Independently governed charter school is not a state instrumentality

Plain-English summary

A nonprofit charter school sought refunds of FICA taxes on the theory that it was a wholly owned instrumentality of a state or political subdivision. Applying the six factors in Revenue Ruling 57-128, Chief Counsel found that the school served a governmental educational purpose and had statutory authorization, but private individuals selected its governing board, no public authority controlled ordinary operations or budgeting, and state oversight was primarily regulatory. Public funding and participation in governmental retirement plans did not overcome the school’s operational and financial autonomy. The school therefore remained subject to FICA on employee compensation.

Ruling snapshot

• Question: Is the independently governed charter school a wholly owned state instrumentality under section 3121(b)(7)(F)?
• Outcome: Advice given: no, the school is not a wholly owned instrumentality and its employee compensation remains subject to FICA.
• Key authorities: IRC §§ 3101, 3111, 3121(b)(7), 3121(u)(2); Rev. Rul. 57-128, 1957-1 C.B. 311; Rev. Rul. 65-26, 1965-1 C.B. 444; Rev. Rul. 69-453, 1969-2 C.B. 182; Unibrand Inc. v. Commissioner, 140 T.C. 230 (2013)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201519027
       Release Date: 5/8/2015
       CC:TEGE:EOEG:ET2LCAMILLO                              Third Party Communication: None
       PRESP-134939-13                                       Date of Communication: Not Applicable

UILC: 3121.02-05

date: January 23, 2015

 to:   David A. Conrad
       Area Counsel, Tax Exempt and Government Entities
       (CC:TEGEDC:MSDENSL)

from: Lynne Camillo
(Chief, Employment Tax Branch 2)
Office of the Associate Chief Counsel, Tax Exempt and Government Entities
(CC:TEGE:EOEG:ET2)

subject: Wholly-Owned Instrumentality Status of ---------------------Charter School

       This responds to your request for advice on whether ---------------------Charter School is a
       wholly-owned instrumentality of a state or of a political subdivision of a state within the
       meaning of Internal Revenue Code (Code) section 3121(b)(7)(F). This advice may not
       be used or cited as precedent.

       Legend

        --------------------------------------------------------------------
       ------- = State A

       Facts

       Charter School X is a non-profit domestic corporation located in State A. Charter
       School X is also an entity recognized as exempt from federal income tax under Code
       section 501(c)(3). In accordance with the State A Charter Schools Act, Charter School
       X was chartered by the State A Charter School Board and opened in -------------------------
       ------------------------------------------------------------------------------------------------------------------.
       Charter School X currently provides education for children in kindergarten through
       grade eight. Since its inception, Charter School X has been withholding and paying
       taxes under the Federal Insurance Contributions Act (FICA) on remuneration it pays to
       employees. Employees of Charter School X participate in various governmental

PRESP-134939-13 2

retirement plans. In order to determine how to proceed with regard to social security
coverage for employees of charter schools in State A, the Director of the state’s Division
of Finance requested an opinion from the State A Attorney General on whether State A
charter schools are governmental entities. The State A Attorney General responded
with a letter dated --------------------------, concluding that charter schools in State A are
governmental entities under State A law. Charter School X subsequently filed several
claims for refund of FICA tax.

Charter Schools Act

State A laws regulate public schools, charter schools, private schools, home schooling,
and on-line learning. In -------, the State A legislature passed the State A Charter
Schools Act, which authorized the creation of charter schools in State A. (State A Code
Annotated (-------) §§ -------------------------). ------- section --------------------------) provides
that -------------------------------------------------------------schools --------------------------------- -----
--------------------------------------------------------) provides that -----------------------------------------

Under the State A Charter Schools Act, the purposes of charter schools are to: -----------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

-----------------------------------------------------------------------------------------.

A proposal to establish a charter school in State A may be made by an individual or
groups of individuals, including teachers and parents or guardians of students who will
attend the school, or a not-for-profit legal entity organized under the laws of State A. (---
-------- § ------------------------ ).

A proposal to establish a charter school in State A may be authorized in any of -------
ways. A charter may be authorized by the State A Charter School Board. (------- § -------

-- ----------------). The State A Charter School Board consists of --------- members, each
appointed by the Governor. -------- members are appointed based on recommendations
made by State A’s charter schools, and ----- are appointed based on recommendations
from the State A Board of Education. The State A Charter School Board makes
recommendations to the State A Legislature and State A Board of Education on bills
and rules regarding charter schools and assists charter schools in understanding and
PRESP-134939-13 3

carrying out their charter obligations. Under State law, the State A Charter School
Board, a local school board in the State, or a board of trustees of a higher educational
institution in the State may authorize public chartering of a school (---------------------------

------- §-----------------; ------------------------). A charter school is different from a --------------
----------- which is a public school under the control of a local elected school board.
(----------------------------------). Charter schools are ---------------------------------------------------

------------------------------------------------------------------------------------------- (------------------- --
--------).

