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Good news for sectarian educational institutions issuing tax-exempt bonds.

The Sixth Circuit Court of Appeals has held that the issuance of tax-exempt bonds to a sectarian university does not violate the First Amendment as the bonds were part of a neutral program to benefit education and conferred only an indirect benefit on the university. The court held that the nature of the institution is irrelevant and that the conduit financing advanced a governmental interest without creating the impression that the government was endorsing religion.


Since the inception of a federal income tax in 1913, the federal government has continuously provided an exemption for interest on bonds issued "by or on behalf of' states and localities (12). While initially capitalizing on this exemption via the issuance of general obligation bonds, over time, state and local governments issued revenue bonds to finance private business activities to promote economic growth (9). Congress exempted from the federal income tax interest on industrial revenue bonds connected to projects which benefited a local economy. Typically, industrial revenue bonds are issued by a governmental authority, however, the authority does not actually, directly borrow the funds or become liable for repayment of the funds (21).

In a case of first impression, the Sixth Circuit Court of Appeals recently addressed the constitutionality of the issuance of tax-exempt bonds by the Industrial Development Board ("Board") of the Metropolitan Government of Nashville ("Metro") to David Lipscomb University ("Lipscomb"), which was ruled a "pervasively sectarian" educational institution (6). Specifically, the court addressed the issue of whether tax-exempt bond financing to a "pervasively sectarian" educational institution constituted a form of direct state aid with the primary effect of advancing religion, and thus, violating the Establishment Clause of the U.S. Constitution (2). Ultimately, the court answered the question with a resounding--No!

Steele presents an interesting blend of analysis of federal tax law and constitutional law. In this day and age, issues of separation of church and state have been in the forefront of constitutional issues before the Supreme Court (20). While it remains to be seen whether Steele will reach the Supreme Court, it certainly has established a foundation with its well-reasoned opinion for other circuit courts to follow its reasoning. This may have a positive impact on local economies as it will foster the issuance of industrial revenue bonds to all sectarian educational institutions, thus stimulating construction projects and investment throughout the United States. Tax practitioners, businesspersons, underwriters, developers, state and local governments, investors in tax-exempt bonds, and sectarian educational institutions all should be aware of Steele. However, before analyzing Steele, a general overview of the relevant statutory scheme of the Internal Revenue Code of 1986 ("Code"), as amended, governing the typ e of bonds issued in Steele is necessary (13).

Statutory Overview: Tax-Exempt Qualified Private Activity Bonds

Pursuant to Code [section]103(a), "gross income does not include interest on any State or local bond." However, Code [section]103(b) (1) provides that Code [section]103(a) shall not apply to "any private activity bond which is not a qualified bond (within the meaning of Section 141)." A private activity bond is defined, in relevant part, in Code [section]141 (a) (2) as any bond issued as part of an issue "which meets the private loan financing test of subsection (c)." Code (ss)141(c)(1) provides that the "private loan financing test" is met "if the amount of the proceeds of the issue which are to be used (directly or indirectly) to make or finance persons other than governmental units exceeds the lesser of (A) 5 percent of such proceeds, or (B) $5,000,000."

The private activity bonds must also be qualified under Code (ss)141(e) for the interest on the bonds to be tax-exempt. Under Code (ss)141, there are three standards that the bond must satisfy. First, per Code (ss)141(e)(1), the bond must fall within an enumerated category. Code (ss)141(e)(1)(G) enumerates a "qualified 501(c)(3) bond" as a qualified private activity bond. Code (ss)145(a) defines a "qualified 501(c)(3) bond" as a private activity bond if "all property which is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization...." Second, Code (ss)141(e)(2) provides that the bond issue must meet the volume cap requirements of Code (ss)146. Third, Code (ss)141(e)(3) provides that the bond issue must meet "the applicable requirements of each subsection of Section 147." Code (ss)147(f)(2)(A) provides, inter alia, under the public approval requirement for private activity bonds, that the bond must be approved by both the governmental unit which issued the bond and each gov ernmental unit having jurisdiction over the area in which any facility receiving financing through the bond proceeds is located. Congress enacted the public notice and approval requirements to assist in eliminating inappropriate uses of tax-exempt financing and to restore the benefits of it for traditional governmental purposes (11). Accordingly, a bond which satisfies the requirements of Code (ss)141(e) and Code (ss)147 will constitute a "qualified private activity" and the interest thereon will be exempt from federal income tax under Code (ss)103(a).

