Tax Enforcement: IRS Focus on Tax-Exempt Bonds (article)
IRS audits of tax-exempt bonds are on the rise. In recent years, the IRS has sharpened its focus to address many aspects of post-issuance tax compliance of tax-exempt bonds through compliance check questionnaires, IRS Form 990 Schedule K reporting, and the new IRS Form 8038 (an information return filed in connection with a tax-exempt bond issue). Given the IRS’ growing scrutiny of post-issuance bond compliance, 501(c)(3) organizations need to adopt written post-issuance tax compliance policies and implement procedures to assure accurate and complete private use calculations to support their Schedule K bond information reporting filed annually with their IRS Form 990.
What Is Post-issuance Tax Compliance?
Generally, post-issuance tax compliance refers to compliance with the applicable federal tax law requirements over the life of a tax-exempt bond issue. Such requirements include arbitrage rebate, limits on private use, outside management contracts and sponsored research within bond financed facilities (among other matters). Under the federal tax law, at least 95% of the net proceeds of a tax-exempt bond issue must be used in a matter related to the exempt purposes of the 501(c)(3) borrower. Accordingly, the use of bond financed property by for-profit entities, as well as certain management contracts and sponsored research contracts with outside parties (which do not meet specific IRS "safe harbor" contract rules), generally give rise to private use and must be managed to fit within the 5 percent so-called "bad money" portion of the bond issue.
The focus on post-issuance tax compliance by the IRS is multifaceted. Such efforts include (i) the distribution of several hundred questionnaires to 501(c)(3) borrowers of tax-exempt bonds inquiring as to the scope and extent of post-issuance compliance practices and the date of adoption of written post-issuance tax policies, (ii) audits of tax-exempt bonds (including physical examination of the bond financed facilities), and (iii) enhanced information gathering through the IRS Form 8038. Recently, representatives of the IRS indicated that audits of Schedule K returns will commence in the near future.
IRS Schedule K, which needs to be completed annually by 501(c)(3) borrowers of tax-exempt bonds, is the most significant step by the IRS in post-issuance reporting. Schedule K is broken into four main parts and requires responses regarding the following areas: (i) purpose and description of bond issues, (ii) use of bond proceeds, (iii) private business use and unrelated trade or business use, and (iv) arbitrage rebate.
In addition to the above, Schedule K asks the following questions in a yes/no format:
- Does the organization maintain adequate books and records to support the final allocation of bond proceeds?
- Are there any management or research arrangements that may result in private business use?
- Has the organization adopted management practices and procedures to ensure the post-issuance compliance of its tax-exempt bonds?
- Does the organization routinely engage bond counsel or other outside counsel to review any management, service or research contracts relating to bond financed property?
For 2011 reporting, revised Schedule K requires the filer to identify whether the organization adopted written procedures to ensure that violations of federal tax requirements are timely identified.
Checking "no" to any of the above questions could increase the likelihood of an IRS audit of the listed bond issues or Schedule K itself.
Importantly, Schedule K requires a conduit borrower to provide an annual measurement of private business use and unrelated trade or business use of its bond financed facilities. These calculations are not cumulative and instead represent a snapshot of the use of bond financed facilities over the last 12 month reporting period. Many 501(c)(3) organizations struggle with these calculations given their inherent complexity, the need for comprehensive information and the legal determinations often required. For example, to accurately determine the level of private use for Schedule K reporting, a 501(c)(3) organization needs to be able to determine which facilities are bond financed, the amount of bond proceed used for such facilities, how those facilities are currently being used, whether any use is private use and, if so, what methodology should be used to measure any private use.
The IRS has included 501(c)(3) Bonds in a list of "Examination Categories" in its fiscal year 2012 Tax Exempt Bonds Work Plan. As part of its tax-exempt bond examination procedures, it is expected that the IRS will comb over Schedule K returns and inquire as to its construction and details. In short, Section 501(c)(3) borrowers of tax-exempt bonds will be held accountable by the IRS and will need to defend and support what they report on their Schedule K.
In order to properly address an IRS inquiry, it is essential that non-profit organizations maintain accurate records regarding private use of tax-exempt bond financed facilities and an accurate inventory of the bond financed improvements. Facts and circumstances regarding the use and operation of the bond financed facilities will likely change from year to year. For example, outside managers, contractors and sponsored research will change over time as well as the range and scope of unrelated trade or business activity. These activities will need to be properly accounted for, analyzed and measured in accordance with Treasury Regulations and incorporated into Schedule K returns annually. Accordingly, reliance on the original private activity analysis of bond counsel from the time of the original issuance of the bonds will not suffice. We recommend that borrowers of tax-exempt bonds consult regularly with their accountants and bond advisors to ensure that they have adequate post-issuance tax compliance safeguards and appropriate procedures to prepare Schedule K in an accurate and complete manner.
For more information regarding tax-exempt bonds, you may contact Ed Oswald at email@example.com. In addition, feel free to contact your local CBIZ advisor with any questions.
By Ed Oswald, Partner - Orrick, Herrington & Sutcliffe LLP
Copyright © 2012 Orrick, Herrington & Sutcliffe LLP. All rights reserved. Reprinted with permission.