All primary and secondary schools in State A, whether public, charter, or private
(including parochial), are subject to various state regulatory requirements. For example,
State A statute requires any public or private school student who participates in
industrial education, a physics laboratory, or a chemistry laboratory in a way that may
endanger his vision to wear --------------------------------------------(--------------------------- ).
Similarly, the law relating to criminal background checks on school personnel is
applicable to ---------------------------------------------------------------------------------------------------
-(--------------------------------). In addition, State A Code section -----------------------
provides that electronic high school courses are provided to -------------------------------------

Charter schools in State A have many of the same requirements and duties as district
schools that may not apply to private schools. ------------------------------------------------------

-----------------------------------------------------------------------------------------------------------(--------
---------------------). Charter schools may not charge tuition or fees, except those fees
normally charged by other public schools. (------- § --------------------. Their curriculum,
programs, admission policies and employment practices must all be nonsectarian. (------

§ ----------------). Charter schools must make the same annual reports as district
schools, including an annual financial audit. (---------------------------). In order to ensure
that charter schools prepare the same annual financial audit that public schools must
prepare, the law provides that each charter school’s charter must include a written
financial plan for the school and the provisions which will be made for the required
annual audit of the school. (------- § ----------------------- ). Charter School X’s charter
provides that it will, on ---------------basis, engage and participate in an independent,
outside audit by a certified public accountant of its financial administrative operation and
will provide the audit to the State A Charter School Board in written form. (Section ----
of Charter). Charter schools must comply with rules and implementing statutes that
prescribe how state appropriations may be spent. (------- § ------------------------).
Additionally, district schools and charter schools must participate in the statewide
testing programs including at a minimum, the State A Performance Assessment System
for Students (------- § -----------------------). Charter schools submit all reports to the State
A Board of Education. (------- section ----------------------). Charter schools must also
PRESP-134939-13 4

comply with the Open and Public Meetings Act, which requires that the state, its
agencies, and its political subdivisions take their actions and deliberate in an open
manner. (------- § -----------------------). Finally, the rules concerning gang prevention
apply to a -------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------(------------------- -----
--------------).

Charter schools in State A are entitled to appropriate portions of local school district
revenues from the school districts in which the charter school students reside. (------- --
--------------------). Additionally, the State A legislature appropriates funds annually to
charter schools to offset some of the local property tax revenues that are not available
to them. Id. Like district schools, charter schools are also eligible to receive a portion of
the State A School --------------- funds. (State A Admin. Code -----------------).
Additionally, charter schools in State A may apply for state or federal start-up funds, and
may receive donations from private parties.

State A law, which concerns the ------------------------------------------------ makes distinctions
between the statutory obligations of charter schools and district schools, including the
following:

(1) Charter schools in State A, including Charter School X, are permitted more
independence than district schools insofar as they are governed by boards that are
independent from the local school districts and are exempt from certain State A Board
of Education rules that govern public employment. (--------------------------------) Charter
schools are exempt from State A Board of Education rules governing ------------------------

-------------------------------------(------- § ----------------------------------------) State A statutory
requirements relating to local school board budget procedures apply only to a public
school controlled by a school district. (------------------------) For example, State A
statute provides: “--------------------------------------------------------------------------------------------

----------------------------- (--------------------------). This purchase restriction is not imposed
on charter schools.

(2) Unlike district schools, charter schools are not required to establish school
community councils or school improvement plans (------- § ----------------------- ).

(3) Charter schools are exempt from other statutory provisions that apply to district
schools, including provisions pertaining to the use of school buildings as civic centers,
provisions requiring the use of activity disclosure statements, provisions requiring
notification of intent to dispose of textbooks, provisions requiring ---------- presentations
on adoption, and provisions requiring an independent evaluation of instructional
materials. (------- § --------------------------------- ).
PRESP-134939-13 5

(4) The fiscal procedures set forth in Chapter ----, Part -- of the State A Code, pertaining
to fiscal procedures in district schools, do not apply to charter schools. (---------------------
------------). These fiscal procedures include local school board budget procedures
(requiring district schools to adopt and publish a budget annually), limits on
appropriations (prohibiting district schools from making any appropriation in excess of
estimated expendable revenue), and monthly budget reports (requiring district school
business administrators to submit monthly reports to the local school board showing
amounts of appropriations and disbursements).

