Frequently Asked Questions / Nonprofit/501(c)(3) Tax-Exempt Bonds
What are they?
- bonds, notes, loans, leases or other debt obligations, the interest on which is excluded from gross income for purposes of the owner’s/lender’s federal income tax
Why use them, what are the benefits?
- no or lower tax costs to the bondowners/lenders resulting from federal and state income tax exemptions of interest on bonds commonly results in lower interest rates payable by the nonprofit/501(c)(3) borrowers
- an individual in a 32% federal tax bracket could be willing to purchase a 3.40% interest rate tax-exempt bond with the same after-tax return as a 5.00% taxable bond
- a corporation in a 21% federal tax bracket could be willing to purchase a 3.95% interest rate tax-exempt bond with the same after-tax return as a 5.00% taxable bond
- tax-exempt rates may be further reduced in States that also exempt interest on bonds from State income taxation
- value of tax-exemption is lender/bondowner specific
Where are current tax-exempt interest rates posted?
What types of nonprofits, 501(c)(3)s, and other borrowers can use tax-exempt finance?
- health systems, hospitals and clinics
- colleges/universities and other higher education institutions
- private schools and charter schools
- senior living communities and care providers
- YMCAs and other national and community nonprofits and charities
- museums, zoos, performing arts centers, community centers and other nonprofit cultural facilities
- sports and recreation facilities
- childcare/daycare organizations
What types of projects/expenditures can be financed?
- generally, any capitalizable project/asset/expenditure (except gambling facilities and a few others)
- certain working capital / operating expenses – consult bond counsel
Can previous expenditures be reimbursed / refinanced?
- yes, with certain tax limits – consult bond counsel regarding reimbursement resolutions and timing
Can taxable loans be refinanced on a tax-exempt basis?
- yes, with certain tax limits – consult bond counsel
Can a taxable loan be documented to retain the option to convert to a tax-exempt obligation?
- yes, with certain tax limits – consult bond counsel to draft and convert
When might tax-exempt financing be considered?
- during the project budgeting process or after initial construction/purchase money financing
What are the special post-issuance compliance considerations for tax-exempt bonds?
- compliance with tax safe-harbors for use by for-profit operators, managers or lessees
- investment monitoring for temporary investments of tax-exempt bond proceeds
- financial reporting and continuing disclosure
What working group members are involved in tax-exempt bond issuance?
- nonprofit/501(c)(3) borrower (and borrower’s counsel)
- governmental conduit issuer/authority (and issuer’s counsel)
- under federal tax law, tax-exempt financings for nonprofit/501(c)(3) borrowers require a state or political subdivision to issue the bonds
- statewide issuers
- local issuers – industrial development authorities, interlocal/joint power authorities
- cities, counties
- under federal tax law, tax-exempt financings for nonprofit/501(c)(3) borrowers require a state or political subdivision to issue the bonds
- underwriter/purchaser (and underwriter’s/purchaser’s counsel) – underwrites or directly purchases
- bond trustee – serves as trustee and paying agent
- bond counsel
- prepares bond transaction documents, coordinates transaction, issues opinions regarding validity and tax-exempt status of bonds
- financial/municipal advisor
- assists issuer or borrower in analyzing financial/monetary benefits of transaction structures
- rating agency
- for certain publicly offered transactions, provides credit rating for securities
Can a nonprofit or governmental entity finance, on a tax-exempt basis, a project undertaken in collaboration with a for-profit entity or a different nonprofit or governmental entity?
- generally, yes, multiple nonprofits and governmental entities can collaborate on projects that are financed on a tax-exempt basis – consult bond counsel
- special tax safe-harbors and tax allocation rules allow certain project collaborations between nonprofits and for-profit entities to be financed in whole or in part with tax-exempt bond proceeds – consult bond counsel
- P3 (public-private-partnership) is current industry term for these collaborations
What is a public offering of bonds?
- underwriting firm assists in offering the bonds for sale to the public
What is a private placement or direct purchase of bonds?
- bonds are directly purchased by a lender or a placement agent helps find a specific purchaser
Can tax-exempt financing be in the form of a loan, lease, notes or other obligations beyond bonds?
What types of interest rates may tax-exempt bonds bear?
- fixed to maturity – single interest rate through maturity
- fixed for term – fixed for term before maturity – e.g., 5/7/10 years
- indexed – reset monthly based on index (e.g., SIFMA, LIBOR) plus margin
- floating /variable – reset daily, weekly, monthly, short-term/commercial paper term (up to 270 days), long-term (period of years) – possibly subject to remarketing arrangements
What types of security and collateral are common for tax-exempt bonds?
