Various Federal and state laws permit certain types of debt financing for a variety of capital improvements (for example, land, buildings, structures, machinery, equipment and other types of facilities) on a tax-exempt basis under Federal income tax laws. The principal advantage of this financing method is the lower interest cost in comparison to the interest rate on conventional debt available to the borrower. Because investors in tax-exempt bonds do not pay Federal income tax on interest payments received on the bonds, these investors are willing to accept an interest rate lower than the interest rate on comparable taxable bonds, the interest on which is subject to Federal income taxation. In addition, some states exempt the interest on tax-exempt bonds from state income taxes, thus magnifying the benefit of tax-exempt financing.

Tax-exempt bonds have traditionally been issued by state and local governmental units for traditional government functions, such as school construction, public infrastructure and municipal utilities. However, certain private organizations may also avail themselves of the benefits of conduit tax-exempt financing through state and local governmental units. One such category is organizations which are exempt from Federal income taxation under Section 501(c)(3) of the Internal Revenue Code of 1986 (the "Code"). "Nonprofit corporations" under state law which have not obtained 501(c)(3) status under Federal tax law cannot utilize tax-exempt financing.

Although 501(c)(3) organizations can utilize tax-exempt financing for capital improvements, Federal tax law allows 501(c)(3) organizations to borrow on a tax-exempt basis only by involving a state or local government unit. This requirement stems from the basic Code rule that only the interest on bonds issued by or on behalf of a state or local governmental unit will be tax-exempt. Thus, the interest on debt issued directly by a 501(c)(3) organization would only be tax-exempt if issued "on behalf of" a state or local government. Because of the additional constraints involved in an "on behalf of" financing, most 501(c)(3) borrowers choose to issue through a state or local government issuer.

Generally tax-exempt bonds are issued by a state or local government issuer which loans the bond proceeds to the 501(c)(3) organization. State law governs which state and local government issuers may issue bonds for 501(c)(3) organizations. Examples of issuers include state and local government units, such as cities, towns and counties, and special state agencies created to serve as conduit issuers for 501(c)(3) organizations. For example, many special state authorities have been formed solely to serve as a conduit issuer for health and/or educational facilities financing.

The advantages and disadvantages of utilizing potential state and local governmental issuers which are available should be carefully analyzed very early in the process. Many local issuers of tax-exempt bonds, such as a city, a town or a county, can only finance activities of a 501(c)(3) organization within that governmental unit's geographic boundaries. Statewide issuers, on the other hand, provide an opportunity to pool the financing needs of 501(c)(3) organizations across the state.

Federal and state law concurrently control the use of tax exempt bond proceeds by 501(c)(3) organizations. The state law pursuant to which the issuer is authorized to issue bonds will typically contain descriptions of eligible borrowers and projects. Review of such limitations is a fundamental part of the issuer selection process described above. For example, some state laws would not permit the financing of working capital or the financing of projects which create jobs as opposed to other functional public purposes, such as health, education or the environment. In addition to statutory restrictions, many issuers have adopted their own policies which may dictate not only eligible projects but may impose credit criteria for the borrower.

Qualified Use vs. Private Use. Section 145 of the Code (the primary Federal tax statute dealing with tax-exempt bonds for 501(c)(3) organizations) requires all property financed by the tax-exempt bonds to be owned by a 501(c)(3) organization or a governmental unit. Tax-exempt bond proceeds must also be used for activities related to a 501(c)(3) organization's exempt purpose. Accordingly, Section 145 of the Code also requires that 95% of the proceeds of the tax-exempt bonds be used in the exempt activities of the 501(c)(3) organization ("Qualified Use"). Use of bond-financed facilities by private businesses, the federal government or by a 501(c)(3) organization in an unrelated trade or business (collectively, "Private Use") is not permitted. In 1997, final regulations interpreting certain concepts of Private Use became effective. Although these regulations provide detailed guidance in several areas, there is still much ambiguity in the legal analysis of Private Use.

In determining whether certain assets should be financed from the proceeds of tax exempt bonds, careful consideration should be given to the expected use of the assets during the term of the bonds. As described under the heading Private Use of Bond Financed Facilities below, a change in the use of bond financed facilities subsequent to the date of issuance may cause the bonds to lose their exempt status unless certain remedial actions are taken.