(5) Unlike district schools, a charter school’s governing body has authority to determine
the level of compensation, and the terms and conditions of employment, for its

employees. (------------------------).

Prior to -----------of each year, a charter school may identify and report to the State A
Charter School Board its innovative practices that fulfill the purposes of charter schools.
(------- § ------------------). If any charter school in State A fails to comply with its charter
or fails to comply with State A statutory requirements that apply to charter schools
(including the requirements to meet all applicable federal, state, and local health, safety,
and civil rights requirements, to file ---------------financial audit report, and to comply with
the prohibition on charging tuition and fees not normally charged by district schools), the
entity which chartered the school can exercise direct control over the school by (a)
removing a charter school director or finance officer, (b) removing a governing board
member, or (c) appointing an interim director or mentor to work with the charter school
or (d) terminating the school’s charter. (------- § -----------------). Upon termination of a
charter school, any assets remaining after payment and discharge of the closing
school’s liabilities and obligations ------------------------------------------------------------------------

--------------------------(----------------------------------- ).

Charter School X

Charter School X was authorized by the State A Charter School Board, the -----------------

----------and was approved by the State A State Board of Education on -----------------------
-----------------------------------------------------------------------------------------------------------------.
The charter was last renewed on --------------------. Charter School X is operated by a
Charter School Governing Board (Governing Board), which is the board designated by
the charter school -------------------------------------------------------------------- (State A
Administrative Code ---------------------). The requirements on the composition for the
Governing Board are addressed in Charter School X’s Charter, which is defined as a
written contractual agreement between Charter School X and its chartering entity setting
forth the terms and conditions for operation of the charter school. (------- §-------------------
----------- ). Charter School X’s Charter provides that its Governing Board will be
comprised of --------- members. No governmental approval of the composition of the
PRESP-134939-13 6

Governing Board is needed. The Charter further provides that the term of office for
each Governing Board member is ------years. The parents of currently enrolled students
elect new Governing Board members to fill expiring positions at ---------------parent
meeting. Each family is given ------ vote in the election of Governing Board members. If
a Governing Board member resigns or is dismissed, the Governing Board will select a
replacement to fill the remainder of the unexpired term. (Charter section --, ----------------
------------and Bylaws section -----).

As a section 501(c)(3) organization, Charter School X files a Form 990, Return of
Organization Exempt From Income Tax. Charter School X’s ------- Form 990, item ---, --
-----, indicates that all --------- of the Governing Board members serving on Charter
School X’s Board of Directors are --------------------- Charter School X also has a ----------

member Board of Trustees. The Governing Board elects the Trustees. (Bylaws -------).
The majority of the trustees must come from the family units of students actively
enrolled in the Charter School. (Bylaws -------). Charter School X’s Bylaws permit up to
----% of the Trustees to be -----------------------------i.e., persons being compensated for
services provided to the corporation or relatives of such persons. (Bylaws -------).
Charter School X’s Bylaws permit the Board of Directors to delegate the management
activities of the school to others.

Charter School X’s Bylaws were adopted by its Governing Board and are not part of the
Charter or other agreement with Charter School X’s chartering entity. The Bylaws
provide that the “----------------------------------------------------------------------------------------------

-(Bylaws ------). Charter School X’s Governing Board is granted the powers to conduct,
manage, and control the affairs and activities of the corporation, to make rules and
regulations, and to carry on a business at a profit and apply any profit that results from
the business activity to any activity in which the corporation may engage. (Bylaws -------
and -------). Moreover, Charter School X’s Board may approve a ------------------------------

------------------------------------------------------------- (Bylaws --).

Enrollment preference in Charter School X may be given to -------------------------------------
------------------------------------------------------- (--------------------------------). Charter School
X’s Charter provides that -----------------------------------------------------------------------------------

----------------------------------------------------- If Charter School X is oversubscribed, the
Charter states that admission will be offered based on the results of a lottery in
accordance with state and federal requirements. (Charter, section --).

