Anatomy Of A 501(c)(3) Financing: Avoiding Pitfalls In Structuring A Tax-Exempt Loan To A Not-For-Profit Entity

Tuesday, May 1, 2007 - 01:00

In recent years, 501(c)(3) entities have increasingly come to rely on tax-exempt loans and bonds to fund their capital projects. Due to the complex and sometimes convoluted maze of the Internal Revenue Code (the "Code") of 1986, structuring a tax-exempt loan carefully is essential if the loan is to be exempt from federal and state income taxes.

Too often, by the time the deal is brought to the attention of qualified bond counsel, issues have arisen with regard to the structure of the transaction or governance issues relating to the 501(c)(3) borrower that could have been avoided had bond counsel been consulted earlier. The purpose of this article, therefore, is not to present an exhaustive outline of the legal and tax issues relating to tax-exempt financing, but instead to highlight some of the more basic and important concepts of which a potential 501(c)(3) borrower and its lender should be aware.

Role of Bond/Note Counsel. The role of bond counsel is to ensure that the bonds or note being issued and the use of the proceeds thereof comply with the requirements of the Code. Bond counsel will:


Deliver an opinion to the bondholders or purchasers of the note to the effect that interest on the bonds or note is exempt from state and federal income taxes.


Perform due diligence on the borrower to ensure its status as a 501(c)(3) entity and that the facility being financed complies with the restrictions and limitations of the Code.


"Quarterback" the deal and file the IRS Form 8038 relating to the issuance of the bonds or note.

Bond counsel frequently serves as borrower's counsel as well.

Reimbursement Of Borrower

Borrowers frequently seek to reimburse themselves from bond proceeds for costs that they incur prior to issuance of the debt offering. In order to do so, a borrower must generally enact a declaration of official intent that complies with the requirements of the Code. Typically, a declaration of official intent is adopted in the same manner as a board resolution.

The declaration of official intent must meet the requirements of the Code and must be adopted not later than 60 days after the date of payment of the original expenditure. There is a special exception for certain preliminary expenditures such as architectural, engineering, surveying, soil testing and similar costs that are incurred prior to the commencement of construction or rehabilitation of a project. While such expenditures can be incurred without regard to when the declaration of official intent is adopted, they cannot exceed 20% of the ultimate debt issuance.

Public Bond Issue v. Private Placement

The borrower must elect between either a publicly offered bond or a privately placed bond note. Publicly offered bonds involve a larger financing team and increased costs, but often yield significant interest rate advantages. Privately placed notes usually take the form of a typical bank financing.

Public bond issues may also require a rating from a rating agency, such as Moody's or Standard & Poors. Also, depending on its creditworthiness, the borrower may have to obtain credit enhancement such as a letter of credit or bond insurance backing up the repayment of the bonds.

Advantages of Public Bond Issue:

(a) Potential to borrow significant amounts at a very low interest rate.

(b) Flexibility of financing options.

Disadvantages of Public Bond Issue:

(a) Higher cost of issuance.

(b) Complexity.

(c) Disclosure.

(d) Official statement.

Advantages of Private Placement:

(a) Less complex.

(b) Shorter time period to close.

(c) Less Disclosure.

Disadvantages of Private Placement:

(a) Longer time period to recover costs.

(b) Higher interest rate than public bond issue.

(c) Lower amount of finance.

TEFRA Hearing

In order to meet the requirements of the Code, the authority issuing the bonds must conduct what is known as a Tax Equity and Fiscal Responsibility Act hearing. This is a public hearing in which the financing is discussed and pursuant to which the public has an opportunity to comment. This hearing, held before the authority officers, must be held at least 14 days after notice is given in a newspaper of general publication for the jurisdiction in which the project is located, and in which the issuing authority is located.

Use Of Proceeds

The Code requires that all property to be financed by tax-exempt debt must be owned and used by a Section 501(c)(3) organization. Additionally, the Code requires that at least 95% of the net proceeds must be used only by a 501(c)(3) organization engaged in exempt activities, leaving up to 5% use for "bad money" purposes, including costs of issuance. Closing costs, such as authority fees and bank and bond counsel fees, may be paid from the proceeds so long as such costs do not exceed 2% of the total amount of the bonds.

Unrelated Trade Or Business

Since an unrelated trade or business is not a "good use" and, therefore, counts toward the 5% "bad money" limitation, together with other private use and costs of issuance, it is important to understand what types of activities will constitute an unrelated trade or business. Qualified bond counsel should be consulted by a 501(c)(3) entity prior to entering into contracts and leases relating to the management and rental of the real property to ensure not only that future financings will not be jeopardized, but also that the 501(c)(3) entity's tax-exempt status will not be undermined.

