The tax-exempt bond area is closely overseen and regulated by the IRS tax-exempt bond (TEB) division. In 2016, TEB has been allocating half of its resources to examination casework. Included in the examination casework category are referrals and claims, TEB’s market segmentation program and the division’s compliance check/soft letter program. Given the importance of tax-exempt bond financing to your organization, the complexity of maintaining post-issuance qualification of your bonds, and the IRS’s oversight of this area, your organization should understand the requirements for post-issuance compliance and monitor the use of bond-financed facilities to ensure continuing compliance. The penalties for noncompliance could be costly.
Definition and Use
Tax-exempt charitable organizations are eligible to issue qualified 501(c)(3) bonds, a type of private activity bond. Not-for-profits, particularly schools and hospitals, frequently use qualified 501(c)(3) bonds for real estate purchases and other large capital investments.
The qualified tax-exempt bonds are advantageous because the interest paid is tax-exempt to the recipient so long as the issuer meets qualification criteria throughout the lifetime of the bond. Consequently, the bondholders are willing to accept lower-than-market interest rates. In exchange for these favorable borrowing conditions, the organization must abide by restrictions on the use of the bond financing and fulfill informational and other compliance requirements applicable to the bonds.
Bond issuers must meet requirements outlined in Section 145 of the Internal Revenue Code in order to maintain the qualification of the tax-exempt bond. These requirements must be met throughout the bond’s life, so prior to bond issuance, it is critical that the 501(c)(3) organizations have compliance procedures in place to monitor the tax-exempt bonds and the usage of the bond-financed facilities.
Not-for-profits must pass two tests to maintain the qualification of the 501(c)(3) bonds they have issued—the Ownership test and the Modified Private Business test.
For the not-for-profit to meet the ownership test, the property financed by the net proceeds of the tax-exempt bond must be owned by a 501(c)(3) organization or a state or local government unit. Not-for-profits must maintain their 501(c)(3) statuses throughout the lifetime of the bond in order for the bond to continue to benefit from tax exemption.
Tax-exempt bonds are also subject to a 5 percent limitation on so-called “private use.” Generally speaking, private use refers to use of the bond-financed facilities by a 501(c)(3) organization in an activity constituting an unrelated trade or business and/or use of the bond financed facilities by other than a 501(c)(3) organization. It is also important to note that bond issuance costs, which may be as much as 2 percent of the face amount of the bond issue, count toward the 5 percent private business limitation. Consequently, if bond issuance costs amount to 2 percent of the net proceeds of the bond, the maximum allowable private use is effectively reduced to 3 percent.
Consider the following example. A not-for-profit organization issued a tax-exempt bond to finance the construction of a new headquarters building. The organization leases the first floor of its new building to a restaurant. The restaurant’s use of bond-financed space would constitute private business use and contribute toward the 5 percent limitation. If the private business use of the bond financed building (including issuance costs which are treated as private use) exceeds the 5 percent limitation, the bond could lose its tax-exempt status.
Reporting requirements also play an important role in maintaining a bond’s tax-exempt status. Not-for-profits are generally required to file Form 990 Return of Organization Exempt From Income Tax every year. The timely filing of Form 990 is required to maintain an organization’s 501(c)(3) tax-exempt status. Organizations that do not timely file their Form 990 for three consecutive years are subject to revocation of their tax-exempt status, and to the extent that a revoked organization has issued tax-exempt bonds, the bonds would lose their tax-exempt status because the revoked organization would no longer meet the ownership test described above.
Section 501(c)(3) organizations that have tax-exempt bonds with principal outstanding of more than $100,000 are required to complete Form 990, Schedule K Supplemental Information on Tax-Exempt Bonds as part of their annual Form 990 filing. On this schedule, the organization describes the tax-exempt bond including its issue date and price and description of the purpose of the bond. Schedule K also asks for data on the bond, including how the organization has spent the bond proceeds and the amount of bond proceeds the organization has not yet spent.
Organizations should be diligent when completing their Schedule K because TEB scrutinizes Schedule K as part of its examination selection methodology. When reviewing Schedule Ks, the IRS is interested in compliance with the private business use rules, the arbitrage rules, etc. The IRS is also interested in filers’ responses to the various governance-related questions on the Schedule K, such as whether the organization has written procedures in place to ensure compliance with the private business use rules, the arbitrage rules and to ensure timely identification and correction of bond violations and resolution through the IRS voluntary closing agreement program if self-remediation is not possible.
The Importance of Written Procedures
With the TEB scrutinizing compliance with the tax-exempt bond rules, organizations are well advised to adopt and maintain written procedures to ensure post-issuance compliance of their bonds and to allow the most optimal responses to the Schedule K governance questions. Procedures should include diligent maintenance of records relating to usage of bond-financed facilities and measurement and tracking of private business use.
For more information regarding tax-exempt bonds and related compliance requirements, please contact us.
Craig Klein is a Managing Director in the Tax Group at CBIZ Tofias. Craig can be reached at firstname.lastname@example.org or 617.761.0509.