Charter School X’s Articles of Incorporation provide that ------------------------------------------

PRESP-134939-13 7

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

-(Article ---------------------, Articles of Incorporation).However, Article --- of Charter
School ----- Articles of Incorporation is inconsistent with the state statute governing
charter school closures, which provides that after the satisfaction of charter school
liabilities and obligations, the remaining assets shall be returned to the closing charter
school’s chartering entity. (------- § --------------------------).

In its Charter, Charter School X agreed, as is required by State A law, to engage and
participate in an independent outside audit by a certified public accountant of its
financial and administrative operations on ---------------basis. (Charter, section ----).
Charter School X is required by State A law to file its ---------- financial audit with the
Office of the State Auditor. (-------------------------------) and Charter, section ----).

Federal Tax Law

Code sections 3101 and 3111 impose taxes under the Federal Insurance Contributions
Act (FICA) on the wages paid by employers to employees with respect to employment.
Code sections 3101(a) and 3111(a) impose Old-Age, Survivors, and Disability
Insurance (OASDI) taxes on the wages of employees. Sections 3101(b) and 3111(b)
impose Hospital Insurance (HI) taxes on the wages of employees.

Code section 3121(b)(7) provides that, for purposes of the FICA tax, “employment” does
not include service performed in the employ of a State, or of any political subdivision
thereof, or any instrumentality of any one or more of the foregoing that is wholly owned
thereby. Code section 3121(b)(7)(F) provides that this exception does not apply if the
employee is not a qualified participant in a retirement system of the state, political
subdivision, or instrumentality.

Code section 3121(u)(2) of the Code provides that, for services performed after March
31, 1986, Code section 3121(b)(7) does not relieve state and local government
employers and employees of liability for the HI portion of the FICA tax imposed by Code
sections 3101(b) and 3111(b).

The separate exemptions provided for hospitals and schools in Code section 3121(b)
indicate that the state and local governmental exemption was not intended to apply to
every organization that performs an important social or charitable function that is also
sometimes performed by the government. See, e.g., Code section 3121(b)(7)(C)(i),
(b)(10).

Revenue Ruling 57-128, 1957-1 C.B. 311, provides that the following factors will
govern in determining whether an organization is an instrumentality of one or more
PRESP-134939-13 8

states or political subdivisions for purposes of Section 3121: (1) whether it is used for a
governmental purpose and performs a governmental function; (2) whether performance
of its function is on behalf or one of one or more states or political subdivisions; (3)
whether there are any private interests involved, or whether the states or political
subdivisions involved have the powers and interests of an owner; (4) whether control
and supervision of the organization is vested in public authority or authorities; (5) if
express or implied statutory or other authority is necessary for the creation and/or use of
such an instrumentality, and whether such authority exists; and (6) the degree of
financial autonomy and the source of its operating expenses.

Although all of the above factors are considered in determining whether an entity is an
instrumentality, such determination requires a balancing of all the factors. The fact that
a State permits employees of the organization to participate in the State’s retirement
plan is not determinative of the organization’s status as an instrumentality. Revenue
Ruling 69-362, 1969-1 C.B. 254, provides that the term “instrumentality of the United
States” as used in Code section 3121(b) is construed as meaning only such agencies
as are made use of by the Government as an instrument through which it directly
exercises some governmental power, and that it does not include private persons who,
by contract with the Government, have undertaken to perform some services for the
government. In this case, State A has contracted, through the State A Charter School
Board, with Charter School X to provide educational services, and yet does not directly
or indirectly exercise control over the government funds expended by Charter School X.

In Revenue Ruling 69-453, 1969-2 C.B. 182, the Internal Revenue Service (IRS) held
that a Connecticut soil and water conservation district was not a wholly owned
instrumentality of the state. The ruling found that the district was a corporation, formed
by private individuals who had complete control over corporate operations; the control
over revenues and expenditures being especially evident. The ruling stated that the
Connecticut law concerning the district was regulatory in nature. The State
Commissioner had the authority to assist private individuals in forming conservation
districts but did not have the authority to operate them. The State Commissioner had
issued regulations suggesting modes of procedure and requiring an annual report of the
district’s operations and financial status. The regulations were designed to insure the
integrity of the corporation but not to direct its operation. The district, like any other
corporation that has an effect on the public interest, is subjected to State regulations
designed to protect the public interest. That ruling referred to Rev. Rul. 57-128, supra, in
its analysis. In holding that the district was not a state instrumentality, the IRS relied on
the fact that the district was formed by private individuals who have complete control of
the corporation operations, particularly control over revenue and expenditures.