Economic Useful Life v. Weighted Average Maturity

Lenders and borrowers should also be aware that under the Code, the note or bond will not qualify for tax exemption if the average maturity of the obligation exceeds 120% of the average reasonably expected economic useful life of the facilities financed with bond proceeds. Economic useful lives of the structures and equipment being purchased and financed are based upon IRS depreciation schedules.

Arbitrage Concerns. Basically, arbitrage occurs when the yield earned by the borrower on the bond "proceeds" exceeds the yield paid by the borrower upon such debt. Unless an exception applies, proceeds that are invested must either be yield-restricted, or excess earning must be rebated to the IRS.

It is important to note that bond "proceeds" include not only the actual funds financed from the tax-exempt obligation, but any "replacement proceeds," which may include:


Funds that would have otherwise been used for the project being financed, such as capital campaign proceeds. In order to avoid having capital campaign proceeds treated as bond proceeds (and therefore subject to yield restrictions), bond counsel often recommends that solicitations be kept as general as possible and that the borrower avoid "earmarking" contributions solely for the capital project that is intended to be financed with the proceeds of the tax-exempt obligation;


Funds that are used or expected to be used to pay or secure debt service on bonds; and


Funds that are pledged as security of the bonds.

The Code provides that proceeds of the bonds spent within three years of the date of issue may earn arbitrage, but any excess earnings must be paid to the Internal Revenue Service unless a safe harbor exists. There are, however, three rebate exceptions set forth in the Code, a six-month exception, an 18-month exception and a two-year exception.

1. Six-Month Rebate Exception. Under the six-month rebate exception, if all of the gross proceeds of the issue have been properly expended within six months of the issue date, the rebate rules are inapplicable.

2. 18-Month Rebate Exception. Under the 18-month rebate exception, at least:


15% of the gross proceeds must be spent within six months of the date of issuance;


60% within 12 months; and


100% within 18 months.

3. Two-Year Rebate Exception. If a borrower anticipates using a majority of the bond proceeds for construction projects, it may also elect to apply the Code's two-year rebate exception. This exception is only available to bond issuances in which at least 75% of the available construction proceeds will be used for construction expenditures. Construction expenditures are those expenditures that may be capitalized as part of the basis of real property and can include items such as rehabilitation costs, wiring, parking areas, plumbing and HVAC systems.

Under the two-year rule:


10% of the bond proceeds must be spent within the first six months;


45% within one year;


75% within 18 months; and


100% within two years.

There are also exceptions for bona fide debt service reserve funds created pursuant to the indenture or other loan document.

Failure to comply with one of the rebate limitations above will result in the borrower having to rebate to the IRS any "excess earnings" earned on the proceeds of the bonds. If the borrower fails to do so at the times set forth in the Code, the bonds could be declared taxable.

A lender or financial institution holding proceeds of the bonds should be aware of the arbitrage requirements and the need to cooperate with the borrower and its rebate analyst in keeping track of yields on such funds and other post-closing reporting requirements. Additionally, before investing the proceeds of the bonds, such a financial institution should consult with bond counsel.

Costs, Interest Rates and Flow of Funds. Fees and expenses are greater than those customarily associated with a typical two-party loan transaction; however, depending on the size of the loan, the borrower can often recoup these excess fees in interest savings over the first few years of the loan. Costs will vary based on the complexity and size of the transactions and will be greater for public bond issues than for private placements.

As with any borrowing, the interest rate available to a borrower is largely dependent upon its creditworthiness. In privately placed transactions, the borrower's creditworthiness is underwritten directly by a bank. In publicly offered bond transactions, in order to achieve a sale of the bonds, a borrower must obtain a credit rating from either Standard & Poors, Fitch or Moody's. Typically, this credit analysis must yield an investment grade rating in order to achieve a successful sale of the bonds. This credit rating will also have a direct correlation to the interest rate that investors will be willing to accept for the corresponding credit risk.

Many borrowers find it advantageous in publicly offered bond transactions to obtain credit enhancement in the form of bond insurance or an irrevocable standby letter of credit issued by a banking institution. Each of these financial products allows the ultimate investors to look beyond the creditworthiness of the actual borrower (a credit rating of the borrower is often not even obtained), and base its investing decision upon the credit rating of the credit-enhancement provider. Most borrowers find that the reduction in interest rates achieved through the purchase of credit-enhancement financial products justifies the related cost.

Valentino F. DiGiorgio III is a Partner at Stradley Ronon Stevens & Young, LLP. He is co-chair of the firm's Public Finance Group, concentrating his practice on commercial lending, tax-exempt financing, banking, compliance law, and federal and state lending law.

Please email the author at vdigiorgio@stradley.com with questions about this article.