WASHINGTON — The Internal Revenue Service’s tax-exempt bond office released information on Friday about how financial restructurings of facilities or other property by states, localities or nonprofit organizations can cause tax-law problems and what remedies can be taken to avoid sanctions.
The information included a paper called, “Sale of Assets Financed with Tax-Exempt Bonds by State and Local Governments and 501(c)(3) Organizations,” as well as links to other resources on the IRS website.
The IRS posted the guidance because, with the slow pace of the economic recovery, some state and local governments or nonprofits are trying to raise funds by selling facilities or property financed with tax-exempt bonds and do not realize that these sales may result in violations of the tax requirements for the bonds.
If, for example, a state has financed the construction of a government building with general obligation bonds and then sells that building to a private company, the bonds could become taxable private-activity bonds.
Bonds are PABs if more than 10% of the proceeds are used by a private party and more than 10% of the debt service is directly or indirectly secured by, or derived from, payments by a private entity. PABs are taxable if the projects they finance do not fall within certain categories, such as airport or sewer and water facilities.
For facilities financed with 501(c)(3) bonds, which are tax-exempt PABs, no more than 5% of the proceeds can be used by private parties.
The tax-exempt bond office said that, in order for governmental or 501(c)(3) bond issuers to take remedial action to avoid having their bonds become taxable as a result of a sale of property, they must first have met five basic conditions.
First, at the time of issuance they must have reasonably expected that the bonds would not meet the private use, business, or other tests that would have made them taxable PABs.
Second, the term of the bonds must not be outstanding longer than is reasonably necessary for the qualified purpose of the issue, meaning generally they must not be outstanding for more than 120% of the average, reasonably expected economic life of the financed property.
Third, the property must be sold for fair-market value through a bona fide and arm’s length transaction.
Fourth, proceeds from the sale must be treated as “gross proceeds,” which are subject to yield restriction and arbitrage rebate requirements.
Fith, except for a remedial action involving the redemption or defeasance of the bonds, the proceeds must have been spent on a qualified purpose before the bond-financed assets were sold.
The paper also describes three remedial actions that can be taken to avoid sanctions if the sale of bond-financed property results in potential tax-law problems.
First, the issuer can redeem or defease the amount of bonds that financed the facility that was sold.
Second, the proceeds from the sale can be used for some other governmental or 501(c)(3) purpose.
Finally, the bonds can be reissued as other bonds that meet tax requirements. For example, if a city builds a hospital and later sells the hospital to a nonprofit organization, while the bonds no longer qualify as governmental bonds, the city could take steps to ensure they meet the requirements for 501(c)(3) bonds.