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Proposed IRS rules clarify tax-exempt status of private activity bonds.

The Internal Revenue Service recently issued proposed rules to provide comprehensive guidance on the permissable tax-exempt use of so-called private activity bonds by cities and towns.

The proposed IRS regulations would replace existing federal regulations on small issue industrial development bonds (idbs) and other private activity municipal bonds and replace them with comprehensive rules addressing the private business tests and private loan financing test.

The IRS issued the proposed regulations in the December 30th Federal Register, pp. 67658-67690, setting a deadline for witten comments of May 15, 1995. The regulations are issued to help cities and towns through providing guidance on the application of private activity bond restrictions. The guidance covers management contracts, private loan tests, and other issues.

The IRS will hold hearings on the 143 pages of federal regulations on June 8. The regulations are scheduled to become effective 60 days after the final version is issued. The regulations are to implement the changes in the 1986 Tax Reform Act.

Under the 1986 Act, Congress changed the definition of traditional public purpose bonds to define them as private activity bonds if more than ten percent of the use is by a non- governmental party (federal, nonprofit, or private), or if more than ten percent of the debt service is derived from or secured by private parties. The former definition was 25 percent.

Under the change, most airports, convention centers, and a number of other municipally owned and operated facilities are defined under federal law as private activities rather than public. The 1986 law created categories under which cities could issue municipal tax exempt bonds or private activity bonds for certain water and sewer facilities; solid waste facilities; single and multifamily housing; airports, docks, and wharves; mass transit; heating and cooling; local alectric and gas facilities; publicly- owned hazardous waste facilities; small issue industrial development bonds (idbs); and non-profit hospital and university bonds.

Under the proposals, a city's bond would be considered tax-exempt if the city reasonably expects it to be eligible or if the IRS looks to the actual use of the bond proceeds.

For the first time, the IRS defines "general public use," and gives several bright-line tests and examples to aid municipal governments in determining whether a potential use will pass or fail. The effort is to distinguish between facilities intended to benefit a large number of persons primarily engaged in the same type of trade or business (private use) as opposed to those engaged in different types.

Management Contracts

One area of consistent confusion under the private activity issue has been management contracts, especially for solid waste facilities. The proposed rules would make a management contract okay if:

* it does not exceed five years, and at least 50 percent of the compensation is basewd on a fixed fee; or if the contract does not exceed three years and the compensation is based on a per unit fee;

* it does not exceed ten years and 80 percent of the compensation is based on a fixed periodic fee; or

* it does not exceed 15 years, and all the compensation is based on a fixed periodic fee.

Enterprise Zone Bond

The proposed rules set limits on the amount of issuance allowed in each zone in a city and for each business at the level of the ultimate borrower in any loans-to-lenders program.

Problem Remedies

The proposed regulations also set forth, for the first time, options a city can follow to fix problems and to come into eligibility or compliance.

One option is to redeem or "defease" the nonqualifying bond issue. Another option is to sell the nonqualifying facility and to use the sale proceeds for a qualifying use. A final option the IRS is considering would permit a municipality to to make a straight payment to the IRS to prevent the municipality's bondholders from being taxed.

Submit Comments

Cities wishing to comment should send their comments to:

CC:DOM:CORP:T:R (F1-72-88), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, D.C., 20044.
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Title Annotation:Internal Revenue Service
Author:Shafroth, Frank
Publication:Nation's Cities Weekly
Date:Jan 23, 1995
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