Tax Court Slashes $132M Deduction in For-Profit College Conversion

The $132 Million Valuation Gap

The case centered on a massive discrepancy in valuation. Petitioner Carl Barney sought a $24.9 million refund, hinging on a charitable deduction of $132.4 million stemming from a "bargain sale," while the IRS determined a deficiency of over $31 million, plus a potential $12.4 million penalty under Section 6662(h). Section 6662(h) imposes a 40% penalty on substantial underpayments of tax attributable to gross valuation misstatements. At the heart of the dispute was the valuation of assets transferred to a non-profit entity as part of a broader trend involving the conversion of for-profit colleges. Ultimately, the Tax Court sided mostly with the IRS on valuation, drastically reducing the deduction from $132.4 million to approximately $33 million, but rejected the IRS's attempt to disallow the gift entirely.

From Boom to Regulatory Bust

As noted, Section 6662(h) imposes a 40% penalty on substantial underpayments of tax attributable to gross valuation misstatements. At the heart of the dispute was the valuation of assets transferred to a non-profit entity as part of a broader trend involving the conversion of for-profit colleges. Ultimately, the Tax Court sided mostly with the IRS on valuation, drastically reducing the deduction from $132.4 million to approximately $33 million, but rejected the IRS's attempt to disallow the gift entirely.

The genesis of the tax dispute lies in the history of a set of for-profit colleges controlled by Carl Barney. Beginning in 1985, Barney acquired a series of post-secondary educational institutions, ultimately operating them through five S corporations: Stevens-Henager College, Inc. (SHC), CollegeAmerica Arizona, Inc. (CAAI), CollegeAmerica Services, Inc. (CASI), California College, Inc. (CCI), and CollegeAmerica Denver, Inc. (CADI). These "Colleges" operated across Utah, Idaho, Colorado, Wyoming, Arizona, and California. In 2012, Barney transferred these S corporations to the Center for Excellence in Higher Education (CEHE) in a transaction that would become the subject of intense scrutiny by the IRS.

Barney had considered selling the Colleges as early as 2009, engaging Goldman Sachs to assist in the process. Although an offer was received, the sale was not completed due to the financial turmoil of the Great Recession, the period of worldwide economic downturn occurring from 2007 until 2009. Subsequently, Barney explored the possibility of converting the for-profit colleges into nonprofit entities.

The years preceding the 2012 transaction can be divided into two distinct periods: a period of rapid growth and a subsequent period of decline, each significantly impacting the colleges' financial performance and ultimately their valuation.

The "Period of Rapid Growth" coincided with changes in federal regulations governing Title IV of the Higher Education Act of 1965. Title IV authorizes the U.S. Department of Education to provide student assistance, including scholarships, grants, and reduced-interest loans to students attending eligible institutions of higher education. Before 2005, institutions were required to conduct at least 50% of their courses and have at least 50% of their students on campus. The repeal of this "50% rule" in 2005 spurred a significant expansion of online enrollment at for-profit colleges from 2006 to 2010. To illustrate, the Colleges' collective enrollment surged from 7,763 students in 2007 to 20,576 in 2010. Correspondingly, tuition revenue increased dramatically, from $55,451,000 in 2007 to $218,920,000 in 2010.

However, this period of growth was followed by a "Period of Decline," triggered by increased regulatory scrutiny and public criticism of the for-profit college industry. Beginning in June 2010, the U.S. Senate Health, Education, Labor, and Pension Committee (HELP), led by Senators Tom Harkin and Richard Durbin, initiated investigations into the sector, holding hearings and issuing reports that called for policy changes and questioned student outcomes at for-profit colleges. The U.S. Government Accountability Office also released critical reports during this time. From 2010 to 2011, the Colleges experienced slower enrollment growth. While enrollment increased from 20,576 to 21,864 and tuition revenue rose to $220,920,000 in 2011, 78% of revenue was derived from Title IV sources. The following year, 2012, saw a clear reversal of fortune, with enrollment decreasing to 19,982 students and tuition revenue falling to $198,836,000.

It was against this backdrop of regulatory headwinds and declining performance that Barney executed the transaction at the heart of the dispute. In 2012, Barney transferred the five S corporations to CEHE in exchange for $431 million in promissory notes. The transfer was structured as a bargain sale and donation, invoking Section 170, which allows a deduction for charitable contributions. The "bargain element" is the difference between the fair market value of the contributed property and the consideration received.

The Battle of the Appraisers

In valuing the contributed S corporations, Barney and the IRS presented starkly different expert opinions. Barney's experts, Richard Pollak and Matthew Connors, valued the entities at approximately $620 million and $700 million, respectively. Pollak, who specialized in valuing for-profit colleges, employed comparable companies analysis, comparable transactions analysis, and discounted cash flow (DCF) analysis. Connors's appraisal primarily used the DCF method, projecting income growth based on the colleges' financial projections.

The IRS countered with Carl S. Saba and Stuart C. Gilson, who pegged the fair market value (FMV) in the $200 million to $300 million range. Saba employed both the DCF method and the guideline public company method, comparing the S corporations to 14 publicly traded companies highlighted in a HELP Committee Report critical of the for-profit higher education sector. Gilson also relied on the DCF method and a comparable company multiples valuation analysis. A key flaw identified by the IRS experts was the "overly optimistic" management projections used by Barney's appraisers. Saba, in particular, noted that these projections failed to adequately account for the regulatory crisis facing for-profit education, including increased scrutiny of Title IV funding—federal student aid under Title IV of the Higher Education Act of 1965—and the looming threat of stricter "gainful employment" rules.