Eligible Assets. Typically, tax-exempt bond proceeds are used to fund the cost of acquiring or constructing capital assets, interest during construction, a debt service reserve fund, certain costs of credit enhancement and other costs of issuance. Costs of issuance funded from bond proceeds are limited to 2% of the proceeds of the bonds. Costs of credit enhancement could be funded in excess of this 2% limitation if certain federal tax criteria are met. Federal law would also permit 501(c)(3) organizations to finance working capital; however, the arbitrage requirements applicable to such financing are somewhat restrictive and may make financing of working capital financially unattractive.

Further, the weighted average maturity of the tax exempt bonds may not exceed 120% of the weighted average useful life of the capital assets being financed, excluding land. Thus, a 501(c)(3) organization would typically avoid selecting equipment, information systems and other short term assets for a significant portion of the assets to be financed if a long term tax exempt financing is anticipated.

Nonhospital Bond Limit. 501(c)(3) organizations may not be the beneficiary of more than $150 million of outstanding tax-exempt nonhospital bonds. However, this limitation does not apply with respect to bonds issued after August 5, 1997, as part of an issue 95% or more of the net proceeds of which are to be used to finance capital expenditures incurred after August 5, 1997. It is important to recognize that advance refunding bonds for outstanding nonhospital bonds would continue to be counted. Further, the 95% capital expenditure requirement may not be satisfied if proceeds of the bonds are used for working capital (e.g., start up costs or interest on the issue beyond the construction period). Such nonqualifying bonds would be counted toward the $150 million limit. The aggregate outstanding amount of tax-exempt nonhospital bonds (the proceeds of which finance or refinance expenditures incurred on or prior to August 5, 1997) of each test period beneficiary must be determined. A test period beneficiary includes any 501(c)(3) organization which owns or is a principal user of the financed facility at any time during the three-year period beginning on the later of the date the facility is placed in service or the date the bonds are issued. All 501(c)(3) organizations under common management and control are treated as one organization for purposes of the $150 million cap. Once a portion of an issue has been allocated to a 501(c)(3) organization, the bonds remain allocable to such entity so long as they are outstanding even if the organization no longer uses the facility.

Bonds Used for Reimbursement. Federal tax law does not allow a 501(c)(3) organization to reimburse expenditures for capital expenditures made prior to the issuance of bonds from bond proceeds unless certain procedures have been followed before the expenditures are incurred. No later than 60 days after the expenditure to be reimbursed is paid, a declaration of official intent to reimburse the expenditure must be adopted by the 501(c)(3) organization, a person or entity designated to declare official intent on behalf of the 501(c)(3) organization, or the issuer of the bonds. Such declaration of official intent must include information specified in the regulations.

Preliminary expenditures such as architectural, engineering, survey, and feasibility study expenditures not exceeding 20 percent of bond proceeds generally are not subject to the official intent requirement. Land acquisition is not considered a preliminary expenditure. The reimbursement must occur on or before 18 months after the later of the date the expenditure was paid or the date the property was placed in service (but not later than 3 years after the original expenditure).

As discussed above, Section 145 of the Code requires that 95% of the proceeds of the tax exempt bonds must be used in the exempt activities of the 501(c)(3) organization. One of the most helpful provisions in the regulations is the rule that, in most cases, Private Use will be measured over the entire term of the bond issue, rather than on an annual basis. Many Private Use issues can be solved by an allocation of tax exempt bond proceeds to 501(c)(3) use or allocation of bond financed facilities among the various users as more fully discussed below. There are rules providing for simultaneous use of facilities, as well as use of discrete portions of the facilities. The following paragraphs highlight the types of Private Use that occur most frequently with 501(c)(3) organizations.

Unrelated Trade or Business. The general unrelated trade or business use principles under Section 513 of the Code are applied to analyze the use of tax-exempt bond financed facilities for this purpose. Problematic areas include a hospital's laboratory services or pharmacy sales to the public, parking lots open to the general public, museum gift shops selling items unrelated to exempt purposes, college facilities used for unrelated summer camps, and performing arts facilities used for meetings unrelated to its exempt purposes. The use of a facility in an unrelated trade or business does not need to generate any income to be Private Use.

Leases, Management Contracts. Use of bond-financed facilities by private businesses can result in Private Use. For example, leases of bond financed property to entities which are not related 501(c)(3) organizations or state or local governmental units result in Private Use. Similarly, management or other service contracts may constitute Private Use by the service provider if the services provided involve the use of tax-exempt bond-financed facilities.

