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Tax Exempt Bonds

Tax Exempt Bonds

Overview

Tax exempt bonds, also known as municipal bonds or governmental bonds are debt obligations of state and local governments that are exempt from federal income tax and that are issued in furtherance of governmental or other qualified purposes.  See 26 U.S.C. § 103(a).  Tax exempt bonds are commonly issued to finance long term capital requirements of hospitals that are exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code (the “Code”).  See 26 U.S.C. § 145.  Generally, in order to qualify for tax exemption under Section 501(c)(3), a hospital must be organized and operated exclusively for charitable, scientific, educational, religious or other qualified purposes. 

Tax exempt bond financing for tax exempt hospitals provides an important government subsidy that allows these organizations to realize lower borrowing costs associated with their debt financing.  Tax exempt bonds generally pay lower interest rates than other bonds because investors are willing to accept a lower rate of return in exchange for tax-exempt interest.  This indirect government subsidy furthers the charitable purposes of tax exempt hospitals in providing care to the general population, including those who receive health care benefits under a federal or state sponsored health plan (see Medicare or Medicaid) and those who are unable to pay for the cost of their health care services.

Policy

Congressional policy behind bestowing tax exempt status on qualifying charitable organizations rests on the premise that these organizations provide services that the government would otherwise have to provide.  The promotion of health has long been recognized as a charitable purpose. Hospitals historically were tax exempt institutions because many were operated by religious or philanthropic organizations that provided health care to the poor.  Today many hospitals are organized and operated exclusively for charitable purposes and therefore qualify for tax exemption under Section 501(c)(3). 

Hospitals that qualify for tax exempt status under Section 501(c)(3) can access tax exempt bond financing to reduce the costs associated primarily with construction of facilities and with other long-term capital requirements to carry out their charitable mission. Congressional policy in the area of tax exempt bonds also includes restrictions in the Code that are designed to prevent private benefit from being derived from these bonds (see Authority section below).  The Internal Revenue Service (“IRS”) created the Tax Exempt Bond office to provide guidance and to ensure compliance with the Code through its examination program.  As a result, tax exempt bond issues may be selected for audit to determine their compliance with applicable federal law and regulations. 

Authority

The Code provides that gross income does not include interest from any state or local bond, with exceptions for bonds that are private activity bonds, arbitrage bonds, or unregistered bonds.  See 26 U.S.C. § 103(a)-(b); see also 26 U.S.C. §§ 141, 148 and 149.  Tax exempt bonds are governed by Sections 141 – 150 of the Code, as enacted in the Tax Reform Act of 1986 (P.L. 99-514).  There are several types of tax exempt bonds defined in the Code, and tax exempt bonds for hospitals are defined generally as “qualified 501(c)(3) bonds.”  See 26 U.S.C. § 145(a).  Qualified 501(c)(3) bonds are qualified private activity bonds issued to finance property owned by either an organization described in Section 501(c)(3) (i.e. a tax exempt hospital) or by a governmental unit.  See id.;see also 26 C.F.R. §§ 1.141-0 – 1.141-15.  Under the category of qualified 501(c)(3) bonds, the Code further defines a “qualified hospital bond” as any bond issued as part of an issue where 95 percent or more of the net proceeds are to be used with respect to a hospital.  See 26 U.S.C. § 145(c). 

There are two requirements for a bond to be a “qualified 501(c)(3) bond:” 1) all property that is to be provided by the net proceeds of the bond issue must be owned by a 501(c)(3) organization or governmental unit; and 2) a minimum of 95% of the net bond proceeds of a qualified 501(c)(3) bond issue must be used for the exempt activities of a 501(c)(3) organization.  See 26 U.S.C. § 145(a)(1)-(2).  The result is that a qualified 501(c)(3) bond must satisfy both an “ownership test” and a “private use test.”  See id. 

The ownership test requires that all property acquired by the net proceeds of the bond issue be owned by either a 501(c)(3) entity or a governmental entity.  For example, a tax exempt hospital could issue a series of qualified 501(c)(3) bonds if the proceeds of the bond issue were used to construct a new treatment center that was owned by the tax exempt hospital. 

The private use test is satisfied if a minimum of 95% of the net bond proceeds of the issue of qualified 501(c)(3) bonds are used to carry out the exempt activities of a qualified 501(c)(3) organization.  Simply stated, this means that no more than 5% of a qualified 501(c)(3) bond issue’s proceeds may be used in a private business use or in any unrelated business or trade activity.  See 26 U.S.C. § 513(a).  An unrelated business or trade activity is any trade or business that is not substantially related to the exercise or performance of an exempt purpose, and that does not meet one of the following three exceptions: 1) activities performed without receipt of compensation; 2) activities carried on primarily for the convenience of an organization’s members; or 3) activities selling merchandise substantially all of which was received as gifts or contributions.  See id. 

One important limitation on the use of tax exempt bond financing is that property financed by an issue of qualified 501(c)(3) bonds must not be used in a trade or business of any person other than a 501(c)(3) organization while continuing to be owned by a 501(c)(3) organization. Violations of this statute cause the 501(c)(3) organization to be treated as if it used the property in an unrelated trade or business.  See 26 U.S.C. § 150(b)(3)(A). Because of this unauthorized use, the 501(c)(3) organization is treated as having income from an unrelated trade or business equal to the minimum of the fair rental value of the property. See id.  Additionally, the interest on the bond financing is deemed to be nondeductible as to the income of the unrelated trade or business.   See 26 U.S.C. § 150(b)(3)(A)-(B).

