The Trump administration's proposal to link a private school's tax-exempt status to racial discrimination policies will increase compliance, disclosure, and review demands on attorneys, investors, underwriters and issuers in the municipal bond market.
It also creates uncertainty for existing tax-exempt bonds if schools risk losing their 501(c)(3) status.
That's according to bond and 501(c)(3) attorneys who are tracking the
Building on the administration's broader anti-DEI efforts, the IRS and Treasury Department last Thursday unveiled the
The rule "reaches every corner of school operations — admissions, scholarships and loans, athletics, and any school-administered program," said law firm Archer & Greiner, P.C. in a Sept. 4
The rule "also sweeps away older IRS guidance that tolerated certain racial preferences," the firm said.
It would affect more than 18,000 private universities, colleges, primary and secondary schools and trade schools, the IRS said.
In addition to affecting tax-exempt borrowing, the rule carries credit implications by restricting an affected school's ability to receive tax-deductible contributions and tax-free investment growth while driving up borrowing costs.
"Institutions should expect continued increased scrutiny not only of explicit racial classifications, but also of the objectives, implementation, and documentation underlying race-neutral policies and programs," said Nixon Peabody in a Sept. 4
With a proposed effective date of May 2027, some market participants suggested the rule may spur more near-term higher education tax-exempt paper.
But attorneys warned that the rule introduces significant uncertainty into the muni market and a fresh set of credit risks.
"The proposal could introduce a new category of diligence and credit risk into the higher education bond market," said Taylor Klavan, public finance and infrastructure shareholder at Greenberg Traurig's Houston office.
"Private schools perceived as presenting a greater compliance risk in this area could face more diligence, longer financing timelines, higher transaction and borrowing costs, or more limited market access," Klavan said.
The proposal creates concerns for bond counsel, investors, underwriters and ratings agencies, she said. "Even uncertainty about compliance could make it more challenging for bond counsel to give an unqualified tax opinion and could lead underwriters, issuers and investors to require additional diligence," Klavan said.
Issuing tax-exempt bonds requires a "clean opinion" from bond counsel about a school's 501(c)(3) status, and the proposed regulations "would make it considerably more difficult to issue such an opinion because any reference to race, color or national or ethnic origin in any educational policy or practice, regardless of the severity, intent, or impact of the discrimination, could potentially jeopardize the issuer's tax-exempt status," said Alexander Reid, national leader of BakerHostetler's Tax-Exempt Organizations and Charitable Giving team.
The rule could particularly affect schools that historically serve specific populations identified by race or ethnicity, Reid said.
"These schools would have to choose between tax-exempt status and abandoning their missions because the proposed regulations prohibit adopting, maintaining, or enforcing 'any policy or practice that discriminates on the basis of race, color, or national or ethnic origin' regardless of the purpose of the discrimination," he said.
The proposal also raises questions around outstanding tax-exempt paper, attorneys said.
"This could cause havoc with respect to future and outstanding tax-exempt bond deals if the regulation becomes effective and a school/its counsel is not comfortable that the school is in compliance with the new regulations," said Richard Moore, tax partner at Orrick, Herrington & Sutcliffe.
The rule "could present both opinion and disclosure issues," Moore said. "If this concern is widespread, it would impact the issuance level in the market," he said, adding that it's too early for definitive conclusions.
The proposal could lead to bonds with built-in extraordinary redemption provisions in case the debt becomes taxable, Klavan said.
"But those protections can create their own credit concerns: requiring a private school to redeem its bonds precisely when it is dealing with the financial consequences of losing its exemption could compound the problem," she said.
Once the IRS has zeroed in on a school, it could "move quickly" to revoke its status, according to Reid. Treasury regulations give the IRS "facially broad authority to revoke an exemption determination letter by notice, potentially before the ordinary audit procedures," he said. The regulation also contemplates revocation by notice to the taxpayer, he added.
"A revocation by notice could well impact the taxability of outstanding bonds, which would in turn implicate Rule 15c2-12 disclosure, even without a Form 5701-TEP or an IRS determination that interest on the bonds is taxable," he said.
The loss of exempt status for a school would jeopardize the tax-exempt treatment of its outstanding qualified 501(c)(3) bonds "unless appropriate remedial action is available," such as transfer ownership and use to another 501(c)(3) organization or state or local government, said Klavan.
"There could also be a cascading effect across the school's broader debt portfolio," she added. "Loss of 501(c)(3) status could trigger defaults under bond documents and potentially cross-defaults under other debt arrangements. Private schools may also need to consider continuing disclosure obligations if their exempt status is at risk," she said.
The rule is a long way from being finalized and is likely to face legal challenges along the way, Reid said.
There are "significant questions about the legal viability of the proposed regulations," Reid said. "In any event, there are likely to be numerous legal challenges to the proposed regulation that may well delay its implementation and affect its final wording."
The IRS is taking comments on the proposal until Nov. 3.
