Tax exempt bonds: IRS examinations are coming. Will your organization be ready?

The Internal Revenue Service (IRS) recently announced the beginning of an examination program focused on issuers (and conduit borrowers--indirectly) of tax-exempt bonds. The audits are set to begin this summer.

In addition, the IRS has sent a number of questionnaires to hospitals. While these do not contain questions on bond financing, if the IRS follows up with examinations, bond compliance could be an issue.

If your organization has previously received the proceeds from tax-exempt bonds, you should ensure that subsequent spending of the loaned proceeds did not create "private use." If the answer is (or has been) "yes." the underlying bonds' tax-exempt status might be in jeopardy. If the IRS discovers the violation during its stated forthcoming random audits,

you might face steep penalties.

The rules governing tax-exempt bonds are very complex, and there are numerous potential pitfalls. Failure to comply with the requirements of the Internal Revenue Code can subject you to significant financial penalties. In the worst case scenario, interest on the bonds can become taxable to the investors who own them. Consequently, compliance with the code provisions is crucial.

Perhaps the most critical requirement in this regard is that your tax-exempt loaned proceeds should not create a subsequent private use of those proceeds as detailed in Code Section 141. Most bond documents that issuers (and conduit borrowers) execute contain an initial covenant that requires them to not create subsequent private use of the loaned tax-exempt proceeds. Here is an example of such a covenant:

"... pursuant to the Bond's Non-arbitrage Certificate and Compliance Agreement, the Company will not use the proceeds of the Bonds which may cause the Bonds to be 'private activity bonds' that are not qualified 501(c)(3) bonds as defined in and for purposes of Sections 141(e)(1)(G) and 145 of the Code (the Code or IRC), and that it will take all actions necessary to prevent the Bonds from becoming bonds that are not qualified 501(c)(3) bonds pursuant to the Code and any applicable regulations."

If your organization has been the beneficiary of a prior tax-exempt borrowing or is weighing the benefits and costs of a future one, you must fully understand these tax requirements which apply after closing. If you do not comply, you might face serious consequences.

Problem areas

You do not want to have private activity bonds; therefore, the purpose of this article is to discuss these IRC private activity use requirements. We will also highlight the likelihood of upcoming IRS random audits in this area and contractual risks of noncompliance (e.g., failure to adhere to tax covenants within a Non-Arbitrage Certificate, Loan Agreement, or Trust Indenture as highlighted above).

In an effort to encourage certain types of "blessed" construction projects for Section 501(c)(3) and related higher education or similar hospital type entities, Code Section 103(a) provides an exclusion for interest earned on bonds issued by state and local governments. Code Section 103(b), however, revokes the exclusion if the bonds are determined to be either arbitrage bonds (not the subject of this article) or "any private activity bond which is not a qualified bond." Code Section 141 defines a "private activity bond."

Code Section 141(a) explains that a private activity bond is "any bond issued as part of an issue which meets the private business use test ... and the private security or payment test ... or which meets the private loan financing test." Additionally, Section 145 permits tax-exempt private activity bonds issued for qualified 501(c)(3) entities such as universities, hospitals and other (c)(3) organizations to come within the scope of Section 103.

In essence, the private activity rules require Section 501(c)(3) organizations to spend or use their tax-exempt proceeds on projects that carry out their particular exempt purpose. Specifically, Code Section 145(a) provides that you will not create a private activity bond if at least 95 percent of the net proceeds are spent for activities which are not part of an unrelated trade or business.

The private business use and security tests and the private loan financing tests are all defined in Code Section 141. In substance, bad (or private business) use is created for Section 501(c)(3) entities if more than 5 percent of net proceeds are used for private business use (activities or purposes unrelated to the stated purposes of the Section 501 (c)(3) organization). In general, the private security or payment test is similarly met if 5 percent or greater of the net tax-exempt proceeds are used to secure private business use property. Lastly, the private loan financing test is met if the lesser of 5 percent or five million dollars are used to finance loans other than for the stated Section 501(c)(3) purpose.