In Revenue Ruling 65-26, 1965-1 C.B. 444, the IRS found that a municipal league
organized by individuals under the private, not-for-profit corporation laws of a state was
not an instrumentality of a state or a political subdivision of a state within the meaning of
Code section 3121(b)(7). Although the municipal league’s governing body was a board
of trustees comprised of municipal officers, the IRS concluded that control and
PRESP-134939-13 9

supervision of the league was not vested in any public authority or authorities because
the trustees were acting as individuals with no power of agency from their respective
municipalities.

In Unibrand Inc. v. Commissioner, 140 T.C. 230 (2013), the Tax Court relied upon the
factors in Rev. Rul. 57-128 in concluding that a state-chartered corporation wholly
owned by an Indian tribe was not an instrumentality of the tribe for federal tax purposes.
Noting that the tribe, as sole shareholder of the corporation, had the power to control or
abolish the corporation, the court nevertheless held that the corporation was not an
instrumentality of the tribe because nothing in the corporation’s charter or bylaws gave
the tribe’s council authority to directly manage the corporation’s operations or
supersede the action of the board of directors, nor was there any requirement that tribal
members serve on the board.

Governmental entity determinations are used in many contexts of federal law and courts
have used various tests—sometimes interchangeably--to determine whether entities are
governmental or private for such purposes. Although not determinative of federal tax
treatment, courts’ determinations of government entity status in other contexts can be
instructive. In such cases, the tests typically focus on whether the government has
sufficient authority to manage and control entities. For example, in National Labor
Relations Board v. Natural Gas Utility District of Hawkins County, Tehhessee, 402 U.S.
600 (1971), the Supreme Court interpreted the term “political subdivision” for purposes
of the National Labor Relations Authority (NLRA). Although the Supreme Court in
Hawkins County analyzed whether the employer at issue was a political subdivision for
purposes of the NLRA, courts have used the same analysis for determining whether an
entity is an agency or instrumentality of a state or a political subdivision of a state for
purposes of ERISA.1 The two-prong test in Hawkins County analyzes whether the
entity has been “(1) created directly by the state, so as to constitute departments or
administrative arms of the government, or (2) administered by individuals who are
responsible to public officials or to the general electorate.”2 Other courts have used the
test under Revenue Ruling 57-128 in determining whether an entity is an agency or
instrumentality for purposes of the governmental plan definition under ERISA.3
1
“The NLRB guidelines are a useful aid in interpreting ERISA’s governmental exemption, because ERISA, like the
National Labor Relations Act, ‘represent[s] an effort to strike an appropriate balance between the interests of
employers and labor organizations.’” Rose v. Long Island Railroad Pension Plan, 828 F.2d 910, 916 (2nd Cir. 1987),
cert. denied, 485 U.S. 936 (1988) (quoting H.R. Rep. No. 533, reprinted in 1974 USCCAN at 4647). See also,
Shannon v. Shannon, 965 F.2d 542, 547 (7th Cir. 1992), cert. denied, 506 U.S. 1028 (1992) (stating that the proper
test for determining whether an entity is an agency or instrumentality of a State or political subdivision for
purposes of ERISA is the Hawkins test).
2
Hawkins County, 402 U.S. at 604-05.
3 nd
See Rose v. Long Island Railroad Pension Plan, 828 F.2d 910 (2 Cir. 1987) (stating that, in interpreting the
definition of governmental plan under section 414(d) of the Code, IRS has used the six factors outlined in Rev. Rul.
57-128). See also, Berini v. Federal Reserve Bank of St. Louis, Eighth District, 420 F.Supp.2d 1021 (E.D. Mo. 2005),
(in determining whether the employee benefit plans maintained by the Federal Reserve System were
governmental plans within the meaning of section 3(32) of ERISA, the court used the six-factor test in Rev. Rul. 57-
128),
PRESP-134939-13 10

More specifically, in determining whether an entity is governmental, either as a political
subdivision of a state or an instrumentality of a state or political subdivision, many
courts have focused on the government’s ability (or lack thereof) to manage and control
the entity in both tax and non-tax contexts. For example, in Philadelphia National Bank
v. United States, 666 F.2d 834 (3rd Cir. 1981), the Philadelphia National Bank sued the
United States for a refund of taxes paid on interest received on loans to Temple
University, a private, non-profit corporation founded in 1888 as an educational
institution. Interest on money borrowed by political subdivisions is exempt from federal
income tax. The Bank argued that the interest on the loans was exempt from federal
income tax because the university is a political subdivision acting on behalf of the State
of Pennsylvania. Temple University was reorganized in 1965 as a public university. The
Board of Trustees to Temple University consists of 36 members and 3 ex-officio public
officials. Twelve of the 36 members are appointed by state officials. Temple is subject
to regulatory control and the state sets the tuition schedules for the University. The
court concluded that Temple University is not a political subdivision acting on behalf of
the State of Pennsylvania. The court noted that public officials only control one-third of
the Board of Trustees, leaving the majority of non-public trustees with the power to
manage and control. The court stated that “if Temple were truly a state ‘agency,’ the
state would wholly control the decisions to be made regarding it.” Id. at 839.

