in Notice 2015-07, the IRS published requirements for charter schools to qualify as an instrumentality of state or local government under the public pension plan rules of Internal Code Section 414(d). As a result of Notice 2015-07, charter schools should review the state laws under which they are authorized, and their charter contracts, to confirm that they satisfy the requirements to constitute an instrumentality of state or local government. Notice 2015-07 may also have important implications for a range of other issues affecting charter schools.
The Instrumentality Firestorm in 2011. The 2011 Advance Notice immediately generated a firestorm of controversy and concern within the charter school community. The vast majority of charter schools participate in public pension systems established for governmental units in general, or for public schools, and participation in the public pension system is an important component of charter school compensation. A regulation that would limit the ability of charter schools to qualify as instrumentalities would preclude many charter schools from participating in public pension systems. And the public pension systems themselves would face a risk of no longer meeting IRS requirements if they permitted the participation of non-governmental employers. Further, many state laws require that charter school employees participate in the state’s public pension plan system.
The 2011 Advance Notice was announced after some public pension plan systems declined to admit charter schools as employer members. Those public pension plan systems were concerned that a charter school would not be considered an “instrumentality” of state or local government and that permitting their participation in the public pension plan could disqualify that plan. The exclusion of charter schools by some public pension plans was not without some basis. In other areas of the tax laws, the IRS has taken the position that charter schools are not instrumentalities of state or local government, and the IRS has not always been consistent in these positions. In some cases the IRS has taken the position that charter schools are not instrumentalities of state or local government and must apply for exempt status as 501(c)(3) organizations. The IRS may apply a different “instrumentality” test for charter school bond financings. The IRS has taken the position that because they do not qualify as instrumentalities, charter schools and their supporting organizations (such as building corporations and management entities) must file annual information returns with the IRS (Form 990).
Notice 2015-07 and the Instrumentality Test. Notice 2015-07 sets forth factors that are to be evaluated in determining whether a charter school is an instrumentality of state or local government for purposes of participation in public pension plans. Because instrumentality status is a question of all of the facts and circumstances, there is no safe harbor which a charter school can satisfy and automatically qualify as an instrumentality. Charter schools should be able to satisfy a number of the listed factors easily. However, there are some listed factors which charter schools should evaluate closely to assure they qualify. Those factors include:
- If a charter school is permitted to or elects to withdraw from a public pension plan, the charter school’s employees’ benefits under the public pension plan must continue to be protected and funded under that public pension plan to the same extent that the employees of any other governmental unit are protected, if that governmental unit were to withdraw from the pension plan.
- The charter school must be subject to significant regulatory control and oversight by a governmental entity, such as a state department of education or the chartering school district.
- The school’s chartering authority must be able to hold the charter school accountable for its results.
- All financial interests of ownership in the charter school are held by a state governmental unit, such as the authorizing school district. Upon dissolution or final liquidation of the charter school, the charter school's governing documents require the charter school’s net assets to be distributed to another public school or to a state governmental entity, such as its chartering authority.
What Charter Schools Should Do. Notice 2015-07 provides that if a charter school does not now satisfy these requirements, it may continue to remain in a public pension plan until the final regulations are issued, which will likely take close to a year or more. Also, such charter schools may continue to remain in public pension plans after the final regulations are issued if they satisfy the requirements of Notice 2015-07 by the time final regulations are issued.
Charter schools should review all of the factors listed in Notice 2015-07 with their counsel to confirm that they would be regarded as eligible to participate in their state’s public pension system. In reviewing these factors, charter schools should take into account not only their applicable state law, but their governing instruments and the terms and conditions of agreements with their charter authorizer. In some circumstances, modifications to a charter school’s governing instruments or charter agreements might be appropriate to assure the charter school remains eligible for participation in a public sector pension plan.
Other Implications of Notice 2015-07. Notice 2015-07 was carefully drafted to limit its scope to the eligibility of charter schools to participate in governmental pension plans as instrumentalities of state or local government. While the IRS is clearly reserving the right to require that a charter school satisfy different requirements to qualify as an instrumentality for different tax purposes, charter schools should carefully consider how Notice 2015-07 might otherwise affect their tax status in other respects and use this review to re-examine their current tax reporting positions. Charter schools who have not previously obtained 501(c)(3) status may wish to now consider applying, or should confirm that their income is exempt from taxation under Code Section 115. Charter schools who are not filing Form 990 should evaluate whether they are exempt from filing requirements. Charter schools who are considering tax exempt financing should carefully review their own “instrumentality” status and the instrumentality status of any related borrowers (such as building corporations) with counsel.