By Marc Berger, CPA, JD, LLM
One of the benefits of tax exemption under Internal Revenue Code (IRC) Section 501(c)(3) is the ability to use tax-exempt financing. Tax-exempt bonds generally carry a lower interest rate than taxable bonds and the interest received by the bondholders is excludable from income for federal income tax purposes.
Because of these advantages, tax-exempt bonds are subject to strict federal tax requirements both at the time of issue and for as long as the bonds remain outstanding. The Internal Revenue Service (IRS) recognizes that all requirements are closely monitored and complied with at the time bonds are issued. Bond counsels for the organization, the issuing authority and the underwriter are all keenly focused on closing a clean transaction. However, problems can arise after closing, when all of the outside professionals have moved on to the next transaction.
In order to keep their tax-exempt bonds in compliance, organizations must actively monitor the use of proceeds and bond-financed property throughout the entire period that bonds remain outstanding. The IRS encourages organizations to adopt written procedures which go beyond reliance on the tax certificates included in bond documents. Written procedures should contain certain key characteristics, including:
- Due diligence review at regular intervals;
- Identifying the official or employee responsible for review;
- Training of the responsible official/employee;
- Retention of adequate records to substantiate compliance (e.g., records relating to expenditure of proceeds and use of facilities);
- Procedures reasonably expected to identify noncompliance in a timely manner; and
- Procedures ensuring that the issuer will take steps to correct noncompliance in a timely manner.
The goal of establishing and following written procedures is to identify and resolve noncompliance on a timely basis in order to preserve the preferential status of the bonds.
Ownership and Use of Property
All property financed with 501(c)(3) bonds must be owned by a 501(c)(3) organization or a governmental entity. For this purpose, a “governmental entity” includes a state or local governmental entity, but not a federal entity. In addition, use of bond-financed property in an unrelated trade or business or use by parties other than 501(c)(3) organizations is limited. This type of nonqualified use is known as private business use, or private use. In order to maintain its tax-exempt status, a 501(c)(3) bond issue may not have more than 5 percent private use over its lifetime. The 5 percent limit applies to a bond issue as a whole as opposed to each underlying project being financed. Additionally, the costs associated with a bond issue (e.g., counsel fees, underwriters’ discounts, financial advisory fees, accounting fees, rating agency fees) count toward the 5 percent private use limit. Depending on the size of a bond issue, costs of issuance may range from .5 to 2 percent of the bond issue. As a result, tracking private use becomes very important. The situations that can generate private use fall into the following categories:
- Property sold or leased;
- Property subject to management and service contracts;
- Property involved in research activities; and
- Property used in unrelated business activities.
While each of these situations results in private use, there is some potential relief from private use treatment. Bond-financed property that is sold to a non-501(c)(3) organization or governmental entity can be “remediated.” For example, if an organization’s sales proceeds are used to make qualifying capital expenditures, private use treatment can be avoided. In addition, there are safe harbors for certain management and services contracts as well as for certain research activities. If these safe harbors are met, then no private use will result. Proper planning in each of these situations can avoid exceeding the private use limit.
Section 501(c)(3) organizations with tax-exempt bonds should be tracking private use at regular intervals. This may involve working with an organization’s legal, facilities, contracting, real estate and finance departments. Schedule K of the Form 990, which must be completed by organizations with outstanding tax-exempt bonds, asks whether the organization has established written procedures to track compliance with all of the tax requirements – a question to which all organizations should be answering “yes.” The ability to issue tax-exempt bonds is a benefit that should not be taken for granted, and consistent post-issuance compliance will allow an organization to realize this benefit over many years.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2015). Copyright © 2015 BDO USA, LLP. All rights reserved. www.bdo.com