Qualified zone academy bonds.

A frequently overlooked investment, qualified zone academy bonds (QZABs) are available to banking institutions. In addition to a fair rate of return, investor banks will be facilitating local schools in obtaining financial assistance where most needed. QZABs can also provide an alternative investment for banks with a significant number of municipal bonds in their portfolios.

What Are QZABs?

QZABs are used by states and local educational agencies to provide additional resources for improving school facilities and instruction. These agencies have considerable flexibility in using QZABs for rehabilitating or repairing school facilities, purchasing equipment, developing curricula and training school personnel; they cannot be used for new construction.

The QZAB program was designed to help schools that have the most need for financial assistance. According to Sec. 1397E(d)(4)(A)(iv), to be eligible to use such bonds, a public school must:

1. Be located in an empowerment zone or enterprise community (as defined in Sec. 1391(b)); or

2. Have a reasonable expectation that at least 35% of its students will be eligible for the free or reduced-price lunch program under the Richard B. Russell National School Lunch Act.

In addition, a school is required to receive donations from private entities worth at least 10% of the value of the funds borrowed.

Background

Section 226(a) of the Taxpayer Relief Act of 1997 added Sec. 1397E, to provide a credit to QZAB holders, so that such bonds generally can be issued without discount or interest. Each year, the Federal government allocates $400 million in QZAB bonding authority to the various states (including the District of Columbia and U.S. possessions). States receive a specific amount of QZAB authority based on the number of individuals within each state with incomes below the poverty level. Individual school districts then apply to their state for bonding authority.

Although the QZAB program was originally scheduled to expire at the end of 2001, the Job Creation and Worker Assistance Act of 2002 extended the program to calendar years 2002 and 2003; the Working Families Tax Relief Act of 2004 further extended the program to calendar years 2004 and 2005. While currently, there are no extensions beyond 2005, school districts have until Dec. 31, 2007 to issue QZABs allocated in 2005. Rev. Proc. 2004-72 set forth the maximum face amount of QZABs that may be issued for each state for calendar-year 2005.

How Do QZABs Work?

Under Sec. 1397E(d)(6), banks, insurance companies and other corporatious actively engaged in the business of lending money are the only eligible investors in QZABs. In exchange for the investment, a bondholder receives a Federal, nonrefundable tax credit in lieu of cash interest payments. Under Sec. 1397E(c)(1), the credit may be chimed against regular income tax and alternative minimum tax (AMT) liability. Thus, for banks with significant investments in municipal securities that may already be in an AMT position (due to the AMT preference on tax-exempt interest), an investment in a QZAB may be an attractive alternative.

The credit allowed to the bondholder is includible in gross income as if it were an interest payment on the bond; see Sec. 1397E(g) and Regs. Sec. 1.1397E-1(f)(1).According to Kegs. Sec. 1.1397E-1(f)(2), if the bondholder cannot use the credit (i.e., because it does not have a Federal tax liability), it is allowed a deduction for the current tax year (or succeeding tax year, if elected) in the amount of the unused credit.

The credit also passes through to S corporation shareholders. Sec. 1397E(i) states that each shareholder must take into account his or her pro-rata share of the QZAB credit and cannot adjust the basis of S stock under Sec. 1367 on account of the QZAB rules. Thus, an S shareholder will not be allowed a positive basis adjustment for the QZAB interest included in income.

Determining the Credit

The credit amount is the credit rate multiplied by the bond's face amount, according to Regs. Sec. 1.1397E-1(e)(1). The credit rate is set by Treasury each calendar month; the bonds are issued without discount and interest cost to the issuer. Under Regs. Sec. 1.1397E-1(b), Treasury has the discretion to set the rate daily to respond to market conditions and to allow the bonds to be issued at par.

The credit is allowed on the one-year anniversary of the bond's issuance and the last day of each successive one-year period thereafter. During each calendar month, the IRS determines the maximum term permitted for bonds issued during the following calendar month. On the credit (i.e., anniversary) date, the QZAB holder is allowed the credit's full amount; thus, if a bond-holder sells the QZAB one day before the credit date, the seller is not entitled to a credit for that year; see the exhibit above.

Potential Disadvantages

An unused QZAB credit cannot be carried back or forward. Sec. 1397E does not specifically provide for a carryback or carryforward; thus, if the bondholder does not have a Federal tax liability (regular or AMT), the credit is permanently lost.

QZABs provide limited liquidity. Because QZAB credits are available only to banks, insurance companies and other lenders, there is a limited secondary market for selling bondholders. Thus, a QZAB investor should anticipate holding the bond for its maximum term. The default risk on the bonds is generally low, however, as various funding methods are used to ensure repayment at maturity. For example, the bonds can be collateralized through an escrow account funded with U.S. Treasury strips.

Conclusion

QZABs are a financing immanent that can be used to carry out much-needed school renovations and repairs. The Federal government covers, on average, all of the interest on these bonds, thus enabling schools to save up to 50% of the costs of such construction projects. The interest payment is actually a tax credit, in lieu of cash, provided to financial institutions that hold the bonds. For additional information on the QZAB program, visit the U.S. Department of Education's website, at www.qzab.org.

From Kevin Powers, CPA, and Ann Seelmeyer, CPA, Louisville, KY

Exhibit: QZAB investor's tax ramifications
The tax effect to an investor of a $1 million QZAB with a credit rate
of 5.25% that was issued on July 1, 2005 and matures on July 1, 2020,
would be as follows:

             Taxable
             interest                              Net benefit
              income    Tax at 35%   QZAB credit   to investor

Year 1        $26,250       $9,188            --      ($9,188)
Years 2-15    $52,500      $18,375       $52,500       $34,125
Year 16       $26,250       $9,188       $52,500       $43,312