One of the benefits of tax exemption under Internal Revenue Code (IRC) Section 501(c)(3) is the ability to use tax-exempt financing. Tax-exempt bonds generally carry a lower interest rate than taxable bonds and the interest received by the bondholders is excludable from income for federal income tax purposes.
Because of these advantages, tax-exempt bonds are subject to strict federal tax requirements both at the time of issue and for as long as the bonds remain outstanding, according to Marc Berger, CPA, JD, LLM, director of Nonprofit Tax Services for BDO USA. The Internal Revenue Service (IRS) recognizes that all requirements are closely monitored and complied with at the time bonds are issued. Bond counsels for the organization, the issuing authority and the underwriter are all keenly focused on having a clean transaction close.
Berger warned during his session “Tax-Exempt Bonds and Schedule K” at the AICPA’s Not-for-Profit Industry Conference in National Harbor, Md., that problems can arise after closing, when all of the outside professionals have moved on to the next transaction.
Nonprofit financial managers must actively monitor the use of proceeds and bond-financed property throughout the entire period the bonds remain outstanding to keep the tax-exempt bonds in compliance. The IRS encourages organizations to adopt written procedures that go beyond reliance on tax certificates included in bond documents. The goal of establishing and following written procedures is to identify and resolve noncompliance on a timely basis in order to preserve the preferential status of the bonds, according to Berger.
All property financed with 501(c)(3) bonds must be owned by a 501(c)(3) organization or a governmental entity. In addition, use of bond-financed property in an unrelated trade or business or use by parties other than 501(c)(3) organizations is limited. This type of nonqualified use is known as private business use, or private use.
Berger said to maintain its tax-exempt status, a 501(c)(3) bond issue may not have more than 5 percent private use over the life of the bonds. As a result, tracking private use becomes very important. The situations that can generate private use fall into the following categories:
* Property sold or leased;
* Property subject to management and service contracts;
* Property involved in research activities; and,
* Property used in unrelated business activities
Sec. 501(c)(3) organizations with tax-exempt bonds should be tracking private use at regular intervals. This might involve working with an organization’s legal, facilities, contracting, real estate, and finance departments. Schedule K of the Form 990, which must be completed by organizations with outstanding tax-exempt bonds, asks whether the organization has established written procedures to track compliance with all of the tax requirements.
That’s a question to which all organizational managers should be answering “yes,” Berger told the group. The ability to issue tax-exempt bonds is a benefit that should not be taken for granted. Good post-issuance compliance will allow an organization to realize this benefit over many years.