Issuers of tax-exempt bonds should get savvy about the rules

When an entity like a local government considers issuing tax-exempt bonds, it should make sure the right parties are involved early on. Most bond issuers are not like the city of New York, which employs a staff dedicated to bond financings. In fact, they often lack sophisticated knowledge relating to the issuance of bonds and would be wise to involve a bond counsel to help navigate the legal landscape and ultimately provide a tax-exempt opinion on the bonds. They should also bring on board a municipal adviser to help them understand their financing needs and which types of bonds are best, as each state has different rules governing bonds available for financings. The issuer, bond counsel and the municipal adviser should work closely together through the issuance of the bonds.

Once bonds are sold it is important for the issuer to understand its post-issuance compliance requirements. These include the computation of arbitrage rebate and the filing of Forms 8038 and 990- Schedule K. The issuer is responsible for actively monitoring compliance throughout the entire life of the bond issue, and unfortunately is often unaware of this obligation, or the requirements, until the IRS makes contact.

Background Tax-exempt bonds are debt obligations of state and local governments. The issuers can be cities, towns, counties, schools, industrial development authorities or special taxing districts. Charitable 501(c)(3) organizations, too, frequently issue tax-exempt bonds. There are several types of tax-exempt debt available to issuers, including bonds, notes, certificates of participation and direct purchase loans. The tax-exempt status runs throughout the life of the bonds and means that interest paid to bondholders is not included in gross income. Bonds are sold either tax-exempt or taxable, and their repayment is often secured through the pledge of property taxes, general obligation bonds or from the revenue generated from a particular project.

Establishing a post-issuance compliance program helps the issuer to identify areas of noncompliance and avoid violations. Although a bond issuer that doesn’t follow the rules can have the tax-exempt status of its bonds revoked, this is rare, and most often the issuer remedies the problem with the IRS.

Arbitrage rebate An arbitrage rebate calculation looks at the difference between the tax-exempt yield at which the bonds were sold versus the taxable rate at which the proceeds were invested. If an issuer sells bonds at a tax-exempt rate of 3% and invests the proceeds at 4%, the government wants the difference, or arbitrage, rebated back to it. In other words, arbitrage is earned when the gross proceeds of an issue are used to acquire investments that earn a yield that is materially higher than the yield on the bonds of the issue.

Process and penalties A bond issuer often finds out it has violated the rules when the IRS sends a compliance check questionnaire to evaluate the practices issuers use to monitor compliance with federal tax requirements. The questionnaire is detailed and complicated and usually requires the assistance of bond counsel or tax counsel to complete.

Schedule K also troublesome Apart from arbitrage rules, and more specific to not-for-profits, are Form 990-Schedule K calculations, which require an issuer to provide detailed supplemental information about each outstanding tax-exempt bond issue. The form has six parts, with part three focusing on private business use (PBU). The calculation of PBU requires a thorough review of the bond documents for each issue to determine if at least 95% of the net proceeds of the bond issue were used in a manner related to the exempt purposes of the 501(c)(3) organization. No more than 5% of the net proceeds of the bond issue can be used for PBU or an unrelated trade or business use. Government bonds require at least 90% of the proceeds of the bond issue to be used for governmental purposes.

For example, a university medical center financed with tax-exempt bonds may actually be used by an organization other than a 501(c)(3) or a state and local government. This can occur when the entity leases to a for-profit entity or has certain management contracts (bookstore, physician, concession and cafeteria contracts) or federal or business-sponsored research contracts with a for-profit entity.

Completing Schedule K can be quite a challenge, especially if the issuer has numerous bond issues outstanding and a large number of buildings and facilities financed with bond proceeds. These calculations get complicated, and an issuer should engage a bond counsel or PBU specialist for assistance.

Pay attention As the IRS has ramped up its examinations of tax-exempt bonds for abuse, it has increased the number of questionnaires it sends to issuers. Issuers would be wise to educate themselves and call accountants and attorneys for help.

This content is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information about the issues discussed, contact a Grant Thornton LLP professional.

“Grant Thornton” refers to Grant Thornton LLP, the U.S. member firm of Grant Thornton International Ltd (GTIL), and/or refers to the brand under which the GTIL member firms provide audit, tax and advisory services to their clients, as the context requires. GTIL and each of its member firms are separate legal entities and are not a worldwide partnership. GTIL does not provide services to clients. Services are delivered by the member firms in their respective countries. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another’s acts or omissions. In the United States, visit for details.