The ownership and private use limitations for qualified 501(c)(3) bonds apply to financed assets for the entire time the bonds remain outstanding (or for their entire useful lives, if earlier). However, facts and circumstances that were not anticipated at the time the bonds were issued may result in a change in the ownership or use of the financed assets. If the financed assets will no longer be owned by a governmental unit or Section 501(c)(3) organization or less than 95% of the financed assets will be used for qualifying uses, the Section 501(c)(3) organization must take certain steps to preserve the tax-exempt status of the bonds.

For purposes of this memorandum, "change in use" means a change in the use of a building, equipment or other assets financed with qualified 501(c)(3) bonds or governmental bonds from a use qualifying for tax-exempt financing to a private business use which does not qualify for tax-exempt financing.

General Requirements

Under the applicable Treasury Regulations, the following five threshold requirements must be met in order to prevent a change in use of bond-financed assets from adversely effecting the tax-exempt status of the bonds.

  1. Reasonable Expectations Test. The Section 501(c)(3) organization reasonably expected on the issue date that the bond-financed assets would be used for a qualifying use for the entire term of the bonds. Special rules apply where the Section 501(c)(3) organization expects to take actions that will result in a change in use, which generally require special mandatory redemption provisions.
  2. Maturity Not Unreasonably Long. The maturity date of the bonds must not be longer than is reasonably necessary for the valid 501(c)(3) purpose of the bonds. This requirement is met if the bonds satisfy the maturity limitations (sometimes referred to as the "120% test") generally applicable to qualified 501(c)(3) bonds. The 120% test is a reference to the requirement that the weighted average maturity of the bonds must not exceed 120% of the average reasonably expected useful life of the property being financed with the bonds as of the issue date.
  3. Proceeds Expended. The proceeds of the bonds generally must have been expended on qualifying facilities before the date of the change in use of the bond-financed property.
  4. Fair Market Value Consideration. The terms of the arrangement resulting in a change in use generally must be bona fide and on an arm's-length basis, and the new owner or user must pay fair market value for its acquisition or use of the bond-financed property. Fair market value may be determined by taking into account restrictions on the use of the property that serve a bona fide purpose of the Section 501(c)(3) organization.
  5. Disposition Proceeds Treated as Gross Proceeds for Arbitrage Purposes. The Section 501(c)(3) organization must treat any proceeds of the sale, exchange or other disposition of bond financed property as gross proceeds of the bonds for arbitrage purposes.

Remedial Actions

Assuming the threshold requirements have been satisfied, to preserve the tax-exempt status of the bonds after the change in use, the Section 501(c)(3) organization must take one of the following three remedial actions.

  1. Redemption or Defeasance of Bonds. Within 90 days of the date of the change in use, all of the bonds attributable to the non-qualifying use (the "non-qualifying bonds") must be redeemed or a defeasance escrow must be established for the bonds. Proceeds of other tax-exempt bonds must not be used for this purpose unless such bonds are qualified bonds, taking into account the purchaser's intended use of the bond-financed property.

    If cash is the exclusive consideration for the disposition of bond-financed property, the cash may be used to redeem a pro rata portion of the non-qualifying bonds at the earliest call date after the change in use. In this case, it is not necessary to redeem or defease all of the non-qualifying bonds. If the consideration for the disposition of the bond-financed property is a combination of cash and other items, such as the provision of services, then all of the non-qualifying bonds need to be redeemed or defeased.

    The following example illustrates this special rule for cash dispositions. On September 21, 2005, a hospital authority issues 30-year bonds for the benefit of a not-for-profit health care system with an issue price of $45 million to finance a new outpatient care clinic. Three years after the issue date, the hospital system sells the clinic to a large for-profit pharmacy chain for $25 million. The sale price is the fair market value of the building, as verified by an independent appraiser. The hospital system uses all of the $25 million of disposition proceeds to immediately retire a pro rata portion of the bonds. The remedial action requirement is satisfied, even though not all the bonds are redeemed. Use of a defeasance escrow is only available for bonds having a first call date no more than 10-1/2 years from the issue date.
  2. Alternative Use of Disposition Proceeds. The Section 501(c)(3) organization may use the proceeds from the disposition of bond-financed assets to acquire assets or construct other facilities which could be financed with tax-exempt bond proceeds if: (i) the consideration for the disposition is exclusively cash and (ii) the Section 501(c)(3) organization reasonably expects to spend the disposition proceeds within two years of the date of the change in use. This rule applies even if the disposition proceeds used for the alternative facilities are in an aggregate amount less than the outstanding aggregate principal amount of non-qualifying bonds. The bonds must be treated as a reissuance of qualified 501(c)(3) bonds on the date of the change in use.
  3. Alternative Use of Assets. The facility or other assets with respect to which the change in use occurs generally may be used in an alternative manner for which new tax-exempt bonds could be issued if the existing tax-exempt bonds are: (i) treated as reissued on the date of the change in use and (ii) satisfy all requirements applicable to the reissued tax-exempt bonds throughout the remaining term of the bonds. However, the change in use may not result from a disposition to a purchaser that finances the acquisition with another issue of tax-exempt bonds. Any cash proceeds from the change in use must be used to pay debt service on the existing bonds on the next available payment date or, within 90 days of receipt, be deposited into an escrow that is restricted to the yield on the existing bonds to pay debt service on such bonds on the next available payment date.

Closing Agreement Program pursuant to Revenue Procedure 97-15

General Description. In order to provide Section 501(c)(3) organizations with an alternative action in situations in which remedial action under the regulations cannot be taken (e.g., bonds cannot be called within 10-1/2 years or alternative uses of disposition proceeds or assets is not practical), the Internal Revenue Service ("IRS") developed a closing agreement program pursuant to Revenue Procedure 97-15. There are two variations of closing agreements and this section discusses closing agreements providing that interest on the bonds will not be includible in gross income of bondholders. In general, a closing agreement will cover only the period between the issue date of the bonds and the next date on which the bonds may be redeemed pursuant to their terms after the date of the closing agreement. Thus, the closing agreement process does not allow the non-qualified bonds to remain outstanding beyond the next call date.

Requesting a Closing Agreement. The Section 501(c)(3) organization must file a request for a closing agreement within 180 days from the date of the change in use of the bond-financed assets. The five threshold requirements discussed above must be satisfied. The Section 501(c)(3) organization must agree to provide written notice to the bondholders within 30 days of the date the closing agreement is executed that: (i) the bonds will be redeemed in accordance with the terms of the closing agreement on the next redemption date; and (ii) if the bonds are not redeemed on the next redemption date, the bonds will be treated as private activity bonds that are not tax-exempt bonds as of that date. In addition, the Section 501(c)(3) organization must also: (i) agree to not make any payment required pursuant to the closing agreement from the proceeds of the tax-exempt bonds; and (ii) execute a disclosure consent authorizing the IRS to make public otherwise confidential information relating to the closing agreement if the bonds are not redeemed in accordance with the terms of the closing agreement.

Amount Payable to IRS. Generally, the amount paid to the IRS pursuant to the closing agreement is equal to the estimated present value of the federal income tax liability that would be owed if the interest on the bonds were taxable, rather than tax-exempt, from the date of the change in use of the bond-financed assets to the next redemption date. The Section 501(c)(3) organization must pay such amount to the IRS simultaneously with the execution by such organization of the closing agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.