More on Income Share Agreements: Will Proposed Legislation Fix their Marketability Problem?

By: Diane Ring

Last week I blogged about the apparent resurgence of income share agreements (ISAs), noting for example, Purdue University’s planned offering to juniors and seniors this fall, and the $30 million capital infusion received by ISA provider Cumulus Funding. I discussed how regulatory uncertainty is one likely barrier to more widespread market interest in these instruments. This week I thought I would take a look at the current round of ISA-related legislation in the House and the Senate, which is aimed at addressing some of this uncertainty.

The current legislation is actually the second go round at legislating the consequences of some ISAs. In 2014, Senator Rubio and Representative Petri introduced the Investing in Student Success Act of 2014. That legislation went nowhere. In 2015, Senator Rubio introduced a revised version of his bill, following the introduction of a similar bill in the House by Representatives Todd Young and Jared Polis. Both 2015 bills have much in common, although the Rubio bill tracks the structure of his earlier version. The point of each bill is to clarify the legal and regulatory treatment for those ISAs that fall within the bill’s definition by providing affirmative legal treatment for covered ISAs. ISAs that don’t fall within the bill’s parameters aren’t necessarily barred—they just aren’t covered by the legislation and presumably are left in the same legal limbo in which all ISAs currently operate.

As my co-author Shu-Yi Oei and I have discussed elsewhere, trying to craft one set of rules to cover many types of ISAs is problematic, and as a result, the 2014 bill was both under- and over-inclusive. For example, although it might make sense to regulate ISAs used for education in a manner similar to student loans – such student loan treatment might be inappropriate for ISA funding used to start a business rather than for education. Also, we expressed concern about the possibility of long-term ISAs in which an individual effectively assigns away a significant percentage of future income for what might be virtually all of his or her working life (e.g., a 30 year ISA). The 2014 bill did not limit such agreements.

So, do the 2015 bills do any better?

Apparent Focus on Education-Related ISAs

Perhaps the biggest change is that both 2015 bills appear to be focused exclusively on ISAs related to education. Why do I say appears? The purpose of the proposed Senate legislation, as spelled out in Section 101 of the bill, refers only to funding post secondary education.  However, the introductory language to the Senate bill indicates that the goal is to provide “the legal framework necessary for the growth of innovative private financing options for students to fund postsecondary education, and for other purposes.” Moreover, the definition of income share agreements in Section 102(a) of the Senate version defines an income share agreement to be one where the funds are used for “post secondary education, workforce development, or other purposes.” The “other purposes” language begs the continued question of whether the bill intends to cover ISAs entirely unrelated to education, such as those for start-up funding. Perhaps the language in the bill referring other purposes is an unintended holdover from the prior bill – and the true goal is regulating only ISAs used for education. The House bill similarly has a confusing reference to financing for “other purposes” in its introductory paragraph, but unlike the Senate version, the House bill definition of ISAs is limited to those agreements whose funding is used “only for costs associated with postsecondary education.”

Why might the drafters be moving towards regulating only education ISAs in these two bills?  In the world of debt, many regard educational debt as different from other debt.  Thus, even if it makes sense to regulate education ISAs like education debt, there is no reason to believe that non-educational ISAs should also track student loan treatment. The decision in Rubio’s earlier bill (and in both the Senate and House 2015 bills) to provide that ISAs are not dischargeable in bankruptcy can make sense only if it applies to ISAs that are a substitute for student loans and we want a level playing field as between more tradition educational debt and education-related ISAs.  But if an ISA is replacing funding in a non-education setting, then such nondischargeability could produce distortions. Both of the current House and Senate bills include the bankruptcy nondischargeability provision for ISAs, but if both bills are drafted to cover only education ISAs then such a rule is not the overreach it was in the 2014 version.

Stronger Consumer Protections

Another notable change in both 2015 bills is the stronger emphasis on consumer protections for the funding recipient. These protections take the form of expanded disclosures (more information must be provided to the individual–including information about how the deal compares to a likely loan alternative) as well as additional limits on payments under an ISA that will be covered by the bill. For example, both bills include language that calculates limits on annual payments and maximum percentage pledged that vary with contract term length—the longer the ISA term, the smaller the percentage of income that may be pledged. Clearly the idea is to make sure that individuals have a better sense of what they are getting into, have an understanding of how the ISA compares to probable loan alternatives, and have some backstop to protect them from committing too heavily under an ISA, even if they know the terms.

Tax Treatment

But I have saved the best for last. As this is first and foremost a tax blog, what do the new bills say about taxation of ISAs? Here, there’s only a little bit that’s new. The 2014 Rubio-Petri bill provided that the amounts received from the funding provider under an ISA are not included in the income of the funding recipient, and that the amounts paid to the funding provider are first a return of basis and then are included in income as “interest”. This result was inconsistent with debt taxation and with equity taxation, and the upfront basis recovery for the funding provider was a distinctly generous tax treatment. The 2014 bill compounded the tax inconsistency by labeling the income portion as “interest”, although elsewhere the bill affirmed that the ISAs were not debt. Both 2015 bills repeat this prior tax treatment, with one notable difference. The current bills refer to the amount that the funding provider receives in excess of the amount provided to the individual under the ISA as “income” not “interest” income. So, it appears that we are slowly seeing some progress in terms of tax coherence and careful drafting. As those of us who spend all of our days contemplating the Code know, much can come from the inclusion of a single word.

Will this new round of ISA bills be adequate to the task of alleviating market concerns? Perhaps to some extent. But if the focus of legislation is on education-related ISAs (which might make strategic sense in Congress), then it is not clear that the broader market for ISAs has gained any regulatory certainty.