In Revenue Procedure 97-13, the IRS has set forth the conditions which a management or service contract must meet in order to avoid causing the use of tax-exempt bond-financed facilities by the service provider to be Private Use. Among other criteria, compensation may not be based, in whole or in part, on a share of net profits from the operation of a facility. Further, the service provider must not have a relationship with the borrower that would, in effect, substantially limit the ability of the borrower to exercise its rights under the contract. Revenue Procedure 97-13 outlines the following safe harbors for service contract arrangements that avoid Private Use:

(a) At least 95% of the compensation for services for each annual period during the term of the contract is based on a periodic fixed fee (defined as a stated dollar amount for services rendered for a specified period of time). The term of the contract, including all renewal options, must not exceed the lesser of 85% of the reasonably expected useful life of the financed property and 15 years. A one-time incentive award equal to a single, stated dollar amount is permitted.

(b) At least 80% of the compensation for services for each annual period during the term of the contract is based on a periodic fixed fee. The term of the contract, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the financed property and 10 years. A one-time incentive award as described in (a) is permitted.

(c) Either at least 50% of the compensation for services for each annual period during the term of the contract is based on a periodic fixed fee, or all of the compensation for services is based on a capitation fee (defined as a fixed periodic amount for each person for whom the service provider assumes the responsibility to provide all needed services for a specified period) or a combination of a capitation fee and a periodic fixed fee. The term of the contract, including all renewal options, must not exceed 5 years. The contract must be terminable by the qualified user on reasonable notice, without penalty or cause, at the end of the third year of the contract.

(d) All of the compensation for services is based on a per-unit fee (defined as a fee based on a unit of service provided) or a combination of a per-unit fee and a periodic fixed fee. The term of the contract, including all renewal options, must not exceed 3 years. The contract must be terminable by the qualified user on reasonable notice, without penalty or cause, at the end of the second year of the contract term.

(e) All compensation for services is based on a percentage of fees charged or a combination of a per-unit fee and a percentage of revenue or expense fee. The term of the contract, including all renewal options, must not exceed 2 years. The contract must be terminable by the qualified user on reasonable notice, without penalty or cause, at the end of the first year of the contract term.

Research Agreements. The basic research performed by the borrower at bond-financed facilities of a 501(c)(3) university may constitute Private Use of the bond-financed facilities if a private business funds the research and receives particular benefits from the results of the research. However, two "safe harbors" are described in Revenue Procedure 97-14, under which such funding will not result in Private Use. First, if any resulting technology from the research may be used or licensed by the sponsor only on the same terms as the 501(c)(3) organization would permit use by any nonsponsoring entity, the use of the resulting technology by the sponsor will be treated as Qualified Use. Under this safe harbor, the sponsor must pay a competitive price for its use of the technology, determined at the time that the technology is available for use. Second, if the research is funded by multiple, unrelated industry sponsors, the research to be performed and manner in which it is performed is determined by the 501(c)(3) organization, title to any resulting patent or technology is the 501(c)(3) organization's, and the sponsors may only use the technology on a nonexclusive, royalty free license, the use will be Qualified Use. Note that the foregoing safe harbors only address "basic research" and do not include clinical testing of products.

Agents and Employees. The regulations confirm that use of a facility by agents of a 501(c)(3) borrower does not give rise to Private Use; however, the regulations are silent with respect to employees of the 501(c)(3) borrower. Frequently, employment contracts for senior management or other professional employees may not satisfy the safe harbors of the service contract limitations described below. Representatives of the Internal Revenue Service ("IRS") have indicated that employees are agents of their employers and thus, employment contracts need not satisfy the service contract provider provisions.

Certain Short Term Uses. The regulations provide short term use exceptions which may be helpful under certain circumstances. By focusing on the period of use rather than the term of the contract, multi-year contracts for short periods of use during the year may be disregarded.

Change in Use. A change from a Qualified Use of bond financed facilities after the date of issuance of the bonds to a Private Use can cause the interest on the bonds to become taxable retroactive to the date of issuance. In certain circumstances, remedial actions are available to protect the tax exemption on the bonds. These remedies include redeeming the bonds, using the disposition proceeds for an alternative Qualified Use, using the bond financed facility for an alternative Qualified Use, and paying the IRS an amount equivalent to the lost tax revenues (income or alternative minimum) under Revenue Procedure 97-15. Section 150(b) of the Code also provides for financial penalties in the event of a change in use of bond financed facilities.