- gross/unrestricted revenues/receivables pledges
- mortgages/deeds of trust
- reserve funds
- securities/deposit account control agreements
Can tax-exempt bonds be guaranteed or supported by other liquidity or credit facilities?
- yes, letters of credit, standby bond purchase agreements, bond insurance, guarantees, etc.
Can tax-exempt bonds be paired with other financing strategies like other loans, grants, equity, government programs?
What is the public approval “TEFRA” process?
- federal tax law required public notice and hearing and governmental approval process – consult bond counsel
What is nonqualified use for purposes of federal tax law?
- certain use of tax-exempt bond financed facilities, such as (a) unrelated trade or business use or (b) certain use by for-profit entities (e.g., pursuant to management agreements and leases), can result in nonqualified use that could adversely affect the tax-exempt status of bonds – consult bond counsel for analysis as well as information regarding federal tax code safe-harbors and structuring considerations
Can research be conducted on bond financed property?
- yes, subject to federal tax law limits – consult bond counsel
What are ‘bank-qualified’ bonds?
- ‘bank qualified’ bonds, also known as ‘qualified tax-exempt obligations’, are bonds with a special status that enables banks to deduct 80% of the bank’s carrying cost of the tax-exempt bond – BQ status is only available in limited circumstances for financings of $10,000,000 or less under current federal tax law – consult bond counsel
What are the differences in common redemption features for tax-exempt bonds compared to taxable debt?
- publicly offered tax-exempt bonds traditionally include optional redemption provisions permitting a borrower to redeem/refund bonds at par without premium on and after a specified future date – e.g., 5, 7 or 10 years after the issue date of the bonds and/or tiered redemption premium schedules for redemptions in earlier years
- also, commonly include extraordinary optional redemption provisions permitting early par redemptions upon the occurrence of certain specified extraordinary events
- taxable debt commonly carries a ‘make-whole premium’ concept which requires that the borrower make the lender whole for lost future returns to the lender resulting from the borrower’s early redemption of the debt – this effectively eliminates the ability to refinance taxable debt for a borrower’s economic benefit – and may have the effect of narrowing the reported spread between interest rates for tax-exempt bonds and taxable debt because the taxable debt’s make-whole premium shifts more economic risk to the borrower
What are the typical terms, tenors or maturities of tax-exempt bonds?
- generally, direct purchase/private placement bonds have lender hold periods of 5/7/10 years
- generally, publicly offered bonds have amortizations extending up to 30+ years
What direct purchaser banks and public offering underwriters are active in the tax-exempt bond market?
- large national and international financial institutions and funds
- regional banks and other financial institutions
- specialized underwriting firms
Can tax-exempt bonds be sold directly to individual investors?
How long does a tax-exempt financing transaction take from start to finish?
- commonly 60-90 days – some transactions may be completed more quickly
If an organization or financial officer doesn’t have tax-exempt finance experience, will they be able to handle the issuance process and post-issuance responsibilities?
- yes, bond counsel and the rest of the working group for the bond issuance will guide the borrower through the issuance process and assist in establishing procedures for post-issuance responsibilities
Do all tax-exempt financings require an offering document?
- no, many direct purchase/private placement transactions are completed without offering documents
What is continuing disclosure for publicly offered bonds?
- SEC’s Rule 15c2-12 requires, for certain types of bond offerings, public disclosure on an annual basis of certain financial information and operating data, and disclosure of the occurrence of certain events
What is the MSRB’s EMMA system?
- EMMA is the current website/system for continuing disclosure filings https://emma.msrb.org/
What are continuing disclosure material events?
- 16 events under Rule 15c2-12 that must be reported within 10 business days after their occurrence:
- Principal and interest payment delinquencies
- Non-payment related defaults, if material
- Unscheduled draws on debt service reserves reflecting financial difficulties
- Unscheduled draws on credit enhancements reflecting financial difficulties
- Substitution of credit or liquidity providers, or their failure to perform
- Adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability, Notices of Proposed Issue (IRS Form 5701-TEB) or other material notices or determinations with respect to the tax status of the security, or other material events affecting the tax status of the security
- Modifications to rights of security holders, if material
- Bond calls, if material, and tender offers
- Release, substitution, or sale of property securing repayment of the securities, if material
- Rating changes
- Bankruptcy, insolvency, receivership or similar event of the obligated person
- The consummation of a merger, consolidation, or acquisition involving an obligated person or the sale of all or substantially all of the assets of the obligated person, other than in the ordinary course of business, the entry into a definitive agreement to undertake such an action or the termination of a definitive agreement relating to any such actions, other than pursuant to its terms, if material
- Appointment of a successor or additional trustee or the change of name of a trustee, if material
- (new in 2019) Incurrence of a financial obligation of the obligated person, if material, or agreement to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the obligated person, any of which affect security holders, if material
- (new in 2019) Default, event of acceleration, termination event, modification of terms, or other similar events under the terms of a financial obligation of the obligated person, any of which reflect financial difficulties
What impact did the 2017 federal tax reform have on tax-exempt bonds?