As another example, in Chicago Mathematics & Science Academy Charter School, Inc.,
Employer and Chicago Alliance of Charter Teachers & Staff, IFT, AFT, AFL-CIO,
Petitioner, 359 NLRB No. 41 (December 14, 2012), the National Labor Relations Board
(NLRB) addressed the issue of whether a public charter school was exempt from the
Board’s jurisdiction because it is a political subdivision. The charter school was
organized as a private, nonprofit corporation. The school was run by an independent
board of directors, but the school received all of its funding from the city, state, and
federal governments. Noting that no government entity has authority to appoint or
remove a board member, and no member of the board of directors is a government
official or works for a government entity, the NLRB concluded that the school is not a
political subdivision.

Similarly, although all six of the factors described in Rev. Rul. 57-128 are relevant,
whether an organization qualifies as a wholly-owned instrumentality of a state often
hinges on whether the state has the interests and powers of an owner, manifested in
the state’s ability to control the organization. The state’s power to appoint, and to
remove and replace, a majority of the entity’s governing board and body, is one factor
that would support a conclusion that an entity is controlled by the state.4 Rev. Ruls. 65-

4
Although not determinative of federal tax treatment, in numerous cases involving issues other than
federal taxes, courts have held that the lack of state authority to appoint, remove and replace a majority of
an entity’s governing board negates instrumentality status. See, Shannon v. Shannon, 965 F.2d 542
(The court ruled that the plan of the West Allis Memorial Hospital, Inc., was not a governmental plan
because the City did not have the requisite control of the entity’s Board, in that the City could not remove
PRESP-134939-13 11

26 and 69-453, supra, stand for the proposition that an entity under the control of private
individuals cannot be an instrumentality. Even though the purpose of the municipal
league described in Rev. Rul. 65-26 was to improve municipal government and promote
the general welfare of cities and villages, and the league was governed by municipal
officers, the ruling concluded that the league was not an instrumentality because its
officers were acting as individuals with no power of agency from their respective
municipalities. Similarly, the unincorporated water district in Rev. Rul. 69-453 was
denied status as an instrumentality because it was under complete control of private
individuals. Landowners elected the board of supervisors, who had complete control
over corporate operations, including revenue and expenditures. The state law was
purely regulatory and the regulations were “designed to insure the integrity of the
corporation but not to direct its operation.”

Analysis

As a preliminary matter, we note that ------- section -----------------------------provides that
State A charter schools are to be considered ---------------------------------------------------------
--------------------------, and the State Attorney General has determined that charter
schools in State A are governmental entities under State A law. However, although
these characterizations are factors in determining the Charter School’s status for federal
employment tax purposes, neither the State A statute nor the State Attorney General’s
opinion is determinative. The IRS has consistently applied the factors in Revenue
Ruling 57-128 for determining an entity’s status as an instrumentality for FICA
purposes.

1. Governmental Purpose

This factor concerns whether the entity’s purpose and function is one typically carried
on by a government entity. Charter School X satisfies this first factor indicating state
instrumentality status because it is used for a governmental purpose. Providing tuition-
free elementary and secondary education is a governmental purpose and function.
State A has promulgated rules and standards applicable to open-enrollment charter
schools as an alternative to standard or traditional public education in State A that is
provided by school districts. Note that private parties can serve governmental
purposes.5

2. Function Performed on Behalf of State

any member of the Board and, having once approved the initial composition of the Board, the City could
not appoint or reappoint any person to the Board). See also, NLRB v. Parents and Friends of Specialized
th th
Living Centers, 879 F.2d 1442 (7 Cir. 1989); Truman Medical Center Inc. v. NLRB, 641 F.2d 570 (8 Cir.
th
1981); and Brock v. Chicago Zoological Society, 820 F.2d 909 (7 Cir. 1987).