Originating prior to 1970, the "private activity" rules generally apply to conduit borrowers of all types of tax-exempt debt, including exempt facility bonds; mortgage revenue bonds; small issue bonds; student loan bonds, and, redevelopment bonds as well as qualified 501(c)(3) bonds. Subsequent to the receipt of tax-exempt loan proceeds, borrowers must ensure that post-issuance spending of these proceeds does not create an unrelated or private (bad) use of the proceeds.

The normal definitional rules apply in determining whether you have used the bond proceeds to produce unrelated business income (UBI). Such income results from a trade or business that you regularly carry on that is unrelated to your exempt purpose. However, for this purpose, the modifications allowed for purposes of computing unrelated business taxable income do not apply.

Thus, dividends, interest, rents and royalties will constitute unrelated business income, unless the income is earned as part of carrying out your exempt purpose. You have to carefully invest any excess bond proceeds and monitor how you use the property financed with the bonds to avoid earning unrelated business income. The good news is that the "debt-financed property" rules do not apply, as they only come into play with respect to the passive income modifications. By definition, any property acquired with bond proceeds would be debt-financed.

Be ready

If your organization has been the recipient of a tax-exempt loan, you could be the unlucky recipient of formal notification of an IRS audit regarding the post-issuance use of the proceeds. However, you should not sit and wait for the IRS to come to you. A self-audit to ensure compliance, is not only prudent, it might help avoid unnecessary penalties should the IRS catch you after the fact. In the national Bond Buyer daily newspaper, the IRS has formally announced a "significant enforcement audit initiative by early summer," which will involve 501(c)(3) bond transactions.

Although not public at this time, bond lawyers have suggested that it would be helpful if the IRS made its examination checklist in this regard public. This would better enable borrowers with a detailed checklist to allow for self-examinations to ensure continued compliance. But even without seeing the checklist, experienced practitioners in the bond field can assist you in evaluating your situation. If your self-test yields unsatisfactory results, you should consider using the IRS formal Voluntary Compliance Agreement Program (VCAP1).

In an effort to promote voluntary compliance in the tax-exempt bond arena, the Service's VCAP is a potential option to correct prior post issuance infractions. This would include post-issuance bad private-use of tax-exempt loan proceeds in Section 501(c)(3) transactions. Expansion of the Treasury's previous VCAP to now also include the tax-exempt bond area continues their policy of attempting to only tax innocent bond holders as a final resort.

IRS Notice 2001-60, 2001-40 I.R.B. 304 states that VCAP for tax-exempt bonds is voluntary where violations may be resolved by entering into formal closing agreements. The IRS will take VCAP requests from both known and anonymous parties; however, numerous party requests where factual situations are similar are specifically encouraged. At the time this is written, the specific consequences of using the VCAP program are not clear. The IRS has indicated it will look at the facts and circumstances of each case, and will propose an appropriate sanction (if any) on the organization. It's believed, however, that any sanctions imposed under VCAP will be significantly less severe than those the IRS would propose if they discovered violations during a formal examination.

What should you do?

The rules and regulations of Section 141 and 145 are quite complicated and are a challenge even for experienced practitioners. A simple review of the code and regulations in this area should be more than enough to prove this statement. You probably need to use experts to aid in determining that post-issuance use of proceeds did not violate the private activity use rules.

Ignoring the IRS and legal requirements imposed upon issuers (and conduit borrowers) for the privilege of issuing tax-exempt debt is not something to take lightly. Steeper penalties, along with interest, will result should the IRS catch you before you voluntarily notify them of problems. Given the current regulatory environment in the United States, coupled with the continued national presence of the IRS' tax-exempt bond group, including its emphasis on random audits starting as early as this summer in the 501(c)(3) transaction area, a self-check on post-issuance compliance in this area is not only prudent, but likely a necessity.

All of these post-issuance requirements should not cause you to avoid the substantial financial advantages of tax-exempt financing. However, you must obtain the appropriate advice to ensure that you comply with all of the post-closing requirements of Code Section 141 and 145. Failure to do so can cause substantial headaches, which you can avoid by prudent action.

Harvey Berger, CPA, is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: [e-mail]. Gregg Ichel is a partner in Grant Thornton's Public Finance practice and is based in Minneapolis, Minn. His email is [e-mail]. Editor's Note: All references to VCAP are taken from the official IRS Web site at www.irs.gov/taxexemptbond/article/0,,id=132044,00.html.