Qualified 501(c)(3) bonds are also subject to arbitrage restrictions that limit the ability of the bond issuer to invest proceeds of the bonds, or funds replaced by bond proceeds, at a materially higher yield than the yield on the bonds.  See 26 U.S.C. § 148(a).  A bond is treated as an arbitrage bond if the issuer intentionally uses any portion of the proceeds of the issue to acquire higher yielding investments, or to replace funds that were used directly or indirectly to acquire higher yielding investments.  See id.  Qualified 501(c)(3) bonds lose their tax-exempt status if they are arbitrage bonds under Section 148. 

Two additional restrictions on qualified 501(c)(3) bonds are that: 1) a bond is not treated as a qualified 501(c)(3) bond if the issuance costs financed by the issue exceed 2 percent of the proceeds of the bond issue (see26 U.S.C. § 145(g)); and 2) a private activity bond is not treated as a qualified 501(c)(3) bond if it is part of an issue where the average maturity of bonds exceeds 120 percent of the average reasonably expected economic life of the facilities being financed with the bond proceeds (see 26 U.S.C. § 145(b)).

Agency Guidance

The Internal Revenue Service administers federal tax laws applicable to tax exempt bonds.  The IRS website provides a wealth of information for the Tax Exempt Bond Community.  See http://www.irs.gov/taxexemptbond/index.html?navmenu=menu1.  IRS guidance on tax exempt bonds includes Internal Revenue Manual materials, Revenue Rulings, Revenue Procedures, Notices, announcements and other forms of agency publications.  Practitioners may also wish to subscribe to e-mail updates from the IRS on a variety of tax related topics, including information of interest to the tax exempt bond community. 

Future Direction and Common Areas of Concern

In recent years, Congress and governmental agencies have increased their scrutiny of tax exempt organizations including hospitals and other tax exempt health care facilities.  This increased scrutiny includes additional focus on the area of tax exempt bond financing. 

In August 2007, the IRS announced a new compliance check questionnaire it would use to help evaluate whether tax exempt organizations were ensuring their qualified 501(c)(3) bond financings complied with federal tax requirements that apply post issuance.  See IRS Announces Compliance Check Questionnaire on Tax-Exempt Bond Financings, Health Lawyers Weekly, August 24, 2007, Vol. V Issue 33.  The IRS sent this questionnaire to over 200 exempt organizations that reported outstanding balances of tax exempt liabilities on their 2005 Form 990.  See id.  The IRS characterized this project as the first major step in the IRS’ use of the “soft contact approach” using informal, non-audit contacts to measure and promote tax compliance within the tax exempt bond market.  See http://www.irs.gov/taxexemptbond/article/0,,id=186653,00.html.  This compliance reporting found that less than 50 percent of responding organizations were able to describe in detail their procedures ensuring post-issuance compliance with federal laws governing tax exempt bonds.  See id. 

In December 2007, the IRS issued revised Form 990.  Revised Form 990 includes Schedule K. Schedule K requires tax exempt organizations with tax exempt bonds issued after December 31, 2002 with an outstanding principal amount exceeding $100,000 to provide detailed information on their outstanding liabilities associated with these bonds.  See 2008 Instructions for Schedule K (Form 990) – Supplemental Information on Tax Exempt Bonds, available on the IRS website.  This change imposes a substantial reporting requirement on most tax exempt hospitals because tax exempt bond issues are their most common source of long term capital financing.  Beginning in tax year 2009, Schedule K is required to be fully completed when filing Form 990 (note – the IRS only required Part I of Schedule K to be completed for tax year 2008). 

The IRS also released its FY 2009 Tax Exempt Bonds Workplan.  Seehttp://www.irs.gov/pub/irs-tege/fy_2009_workplan.pdf.  The 2009 work plan outlines the following IRS priorities for ensuring compliance in tax exempt bond issues: 1) maintaining increased enforcement actions against high-risk cases and abusive tax schemes; 2) detecting and deterring abusive tax shelters; 3) addressing the use of derivatives and other financial products to divert rebatable arbitrage; 4) increasing use of compliance check initiatives and corresponding examinations; 5) encouraging greater participation in voluntary compliance programs; and 6) enhancing information gathering through refinements to the tax exempt bond returns and reporting through form revisions.  This work plan demonstrates continuing IRS efforts to monitor compliance with federal law governing tax exempt bond issues.  These issues will continue to be important areas of focus for tax exempt hospitals and health care facilities who rely on tax exempt bonds for their long term capital financing needs. 

Conclusion

Federal law and regulations on tax exempt bonds are very complex and significantly impact the operation of tax exempt hospitals and health care facilities.  Current Congressional interest in the operation of tax exempt hospitals and health care facilities, coupled with focused compliance efforts by the IRS, will provide challenges to tax exempt hospitals and their legal counsel for the foreseeable future. 

Acknowledgement

AHLA would like to thank Delia D. Johnson, J.D., LL.M. (taxation), of Seattle, Washington drafting this article.