5
“Public purpose . . . is more diffuse in the sense that a private party can engage in an activity that has a public
purpose, such as offering private security or charter schools.” In re Las Vegas Monorail, 429 B.R. 770, 796 (2010).
PRESP-134939-13 12

This factor evaluates whether the entity performs functions on behalf of the state.
Charter School X does not satisfy this factor. “In determining whether an entity is
administered by individuals who are responsible to public officials or the general
electorate, the ‘relevant inquiry’ is whether a majority of the individuals who administer
the entity -- the governing board and executive officers -- are appointed by and subject
to removal by public officials.”6 There is no public official on Charter School X’s Board
of Directors or on its Board of Trustees. Charter School X’s governing Board is elected
by parents of children who attend the school, and its Board of Trustees is elected by its
own Board of Directors. Neither the Directors nor the Trustees are acting as individuals
with power of agency from any government entity. See Rev. Rul. 65-26, denying status
as an instrumentality to an entity governed by a board under the control of private
individuals. The mere fact that the operations of an organization may result in a benefit
to the public or that the state or local government encourages the formation and
activities of such organizations and may exercise some regulatory or other broad
oversight and supervision of the organization, does not mean that the organization
performs its function on behalf of the government.7 As explained above, the State A
charter school legislation exempts charter schools from many of the statutory
requirements that apply to public school districts, and permits charter schools to be
operated by a Board of Directors that is independent from the local school district with
little governmental oversight of their day-to-day activities.

3. Private Interest Versus Government Ownership

This third factor looks to whether the government has the powers and interests of an
owner, or whether private interests predominate and control. This factor does not
support Charter School X’s status as an instrumentality. Although the entity receives
State funds and State A law indicates that Charter School X’s assets would be
transferred to a governmental entity upon dissolution (notwithstanding the inconsistent
provision in the Articles), neither State A nor its agencies (State A Charter School Board
or the State A Board of Education) have the powers and interests of an owner. Rather,
control of Charter School X rests with a Board of private individuals elected by parents
of children enrolled in the school, as opposed to governmental officials, and such
individuals operate independently from the local school district or other public authority.
Accordingly, Charter School X’s Board represents private as opposed to public
interests. An entity under the control of private individuals cannot be an instrumentality.
See Rev. Rul. 65-26; see also Revenue Ruling 69-453.

6
Chicago Mathematics & Science Academy Charter School, Inc., Employer and Chicago Alliance of Charter
Teachers & Staff, IFT, AFT, AFL-CIO, Petitioner, 359 NLRB No. 41, 1, 8 (December 14, 2012).
7
Even when regulation is extensive, such regulation does not rise to the level of control. The Las Vegas Monorail
court stated that casinos are highly regulated but no one would argue that extensive regulation would make
casinos governmental entities. See In re Las Vegas Monorail, 429 B.R. at 798.
PRESP-134939-13 13

Furthermore, Charter School X’s bylaws permit the Governing Board to delegate the
management activities of the school to others. Although the Governing Board has not
delegated the school’s management to others, the fact that the bylaws permit delegation
of management to another entity, presumably even to a private management company,
is significant because it further separates the control of the entity from the government.
Additionally, the bylaws permit ----% of the membership of Charter School X’s Board of
Trustees to be composed of individuals receiving compensation for services performed
for the school. Finally, the Governing Board has the specific power ---------------------------

-------------------------------------------------------------- (Bylaws -------).

While charter schools are expected to report regarding their innovative practices and
use of state funds, in these regards the state’s role is largely one of oversight to ensure
basic fulfillment of the purpose of charter schools and ensure integrity in use of state
funds.

4. Public Control and Supervision

The fourth factor is similar to the third factor but focuses more specifically on whether
the control and supervision of the organization is vested in public authority or
authorities. Does the state exercise a degree of control over the entity such that the
entity essentially operates in place of the state? The fact that there are State A laws
regulating Charter School’s activities is not sufficient to satisfy this factor, as extensive
governmental regulation does not equal governmental control. Charter School X is
subject to the State A statute governing charter schools, as well as its own Articles of
Incorporation, Charter and Bylaws. However, the State A law that concerns charter
schools is largely regulatory, rather than proprietary in nature. Charter schools, like any
other educational institutions that have an effect on the public interest, are subject to
state regulations designed to protect the public interest and insure the public integrity of
the entity, but not to direct its operations. See Rev. Rul. 69-453. Moreover, while
Charter School X is subject to regulatory control from State A, it is exempt from many of
the State Board of Education rules that apply to district schools.