The investment and expenditure of tax-exempt bond proceeds are governed by a detailed set of Federal tax statutes and regulations. The differential between taxable and tax-exempt interest rates provide opportunities to 501(c)(3) organizations to recognize profits by borrowing at a low tax-exempt rate and investing the proceeds at a higher taxable rate. Because this is not what Congress intended tax-exempt bonds to be used for, much regulatory effort has been directed toward controlling the amount of profit or "arbitrage" which can be realized by the borrower in a tax-exempt financing. A detailed discussion of the "arbitrage" rules are beyond the scope of this handbook; however, a few points should be considered.

Generally, any interest earnings on investments of tax-exempt bond proceeds in excess of the interest rate on the tax-exempt bonds must be paid back, or "rebated," to the Federal government and cannot be kept by the 501(c)(3) organization. Numerous exceptions to this rule exist to provide relief from this requirement for borrowers who fit within the permitted exceptions. Planning a financing to take advantage of these exceptions, can enhance the overall benefits of the financing for the borrower.

Funds of the 501(c)(3) organization which are deemed to be "replacement proceeds" would also be subject to the arbitrage and rebate rules. Funds which are reasonably expected to be available for use to pay debt service on tax-exempt bonds are replacement proceeds. Amounts are replacement proceeds of a bond issue if such amounts have a sufficiently direct nexus to the bonds or to the exempt purpose of the bonds sufficient to conclude that such amounts would have been used for the exempt purpose if the bond proceeds were not used for that exempt purpose (including payment of debt service). The mere availability or even a preliminary earmarking of amounts for an exempt purpose does not, in itself, establish a sufficient nexus to cause the amounts to be replacement proceeds. The very nature of the financial structure of most 501(c)(3) organizations raise issues with respect to replacement proceeds. In particular, the design of the financing must to take into account the potential ramifications of the institution's endowment funds and the fundraising activities of the 501(c)(3) organizations as described below.

In order to gain a full perspective on the benefits of tax-exempt project financing, the lower tax-exempt interest rate should also be considered in light of the rate of return achieved by the 501(c)(3) organization on invested funds such as endowment, quasi-endowment or "funds functioning as endowment." Careful planning of fundraising efforts and project development can reap important benefits for 501(c)(3) organizations.

Many 501(c)(3) organizations are perpetually faced with dual needs for capital beyond current operating funds. 501(c)(3) organizations need money to build and equip projects and money to add to endowed wealth. If the planning of these two objectives is coordinated, tax-exempt project financing can help increase an institution's wealth and lower the cost of facilities. However, care must be exercised to avoid characterization of bonds as "arbitrage bonds." As described above, arbitrage bonds are bond proceeds which are invested, or used to "replace" funds which are invested, at an interest rate higher than the interest rate on those bonds, with the result that the tax exemption on the bonds is lost. The key to successful coordination of fundraising efforts and debt financing for projects is to avoid the treatment of endowment, pledges and gifts to the 501(c)(3) organization as "replacement proceeds" of the bonds.

The "replacement proceeds" problem can arise with respect to gifts or pledges in five basic contexts:

(1) pledges or gifts restricted to the project purpose by the donor;

(2) pledges or gifts restricted to the project purpose by the terms of the solicitation;

(3) funds, pledges or gifts reasonably expected to be used to pay debt service on the bonds;

(4) funds, pledges or gifts pledged or provided as security for the bonds and reasonably anticipated being available for that purpose; and

(5) funds, pledges or gifts with some other significant "nexus" with the project sufficient to give rise to "replacement proceeds" status (for example, a contemporaneous "gift" or establishment of a fund in the endowment on the project may well be a problem, particularly if such income is actually or constructively used for that purpose).

Ideally, fundraising and project financing can be accomplished in a manner which does not give rise to arbitrage problems. Even if the fundraising effort is contemporaneous with the planning of the project financing or includes specific references to the project to be financed, certain steps may be taken to achieve the deserved result. For example, the borrower should make sure that:

(1) The solicitation is open-ended,

(2) The solicitation does not invite the donor to specify a capital project purpose for the gift or pledge, and

(3) All contracts, acknowledgment letters or other writings associated with the solicitation or receipt of a special gift are not specific to particular capital projects.

Generally speaking, the safest way to proceed (and perhaps the most desirable for the 501(c)(3) organization generally) is to provide that gifts are to be used as directed by the 501(c)(3) organization's board of trustees for a variety of purposes, including capital projects, funds functioning as endowment or other 501(c)(3) purposes. While direction by the donor (or indications in the solicitation materials) that gifts will become part of the endowment of the 501(c)(3) organization will suffice for purposes of preserving the right to do tax-exempt project financing, it may tie the board's hands with respect to use of the moneys for other non project related purposes.