- maximum federal corporate tax rate decrease from 35% to 21% reduced tax advantage to certain corporations (but not individuals) of buying tax-exempt bonds
- eliminated tax-exempt advance refundings – i.e., issuing tax-exempt bonds to refund other outstanding tax-exempt bonds more than 90 days prior to redemption of the outstanding refunded bonds
What are some alternatives to tax-exempt advance refundings?
- ‘cinderella’ bonds – convert from taxable to tax-exempt on a future date
- taxable refunding bonds
- forward purchase transactions – purchaser(s) currently agree to purchase bonds in the future
Can a project for which pledged donations are anticipated to be received in the future be tax-exempt financed?
- yes, transactions can be structured to accommodate projects where pledged donations are expected – consult bond counsel for considerations to have in mind when fundraising campaign is expected
Can a tax-exempt obligation be modified in the future if the owner/lender consents?
- yes, prior to modifying the parties should consult bond counsel regarding tax considerations
What impacts do the changes to lease accounting rules have on tax-exempt obligations?
- some entities with significant operating leases may see accounting increases in debt for purposes of certain financial covenant calculations
What financial covenants are common for tax-exempt obligations?
- Debt Service Coverage Ratio (DSCR) – 1.0:1.0, 1.1:1.0, or 1.2:1.0 tested annually or quarterly
- Days Cash on Hand (DCOH) – specified number of DCOH, tested annually or semi-annually
Who does an organization contact if preliminarily considering tax-exempt financing?
- bond counsel – firstname.lastname@example.org
- governmental issuer
- underwriter/financial advisor
What are common transaction costs of tax-exempt finance?
- issuer fees
- working group professional fees
- rating agency fees (for certain public offerings)
- generally total under 2% of proceeds amount
What happens if an organization decides to sell, lease or otherwise dispose of a bond financed asset?
- consult bond counsel prior to entering into the contemplated transaction to discuss possible remedial actions (e.g., bond redemption or defeasance, asset substitution)
How long can the average maturity of the tax-exempt bonds be compared to the average economic life of the bond financed assets?
- generally, 120% on an aggregate basis
Can tax-exempt bonds be used to pre-finance future project costs?
- yes, generally tax-exempt bond proceeds are to be spent on project costs within 3 years of issuance and can be invested in the interim
What do these frequently used acronyms mean?
- Bond Purchase Agreement – the purchase contract for bonds among the conduit issuer, the nonprofit borrower and the underwriter/purchaser of the bonds
- Bond Trust Indenture – instrument between issuer and trustee setting forth key terms and trust estate for bonds
- Continuing Disclosure Agreement/Undertaking – the borrower’s/obligated person’s agreement to provide certain financial information and operating data to the public (by filing on the EMMA system)
- Debt Service Coverage Ratio – a common financial covenant ratio based on the quotient of net revenue/income available for debt service divided by a certain period’s debt service requirement
- The Depository Trust Company – an entity providing clearing, settlement and book-entry services for certain securities
- Electronic Municipal Market Access website – MSRB’s website for disclosure of municipal securities data and documents https://emma.msrb.org/
- International Swaps and Derivatives Association – a trade organization of swap derivatives market participants
- Maximum Annual Debt Service – a common DSCR denominator based on the maximum debt service requirement in any future year
- Municipal Securities Rulemaking Board – a regulatory organization for municipal securities dealers and municipal advisors
- Master Trust Indenture – instrument between borrower and trustee setting forth key covenants of borrower and trust estate security interests in property of borrower as collateral for borrower’s MTI secured debt on parity basis – MTI obligations are evidenced by issuance of MTI notes
- Official Statement – the offering document used for publicly offered bonds released after the sale date
- Preliminary Official Statement – the offering document used for publicly offered bonds released prior to the sale date
- U.S. Securities and Exchange Commission – a U.S. federal agency that regulates securities industries
- State and Local Government Series Securities – securities offered by the U.S. federal government as yield restricted escrow investments for defeasance of tax-exempt municipal securities
- Swap is not an acronym – swaps are interest rate exchange agreements used to hedge interest rate risks
- Tax Compliance Agreement – agreement among borrower, issuer and trustee for tax compliance
- Uniform Commercial Code – statutory code including provisions for security perfection
The MSRB compiles a more comprehensive glossary of terms relating to municipal securities available at the following webpage http://www.msrb.org/glossary