Steele v. Industrial Development Board of the Metropolitan Government Nashville

The facts in Steele are not overly complex. David Lipscomb University, a private, not-for-profit religious corporation affiliated with the Churches of Christ is a liberal arts university located in Nashville, Tennessee. In the early 1990s, it had an enrollment of approximately 2,500 students. Lipscomb's primary mission has been to integrate Christian faith and practice with the pursuit of academic excellence.

In the early 1990s, Lipscomb undertook a major development project to expand and renovate its campus to facilitate an increase in student enrollment to 3,000. Lipscomb applied for a $15 million, low-interest loan from the Board to fund a new library; convert the old library into administrative offices; construct an intramural building and field, tennis courts and baseball stadium; expand the Swang Business Center; make parking, landscaping and walkway improvements; and acquire computer and fiber optic equipment.

The Board is a public corporation created under the authority of Tennessee statutory law (14). Metro approved the creation of the Board by resolution under Tennessee law (16). Under state law, the Board has the authority to issue tax-exempt revenue bonds for public works projects, including "any nonprofit educational institution in any manner related to or in furtherance of the educational purposes of such institution... (15)." The statute further provides that after the approval and sale of the tax-exempt bonds the bonds do not constitute an indebtedness of either the Board or Metro (17). Also, neither the Board nor Metro can be held liable to pay any portion of the principal or interest on the bonds (17). Further, no state or local government tax revenues are to be spent due to the issuance of the bonds.

The Board provides conduit financing services to a myriad of nonreligious and religious nonprofit organizations. There never was a claim that the Board ever favored or disfavored any religion. In fact, the Board arranged tax-exempt financing for, among others, sectarian and nonsectarian educational institutions, the Jewish Community Center, the YMCA, Nashville Public Radio, and the Easter Seal Society.

The Board approved Lipscomb's request for the loan at a public meeting on April 10, 1990. After another public bearing on May 30, 1990, the Board formally approved the issuance of $15 million in tax-exempt industrial development bonds to finance the loan. On May 31, 1990, Nashville Mayor Bill Boner approved the issuance of the bonds, thus certifying they served a public purpose.

The bonds were sold to private investors and the proceeds were loaned to Lipscomb. The loan agreement stipulated that Lipscomb was not to use any bond-financed facilities for sectarian instruction or as a place of religious worship. Also, Lipscomb was obligated to pay all sums due on the bonds.

Sovran Bank, as trustees for the bondholders, was assigned the loan documents. It provided the principal security for the loan documents via an irrevocable letter of credit for Lipscomb's account to Sovran Bank as trustee for the bondholders. Lipscomb and the Board also entered into a promissory note and loan agreement to provide additional security. Accordingly, even though there was no direct transfer of money from the Board to Lipscomb, the money did flow to Lipscomb in the form of a loan from the Board, which is an instrumentality of Metro. Ultimately, Lipscomb saved about 30 percent of the cost of its development project due to the low-interest loan and was able to increase its enrollment to about 3,000. Furthermore, the tax revenues collected by the government were reduced as the bonds were tax-exempt.

The district court upheld the plaintiffs challenge to the validity of the Board's issuance of the tax-exempt bonds for Lipscomb's benefit (7). The plaintiffs argued that the issuance of the bonds provided an impermissible benefit to a "pervasively sectarian" institution, thus it violated the Establishment Clause of the First Amendment to the United States Constitution (18). The district court granted summary judgment to the plaintiffs and issued a permanent injunction prohibiting the Board and Metro from issuing additional tax-exempt bonds to Lipscomb or any other "pervasively sectarian" institution. The Sixth Circuit Court of Appeals reversed the district court.

First, the circuit court agreed with the holding of the district court that the bonds were qualified private activity bonds under Code [ss]103(a), and thus tax-exempt bonds. The bonds had been issued to Lipscomb, a private educational institution for the purpose of its development project in the amount of $15 million. This satisfied the "private loan financing test" of Code [ss]141(c), thus, the bonds were private activity bonds under Code [ss]141 (a).

The bonds were qualified bonds under Code [ss]141(e). First, they were a "qualified 501(c) (3) bond" as Lipscomb was a 501(c) (3) organization, thus satisfying Code [ss]145(a) as all of the proceeds of the bond issue were loaned to Lipscomb for the construction and renovation projects on its campus. Second, the volume cap requirements of Code [ss]146 were not at issue. Third, the public approval requirement of Code [ss]147(1) (2) (A) was satisfied as the bond issue was approved by the Board, the governmental unit issuing the bonds, and the Mayor, the chief executive officer of Metro, the governmental unit in which Lipscomb's facilities were located.

