A version of this article was published in The Daily Record on April 24, 2017.
Health care organizations that qualify for tax-exempt status under Internal Revenue Code Section 501(c)(3) are able to issue tax-exempt bonds, known as "qualified 501(c)(3) bonds." The ability to issue qualified 501(c)(3) bonds allows a health care organization to realize lower borrowing costs because certain investors are willing to purchase tax-exempt bonds with a lower interest rate (as compared to taxable bonds) in exchange for interest that is free of federal income tax.
There are two requirements for a bond to constitute a qualified 501(c)(3) bond. First, all property financed with the bond proceeds must be owned by a 501(c)(3) organization or a state or local governmental unit. Second, at least ninety-five percent (95%) of the bond proceeds must be used for the exempt activities of the 501(c)(3) organization. Thus, private business use of more than five percent (5%) may cause the bonds to no longer constitute qualified 501(c)(3) bonds and become taxable bonds.
Last year, the United States Treasury Department and the Internal Revenue Service issued final regulations (Regulations) that provide favorable guidance to 501(c)(3) organizations regarding the measurement of private business use for mixed-use projects and projects owned by a partnership in which the partners include a tax-exempt entity and a private business. The Regulations also provide flexible rules regarding remedial action to be taken when a tax-exempt issuer of bonds takes deliberate action that will cause the bonds to become taxable bonds.
A. Mixed-Use Projects
Under proposed regulations, there were two methods to allocate different sources of funds to different portions of "mixed-use projects" (projects financed with both tax-exempt bond proceeds and funds other than from tax-exempt bonds). Under one method, the "discrete portion" method, different sources of funds were allocated to the various discrete portions of the project. Under a second method, the "undivided portion" method, the project is divided into tax-exempt use and private business use portions on a conceptual, rather than a discrete (physical) basis, with the tax-exempt proceeds allocated to the exempt use portion and the other funds allocated to the private business use portion.
The Regulations abandoned the need to choose between the two methods, and make the undivided portion method the exclusive allocation method for mixed-use projects. The undivided portion method provides flexibility to a tax-exempt borrower because it allows for what is known as "floating equity." In other words, because the allocation is not based on a specific physical portion of the project, the actual location of private business use within a mixed-use project may "float," or vary, from year to year.
B. Joint Ownership
The Regulations also address the measurement of private business use when a project is owned by a partnership in which the partners include 501(c)(3) organizations and private business partners. Under proposed regulations, such a partnership was generally treated as an entity that was a private business entity.
The Regulations, however, abandon this approach and treat a partnership as an aggregate of its partners (rather than a separate entity), and set forth a rule for measuring private business use of financed property resulting from the use of such property by a partnership that includes a private business partner. The use of the property by the private business partner is equal to the private business partner?s greatest percentage of the partnership's income or loss attributable to the period that the partnership uses the property.
C. Anticipatory Remedial Action
Lastly, the Regulations contain rules regarding anticipatory remedial action. When the private business use restrictions are violated, it may be necessary to undertake remedial action due to such noncompliance, such as redeeming the nonqualified bonds. In certain situations, such noncompliance may be due to deliberate action by the issuer of the bonds. For example, an issuer may want to sell property that was financed with bond proceeds.
Prior to the issuance of the Regulations, an issuer could take remedial action by redeeming nonqualified bonds within ninety (90) days of the deliberate action that caused the noncompliance. The Regulations, however, provide more flexibility by allowing an issuer to redeem bonds at any time in advance of a deliberate action. To take advantage of this flexibility, an issuer must declare its official intent on or before the date on which it redeems the bonds, and the declaration must identify the financed property with respect to which the anticipatory remedial action is being taken, and describe the deliberate action that potentially may result in the noncompliance.
The Regulations should be welcomed by nonprofit health care organizations that finance projects with qualified 501(c)(3) bonds. The Regulations will be helpful to such organizations in measuring private business use, as well as in undertaking anticipatory remedial action.
Douglas T. Coats