A school district would not be able to issue tax-exempt notes to finance temporary cash-flow shortfalls because of an endowment-like fund it set up with money it received from the settlement of litigation against the state, the Internal Revenue Service concluded in a private-letter ruling.

The ruling, which was dated Aug. 6 but not published until Monday, did not identify the school district and did not surprise bond lawyers.

"I would have been surprised if the ruling had come out the other way," said Thomas Vander Molen, a lawyer at Dorsey & Whitney LLP in Minneapolis.

The ruling revolves around money the district obtained after it sued the state over its efforts to recover reimbursements it made to the district in connection with a voluntary desegregation program. The suit resulted in a settlement under which the state paid an unspecified amount of money to the school district. There were no restrictions on how the money could be used.

The school district decided to set up an endowment-like fund. It planned to invest the money and use most of the interest earnings for its programs, including visual and performing arts and an instructional technology plan. The board of education, which governs the school district, passed a resolution formalizing the creation of the fund, prohibiting any use of the principal for school district programs, and requiring that any principal withdrawn be paid back within a year.

The school district issued taxable tax and revenue anticipation notes for two years after the fund was created. But then it asked the IRS if it could issue tax-exempt Trans.

Under IRS rules, an issuer is not permitted to borrow on a tax-exempt basis to cover ordinary working capital expenses if it has funds available to pay those expenses. The issuer can borrow on a tax-exempt basis to finance temporary cash flow needs if no other money is available.

The rules permit the issuer to treat as unavailable a reasonable working capital reserve that is up to 5% of its actual working capital expenditures in the previous fiscal year. The rules also treat as unavailable certain funds that under legislation or judicial or contractual requirements would have to be reimbursed.

Qualified endowment funds of universities or hospitals are not treated as available if the funds are derived from gifts or bequests, a governing organization restricts the use of the funds, or there is independent verification that the funds are reasonably necessary as part of the organization's permanent working capital.

The school district argued that the principal of its fund should not be considered available because the board of education restricted its use. But the IRS said in the ruling: "We conclude that the self-imposed restrictions on the use of the fund is a transaction entered into for a principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates."

The district also argued that the amount of the fund plus 5% of its prior year working capital expenditures would constitute a reasonable working capital reserve. But the IRS said it was unable to determine if that amount would be a reasonable capital reserve.

Finally, the district claimed the fund was the equivalent of a qualified endowment fund. But the IRS disagreed, pointing out that the district's fund was created from the settlement of litigation, not from gifts or bequests.

"The principal purpose ... is to invest the fund for the production of income rather than to spend the fund for a governmental purpose," the IRS told the district in the ruling. "Instead of using the corpus of the fund to pay its working capital expenditures, the district proposes to issue the bonds to pay working capital expenditures, while the fund is invested in potentially materially higher yielding investments."

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