The circuit court next addressed the issue as to whether the issuance of tax-exempt bonds violates the Establishment Clause when the bonds benefit a "pervasively sectarian" educational institution - an issue heretofore not addressed by any other circuit court or the Supreme Court.

The First Amendment to the United States Constitution, which is made applicable to the states via the Fourteenth Amendment, provides that "Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof (17)." It is a well-settled fact of law that the Establishment Clause and the Free Exercise Clause of the First Amendment must work in harmony (4,19).

The district court's ruling was founded on its finding that Lipscomb was a "pervasively sectarian" institution, thus, it could receive no state aid as its secular activities cannot be separated from its sectarian activities. The circuit court rejected the reasoning of the district court and instead focused on the nature of the aid in question, rather than the fact that Lipscomb was a "pervasively sectarian" institution.

The court noted that the aid in Steele was virtually identical to the bonding mechanism in Hunt wherein the Supreme Court described the program as follows:

The "state aid" involved in this case is of a very special sort. We have here no expenditure of public funds, either by grant or loan, no reimbursement by a State for expenditures made by a parochial school or college, and no extending or committing of a State's credit. Rather, the only state aid consists, not of financial assistance directly or indirectly which would implicate public funds or credit, but the creation of an instrumentality (the Authority) through which educational institutions may borrow funds on the basis of their own credit and the security of their own property upon more favorable interest terms than otherwise would be available. The Supreme Court of New Jersey characterized the assistance rendered an educational institution under an act generally similar to the South Carolina Act as merely being a "governmental service." The South Carolina Supreme Court, in the opinion below, described the role of the State as that of a "mere conduit (8)."

The circuit court noted that Hunt seems to indicate that a governmental unit could serve as a conduit for a "pervasively sectarian" institution to receive the proceeds of tax-exempt bonds if no public funds were expended. However, in Hunt, the schools were held to not be "pervasively sectarian," thus Hunt did not directly address the issue in Steele.

The Steele court reasoned that the Supreme Court had upheld a tax exemption for real estate owned by religious organizations as not a sponsorship of religion in Walz (19). Furthermore, the Supreme Court has ruled that an indirect financial benefit provided through a religiously neutral tax is not unconstitutional. Religious institutions may receive indirect benefits through state law tax deductions allowed for items such as tuition and fees, so long as the tax benefit is neutrally available--i.e., to secular and nonsecular, private and public, educational institutions alike (3).

In Steele, the court noted that the Board had issued bonds to both sectarian and nonsectarian entities on a neutral basis. In fact, no claim had ever been made that the Board favored or disfavored one religion or another. Accordingly, the court ruled that the benefits of the bonds at issue were similar to an indirect financial benefit conferred by a religiously neutral tax or deduction.

The court found it significant that any entity seeking a tax-exempt bond had to arrange the financing through exclusively private lenders of the funds--i.e., Sovran Bank was used by Lipscomb. Also, the bondholders' sole recourse was against Lipscomb and neither the Board nor Metro had any liability relative to the bonds. In addition, no government funds were utilized in the transaction.

The court stated that it was necessary for a governmental unit to issue the bonds in order to satisfy the requirements of Code [ss]147(f)(2)(A) mandating state or local government issuance and approval of the bond issue. However, the court noted that there is no requirement that the qualified private activity bond finance a typical governmental function, such as highway construction or police protection. Instead, the bond issue may finance many purposes, including economic development or higher education. Since the Tennessee law required that the bonds serve the "furtherance of the educational purposes of such institution...," the court concluded that the issuance of the tax-exempt bonds on a neutral basis provided a generally available government benefit which does not violate the Establishment Clause (15).

The court went on to apply the test formulated and subsequently modified by the Supreme Court which applies to Establishment Clause cases (1,10). Originally, a statute passed the test only if it had "a secular legislative purpose," if its "principal or primary effect" was one that "neither advanced nor inhibited religion," and if it did "not foster an excessive government entanglement with religion." When it modified the test, the Court folded the entanglement query into the primary effect test (20).

The court ruled that the issuance of the bonds had a clear governmental, secular purpose as it promoted economic and educational development It promoted job-producing construction projects at Lipscomb. It helped produce a more educated populace which is better able to generate new development and economic opportunity. In fact, Lipscomb received only the same type of financing for its development project as any other private institution whether it be religious or nonreligious. Further, the loan agreement specifically prohibited Lipscomb from using any of the bond-financed facilities for sectarian instruction or religious worship.

Significantly, the court ruled that the bond program did not present the perception of government endorsement of a religion to a reasonable observer. The reasonable observer would know the history and context of Metro's bond program and see it as part of a plan to finance economic development rather than to endorse a religion (20).