Furthermore, as noted above, Charter School X is an independently run nonprofit
corporation with an independent Governing Board. The Governing Board is composed
of private individuals elected by parents of children enrolled in the school, on a self-
perpetuating basis, and none of the Governing Board’s members is appointed by a
governmental entity. State A has no control over the composition and selection of
Charter School X’s Governing Board. In addition, no governmental entity controls or
supervises the school in its day-to-day operations. State A statutes do not require that
control and supervision of the Charter School be vested in a public authority or
authorities. Rather, the control and supervision of the Charter School is vested in the ---

PRESP-134939-13 14

-----------------------------------------------------------------------(State A Administrative Code ------
-----------------).

Although State A law authorizes the chartering entity to remove directors, terminate
Charter School X’s Charter, or appoint an interim director if Charter School X is not in
compliance with its Charter or with State A law, control and supervision of the
organization is not vested in any public authority because nothing in Charter School X’s
charter or bylaws gives any governmental entity the authority to manage Charter School
X’s day-to-day operations, appoint its Governing Board, or serve on the Governing
Board or the Board of Trustees. The authority to remove directors and appoint an
interim director arises only if Charter School X fails to comply with its charter or with
certain statutory provisions that apply to charter schools. State A has no authority to
exercise control over Charter School X under ordinary circumstances where Charter
School X is operating in compliance with its charter and with state law. This is similar to
Uniband, supra, in which the Tax Court concluded that an Indian tribe, as sole
shareholder of a state-chartered corporation had ultimate power to control or abolish the
corporation and to name its officers and directors, but nevertheless the corporation did
not satisfy the fourth factor of Rev. Rul. 57-128 because nothing in the corporation’s
charter or bylaws gave the tribal council authority to directly manage the operations of
the corporation or supersede the action of the board of directors, nor was there any
requirement that tribal members serve on the board.

5. Statutory Authority

The fifth factor looks at whether express or implied statutory or other authority is
necessary for the creation and/or use of such an instrumentality. Charter School X
satisfies this factor. State A statutes authorize the State Charter School Board to grant
a charter for an open-enrollment charter school to a Code section 501(c)(3)
organization. Although there is no specific legislation creating Charter School X,
Charter School X was chartered pursuant to the authority of State A statute. Express
statutory authority is necessary for the creation and use of a charter school in State A
and such statutory authority exists. See --------------et seq.

6. Financial Autonomy/Source of Operating Funds

The sixth factor of Rev. Rul. 57-128 evaluates the degree of financial autonomy and the
source of the entity’s operating expenses. This factor is neutral in this case. The State
provides virtually all of Charter School X’s funding. However, an entity is not
governmental simply because it receives public funding or operates pursuant to a
contract with a governmental entity. The overall financial planning, and day-to-day
financial operations are in the hands of Charter School X’s independent Governing
Board. A governmental unit’s provision of support to a private organization does not
render that organization an instrumentality within the meaning of Code section
3121(b)(7)(F). Thus, although the Charter School receives the bulk of its operating
funds from governmental entities, it is financially autonomous because it is not subject
PRESP-134939-13 15

to any meaningful governmental control, supervision, or oversight over the school’s
budget, salaries, employee terminations, contracts, student mix, and so on. Although
Charter School X is required to engage and participate in an independent outside audit
by a certified public accountant, and file the ---------- financial audit to the State Charter
School Board, the State does not play a role in the School’s financial planning. In this
regard, unlike district schools, Charter School X is not required to publish a budget
annually or submit monthly budget reports to the local school board and Charter School
X determines the level of compensation for its own employees.

Conclusion:

Although all six factors described in Revenue Ruling 57-128 are considered in
determining whether an organization is an instrumentality of a government, the mere
satisfaction of one or more of the factors is not necessarily determinative. The
determination ultimately requires consideration of the totality of the circumstances.
Although Charter School X is publicly funded and performs the governmental function of
providing public education in State A, it does not perform this function on behalf of State
A because State A exercises no meaningful control over Charter School X’s day-to-day
operations or its budget and the laws of State A permit Charter School X to operate
independently from the local school district. No governmental entity has the power to
appoint Charter School X’s governing board and the organization’s bylaws permit
management to be delegated to a private management company. Based on the above
analysis, we conclude that Charter School X does not qualify as a wholly-owned
instrumentality of the state or of a political subdivision of the state for purposes of FICA
tax liability under Code section 3121(b)(7)(F) with respect to compensation paid to
Charter School X’s employees.

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