A solicitation may also be open-ended even if it is for a specific "campaign" if the campaign goals include providing funds for an open-ended list of purposes. Under this approach, specific capital projects may be mentioned as examples of uses to which the funds might be put and as expression of the institution's current development plans. The campaign solicitations, however, should also make it clear that other purposes are permissible and that moneys will not be applied in any particular order upon receipt. Thus, any particular gifts, when received, do not have to be applied to offset or repay financing for particular buildings.

An open-ended solicitation will avoid an inadvertent restriction of a gift or pledge because of the language of the solicitation or request. Care should be taken to craft the structure of the campaign or specific requests in order to avoid this problem.

Problems will also arise if pledges or gifts are restricted as to purpose by the donor. This can be an intentional or merely inadvertent expression of a significant interest by the donor. Care should be taken in the drafting of written materials which will express the donor's intent not to restrict the pledge or gift to a particular capital project. For example, the pledge card should not enable the donor to indicate that the pledge is for a specific building or capital project. Rather, if any purpose is stated, it should be a reference to the open-ended "campaign" as described above.

Similarly, letters of acknowledgment from the institution to the donor acknowledging a pledge or commitment more informally given should, where possible, state an open-ended purpose for the gift and should not state a limited purpose (for example, they should not say, "Thank you for your $1,000,000 pledge for our new fine arts building.")

Finally, care should be taken not to create circumstances which give rise to a sufficient nexus between gifts or pledges which are not restricted for specific capital project purposes on their face so that they, nevertheless, become "replacement proceeds" for arbitrage purposes. For example, Federal arbitrage law makes clear that "pledged funds" would be considered replacement proceeds. Therefore, unless absolutely required by the lender or bond purchaser, campaign pledges or gifts should not be pledged as security for a bond issue. Similarly, moneys set aside and actually expected to be used to make payments on bonds will also be considered replacement proceeds. Therefore, care should be taken so that fund drive and other such receipts are not specifically identified and set aside as the source of repayment for a tax-exempt borrowing; otherwise, the term of the borrowing is limited to the time such receipts are available. In effect, then, the tax-exempt borrowing becomes a fund drive anticipation borrowing, which may be less effective from a cash flow and cash management perspective than a longer term borrowing payable from general receipts.

A more elusive nexus can also be created in a number of circumstances. Take, for example, the situation in which a gift is made to a 501(c)(3) organization in an amount equal to the cost of a project, the project will be named after the donor, and, in press conferences and press releases, the donor and the institution have indicated that the gift is for the project and that "the donor's generosity has enabled the institution to build the project." In this circumstance, quite arguably, while the gift itself is unrestricted, a sufficient nexus has been created between the gift and the tax-exempt borrowing such that the gift moneys, when received, would be considered proceeds. An inappropriate nexus is not created simply by naming a building after a donor, but such a gesture obviously could support inferences that such a connection exists. The connection should be rebutted in other ways in that scenario.

In contrast, an organization may elect to structure specific fundraising efforts for a project with the intent that the proceeds be used to retire the tax-exempt project financing as quickly as possible. In that scenario, the 501(c)(3) organization utilizes tax-exempt debt as a cheaper source of construction financing than either funds borrowed on a taxable basis from a bank or the expenditure of its own funds in anticipation of the gift receipts. When gifts which are dedicated to the project are received, those moneys would need to be deposited into the sinking fund for repayment of the bonds. In that scenario, the tax-exempt financing probably would not be a long-term financing in which benefits can be achieved from the tax-exempt financing rates vis-a-vis the long-term endowment rate of return; nevertheless, a relative benefit can be definitely obtained in at least two ways. First, the cost of the project is reduced because the tax-exempt borrowing cost is less than either the opportunity cost associated with the use of the 501(c)(3) organization's own money or the interest cost associated with taxable borrowings. Second, the institution is able to proceed with construction of the project sooner than might otherwise be the case and begin enjoying the benefits of the project at an earlier date.

Hopefully this discussion of the issues involved in tax-exempt bond financing will encourage potential borrowers to consider a tax-exempt financing. Because of the significant interest rate savings achieved in tax-exempt borrowings, a 501(c)(3) organization should consider tax-exempt financing in connection with any capital project. With appropriate planning before bonds are issued, and with proper monitoring of a bond issue following the date of issuance, tax-exempt financing can be an invaluable tool for 501(c)(3) organizations.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.
Copyright 2001 Ice Miller. All rights reserved.