In conclusion, the Steele court ruled that issuance of qualified private activity bonds to a "pervasively sectarian" educational institution did not violate the Establishment Clause of the First Amendment The bond issue was part of a neutral plan to benefit education, provided by both sectarian and nonsectarian institutions. At best, the bond issue provided only an indirect benefit to Lipscomb. Rather than view the nature of the institution ("pervasively sectarian") as central to its inquiry, the court looked to the nature of the aid. The aid in Steele provided not a direct but an indirect benefit similar to the benefit of a religiously neutral tax or charitable deduction approved in past Supreme Court rulings (3). The bond issue utilized no government funds and the bondholders had no recourse against the Board or Metro in the event of non-payment. The bond issue advanced a clear governmental, secular interest in promoting economic development and education. Furthermore, a reasonable observer would not percei ve the bond program as government endorsement of religion.

Steele represents good news for sectarian institutions, even those "pervasively sectarian," who seek financing for development projects through tax-exempt bonds. Eventually, Steele may reach the Supreme Court and become the law of the land. In the interim, other circuits may adopt the reasoning in Steele. Clearly, when structuring bond financings for sectarian institutions, all those involved should be aware of Steele and fashion the terms of the bond issue accordingly.


(1.) Agostini v. Felton, 521 U.S. 203 (1997).

(2.) Black's Law Dictionary (6th ed. 1990). "Direct" is defined as "immediate; proximate; by the shortest course; without circularity; operating by an immediate connection or relation, instead of operating through a medium; the opposite of indirect." "Indirect" is defined as "not direct in relation or connection; not having an immediate bearing or application; not related in the natural way."

(3.) Bowen v. Kendrick, 487 U.S. 589 (1988); Bradfield v. Roberts, 175 U.S. 291 (1899); Mitchell v Helms, 530 U.S. 793 (2000); Mueller v. Allen, 463 U.S. 388 (1983); Tilton v. Richardson, 403 U.S. 672 (1971); and Wolman v. Walter, 433 U.S. 229 (1977).

(4.) Everson v. Bd. of Educ., 330 U.S. 1 (1947).

(5.) Gilette, Clayton P., "Fiscal Federalism and the Use of Municipal Bond Proceeds," 58 N.Y.U.L. Rev. 1030 (1983).

(6.) H.E. Steele v. Industrial Development Board of Metropolitan Government Nashville, 301 F.3d 401 (CA-6, 2002).

(7.) H.E. Steele v. Industrial Development Board of Metropolitan Government Nashville, 117 F.Supp.2d 693 (M.D. Tenn., 2000).

(8.) Hunt v. McNair, 413 U.S. 734 (1973).

(9.) Johnson, Stuart C., "Multi-Family Housing Bonds: Can the Tax Code Provide an Efficient and Effective Low-Income Housing Program?" 5 Va. Tax Rev 497 (1986).

(10.) Lemon v. Kurtzman, 403 U.S. 602 (1971).

(11.) Senate Committee on Finance, S. Rep. No. 494, 97th Cong. 2d Sess. 168 (1982) and H.R. Conf. Rep. No. 760, 97th Cong. 2d Sess. 518 (1982), 1982-2 C.B. 623-24.

(12.) Tariff Act of 1913, Pub. L. No. 63-16, ch. 16, 38 Stat. 114.

(13.) Title 26 of the United States Code.

(14.) Tenn. Code Ann. [section]7-53-101-[section]7-53-311.

(15.) Tenn. Code Ann. [section]-53-101(11)(A)(vii)(1990 Supp.).

(16.) Tenn. Code Ann [section]7-53-201.

(17.) Tenn. Code Ann. [section]7-53-306 (1985).

(18.) United States Constitution Amend. I and XIV.

(19.) Walz v. Tax Comm., 397 U.S. 664 (1970).

(20.) Zelman v. Simmons-Harris, 536 U.S., 153 L. Ed. 2d 604, 122 S.Ct. 2460 (2002) (the school voucher program in Ohio did not violate the Establishment Clause).

(21.) Zimmerman, "Limiting the Growth of Tax-Exempt Industrial Development Bonds: An Economic Evaluation" (1984) (Cong. Research Serv. Rep. No. 84-37E).
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Title Annotation:a court rules that the issuance of tax-exempt bonds to a sectarian university does not violate the First Amendment
Author:Aquilio, Mark
Publication:Review of Business
Geographic Code:1USA
Date:Mar 22, 2003
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