Court Analysis: Valuing the Asset

The previous section detailed the conflicting appraisals offered by the Petitioner and the IRS, highlighting the "overly optimistic" management projections used by Barney's appraisers, which failed to adequately account for the regulatory crisis facing for-profit education, including increased scrutiny of Title IV funding—federal student aid under Title IV of the Higher Education Act of 1965—and the looming threat of stricter "gainful employment" rules.

To determine whether a bargain sale occurred, the Tax Court needed to determine the Fair Market Value (FMV) of the S corporations transferred. Treasury Regulation § 1.170A-1(c)(2) defines FMV as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." The court acknowledged the expert testimony presented by both sides but emphasized that it is not bound by any single expert's opinion, citing Helvering v. Nat’l Grocery Co., 304 U.S. 282, 294–95 (1938).

The court found the Petitioner's original FMVs, based on the Barrington Appraisal, to be "excessive and self-serving." It noted that the conclusions of the Petitioner's experts were based, in part, on management’s unreasonably optimistic projections. The court deemed these opinions unreliable and out of line with industry practice and then-present market conditions, stating that a true third party considering acquisition of the S corporations would not rely on internal management projections to arrive at a purchase price.

Instead, the Court adopted Professor Gilson's valuation of $300 million as the overall FMV for the S Corporations. The court favored the expert who accounted for the "strong head winds" and "economic struggles" of the for-profit college industry from early 2009. It emphasized that these economic struggles and political headwinds were publicly known and evidenced through investigations initiated by the HELP Committee, the promulgation of the Higher Education Opportunity Act, and Department of Education regulations, all affecting Title IV funding, which constituted approximately 80% of the colleges' funding. The Court found that Professor Gilson performed substantial research on the for-profit college industry and was knowledgeable about current market trends and other difficulties facing the industry. Though acknowledging that Professor Gilson had the benefit of hindsight, the court found his use of general industry figures far more compelling and reliable.

Court Analysis: Valuing the Debt

The previous section highlighted the Court's reliance on Professor Gilson's industry knowledge in valuing the assets transferred. The next critical step was determining the "amount realized" by Mr. Barney in the transaction, as this figure would be subtracted from the asset's fair market value to calculate the bargain sale deduction. The Court turned to Section 1001(a), which states that the gain from the sale of property is the excess of the amount realized over the adjusted basis. Section 1001(b) defines the "amount realized" as the sum of any money received plus the fair market value (FMV) of other property received. The court noted, citing McShain v. Commissioner, that a promissory note is indeed "property other than money" for purposes of Section 1001(b).

Mr. Barney had argued that the purchase notes he received should be treated as "contingent debt instruments" under Treasury Regulation § 1.1275-4, suggesting he overstated the amount realized by $254 million. He pointed to the fact that payments were tied to the future performance of the colleges. The IRS countered that the notes should not be considered contingent debt instruments because any provision for a floating interest rate was too "remote" under Treasury Regulation § 1.1275-2(h)(2).

Ultimately, the Court bypassed the contingent debt instrument argument, focusing instead on the core principle of Section 1001(b): determining the fair market value of the notes received. The Court referenced testimony from Charles Wilhoite, who prepared the original Willamette Report, which initially applied 10% and 20% discounts for lack of marketability to arrive at values between $103 million and $105 million for Note A and $72 million for Note B. The IRS argued against these discounts, suggesting they would be "double counting," as similar discounts were supposedly already factored into the cash flow projections used to determine CEHE's repayment obligations. The Court sided with Professor Gilson, finding his testimony more credible. While acknowledging the appropriateness of a liquidity discount, the court found the Willamette Report's application of a "discount for lack of marketability" to be arbitrary. Therefore, the Court adopted Professor Gilson's conclusion that the fair market value of the purchase notes was $267 million.

The Court rejected Mr. Barney's attempt to retroactively apply Section 108(e)(5), which provides an exception for when a money debt reduction shall be treated as a valid purchase price reduction and not as a discharge of debt when certain conditions are met. The Court found it inappropriate to apply a purchase price adjustment for 2012 based on events that occurred in 2015, especially since Mr. Barney had voluntarily elected out of the installment method. The Court emphasized that each tax year stands on its own. The court determined that Mr. Barney voluntarily forgave a portion of the indebtedness.

Dominion, Control, and the Final Verdict

The IRS argued that Barney retained dominion and control over CEHE (the non-profit) after the transfer, thus negating donative intent and disqualifying the charitable contribution. The IRS pointed to Barney's role as sole member of CEHE with authority to appoint/remove board members, and his creditor rights under the purchase notes which included veto power over capital expenditures. The court rejected this argument.

Referencing established precedent, the court noted that a charitable contribution under Section 170 is synonymous with a "gift." The elements of a valid gift include: a competent donor and donee; a clear intention to relinquish control; an irrevocable transfer of title; delivery; and acceptance. While Barney retained some influence within CEHE, the court found this consistent with his intent to ensure the colleges continued as non-profits. The Court found his testimony credible regarding his intent to transfer the Colleges. Referencing Palmer v. Commissioner, the Court noted that similar fiduciary responsibilities and control did not negate the gift there either. The court concluded that the IRS's objections to Barney's role were insufficient to negate a completed gift.

Ultimately, the court determined that Barney was entitled to a noncash charitable contribution deduction for the transaction. However, the deduction is capped at the bargain element, which is the difference between the fair market value of the S corporations ($300 million, as determined by the court) and the consideration Barney received ($267 million). This results in a deduction of $33 million, significantly less than the $132 million initially claimed.

The court reserved judgment on the accuracy-related penalties proposed by the IRS under Section 6662. Section 6662(a) imposes a penalty on underpayments of tax due to substantial valuation misstatements or negligence. The IRS had argued for either a 40% penalty for a gross valuation misstatement or, alternatively, a 20% penalty. The court stated it will determine if an underpayment exists and whether penalties are applicable after updated computations are furnished.