Originally published January 4 2006
The Internal Revenue Service (IRS) has recently announced that it intends to increase significantly the number of its audits which target "post-issuance compliance in the charitable finance sector." This increased level of scrutiny and the new regulations discussed below together underscore the need for non-profit institutions which have tax-exempt bond debt to establish an effective program to monitor continuously the "private use" at their bond-financed facilities and to keep adequate records of such use.
The U.S. Treasury issued its private activity bond regulations in 1997. These rules provide specific limitations on permitted leases, management contracts, sponsored research and other both structured and less formal arrangements at bond-financed facilities. It is imperative that facilities financed with bond proceeds comply with these regulations during the life of the bond issue. On December 19, 2005, Treasury published long-awaited final regulations as to application of the private activity bond tests to refunding bonds. Rules on refundings had been omitted from the regulations published in 1997 and were issued in proposed form in 2003.
The most noteworthy feature of the proposed regulations was their requirement that governmental and 501(c)(3) bonds issued for refunding purposes be tested for private use on a combined basis with the refunded bonds unless the refunded bonds could satisfy the private use limitations over the shortened period ending with the issuance of the refunding bonds. This rule was intended to limit any advantage from refunding prior bonds which had front-loaded non-qualified use.
The new regulations largely follow the 2003 proposed regulations. What is significant is that Treasury rejected concerns expressed in written comments made in response to the proposed regulations that the use of a combined measuring period in some circumstances would create difficulties for borrowers because of inadequate records as to distant prior periods. Treasury specifically rejected the suggestion that prior compliance with private use limitations should be presumed, subject to a general subjective anti-abuse rule.
This position by Treasury is consistent with what we perceive to be a diminishing willingness by the IRS in audit situations to treat with sympathy a borrower’s lack of adequate records. It is in that context that the IRS’s tax-exempt bond office (TEB) is about to commence an audit program aimed at 501(c)(3) bonds. As reported in the Bond Buyer of December 16, 2005, TEB intends to open 20-50 limited scope audits starting in February, 2006, targeting post-issuance compliance in the non-profit sector.
For these reasons, careful monitoring of the use of bond-financed facilities is essential in order to withstand any inquiries which may be raised on audit and to assure maximum flexibility in responding to any refunding opportunities.
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