Chapter 22 - § 22.3 • ELEMENTS OF A QUALIFIED § 501(C)(3) BOND

• Jurisdiction: Colorado

§ 22.3 • ELEMENTS OF A QUALIFIED § 501(c)(3) BOND

§ 22.3.1—State or Local Government Issuer

Interest that is excluded from gross income under I.R.C. § 103 for federal income tax purposes must be interest accruing on "an obligation of a state or political subdivision thereof," I.R.C. § 103(c)(1), including obligations issued on behalf of such entities. Treas. Reg. § 1.103-1(b).

"Interest" for federal income tax purposes is generally "compensation for the use or forbearance of money." Deputy v. Du Pont, 308 U.S. 488, 498 (1940). As a general matter, "interest" accrues only on instruments that constitute debt for purposes of federal income taxation; therefore, the bond being sold must be (1) a debt obligation, (2) of the state or local governmental issuer for federal tax purposes. See also the discussion of I.R.C. § 103 in § 22.1.

In the context of an issue of qualified § 501(c)(3) bonds, the determination of whether an obligation constitutes indebtedness that bears "interest" for federal tax purposes is a determination to be made by bond counsel. For a discussion regarding the distinction between the terms "indebtedness," "liability," and "obligation," see David C. Garlock et al., Federal Income Taxation of Debt Instruments 1005 (6th ed. 2010). The determination is made based on an analysis of all the facts and circumstances surrounding the issuance of the obligation, and no single factor or criterion is dispositive of the issue. See John Kelley Co. v. Comm'r, 326 U.S. 521, 530 (1946) ("There is no one characteristic, not even exclusion from management, which can be said to be decisive in the determination of whether the obligations are risk investments in the corporations or debts"). Factors the courts have considered in determining whether an instrument constitutes debt (primarily in the context of instruments issued by corporate taxpayers) include:

(1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the [issuer] to obtain funds from outside sources; (5) the "thinness" of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the [issuer]; (15) a provision for redemption at the option of the holder.

Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968) (citing J.S. Biritz Construction Co. v. Comm'r of Internal Revenue, 387 F.2d 451 (8th Cir. 1967); Tomlinson v. 1661 Corp., 377 F.2d 291 (5th Cir. 1967); Smith v. Comm'r of Internal Revenue, 370 F.2d 178 (6th Cir. 1966); Gilbert v. Comm'r of Internal Revenue, 262 F.2d 512 (2d Cir. 1959); 4A Mertens, Law of Federal Income Taxation §§ 26.10a, 26.10c (1966)).

In a tax-exempt qualified § 501(c)(3) bond financing, the bonds are typically limited obligations of the issuer, secured by and payable only from amounts received under the loan agreement (i.e., in the event that the § 501(c)(3) organization borrower does not pay amounts owed under the loan agreement, the issuer will typically have no obligation to make a payment to bondholders from any other funds of the issuer). Notwithstanding the pass-through reality of the conduit structure, and the reality that the state or local governmental issuer typically does not have money or collateral at risk in connection with the bond issuance (other than payments or other amounts to be received under the arrangement with the § 501(c)(3) organization borrower), the Code clearly contemplates, as supported by case law, that such arrangements should be treated as obligations of states or political subdivisions for purposes of I.R.C. § 103. See Fairfax County Economic Development Auth. v. Comm'r, 77 T.C. 546 (1981); cf. Treas. Reg. § 1.148-1(b) (defining the term "program investment" to mean, inter alia, "a purpose investment that is part of a governmental program in which . . . [a]t least 95 percent . . . of the cost of the purpose investments acquired under the program represents one or more loans to . . . [among other types of entities] . . . 501(c)(3) organizations.").

§ 22.3.2—Ownership of Financed Property by a § 501(c)(3) Organization or a State or Local Governmental Unit

All property to be financed by the proceeds of an issue of qualified § 501(c)(3) bonds must be owned for federal income tax purposes by a § 501(c)(3) organization or a state or local government throughout the term of the bonds. I.R.C. § 145(a)(1). There are no de minimis exceptions to the ownership requirement, including for entities such as the federal government or a non-§ 501(c)(3) tax-exempt organization. Id. (providing that, in order for an issue of obligations to qualify as an issue of qualified § 501(c)(3) bonds, "all property which is to be provided by the net proceeds of the issue" must be owned by a § 501(c)(3) organization or a governmental unit) (emphasis added). The ownership requirement applies throughout the life of an issue of qualified § 501(c)(3) bonds. I.R.C. § 145(a)(1); see also Treas. Reg. § 1.145-2(a).

Ownership of property financed with proceeds of an issue of qualified § 501(c)(3) bonds is determined by reference to general federal income tax principles. Joint Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986, H.R. 3838 at 1184 (May 4, 1987). Therefore, holding of title is not dispositive of whether the bond-financed property is "owned" by the § 501(c)(3) organization borrower or a state or local governmental unit; rather, the determination is based on all of the facts and circumstances involving the financed property and the arrangement between the parties involved. Cf. Rev. Rul. 55-540, 1955-2 C.B. 39, 41 (Jan. 1, 1955) ("Whether an agreement, which in form is a lease, is in substance a conditional sales contract depends upon the intent of the parties as evidenced by the provisions of the agreement, read in light of the facts and circumstances existing at the time the agreement was executed"); Corliss v. Bowers, 281 U.S. 376, 378 (1930) (". . . taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed — the actual benefit for which the tax is paid"); Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 255 (1939) ("In the field of taxation, administrators of the laws and the courts are concerned with substance and realities, and formal written documents are not rigidly binding"); Frank Lyon Co. v. United States, 435 U.S. 561, 572-73 (1978) ("In a number of cases, the Court has refused to permit the transfer of formal legal title to shift the incidence of taxation attributable to ownership of property where the transferor continues to retain significant control over the property transferred") (citing Comm'r v. Sunnen, 333 U.S. 591 (1948); Helvering v. Clifford, 30 U.S. 331 (1940)).

As a general matter, the inquiry into whether the § 501(c)(3) organization borrower is treated as the owner of financed property should rely on whether the § 501(c)(3) organization borrower has retained the preponderance of the benefits and burdens associated with the ownership of the financed property. Jasper L. Cummings, Jr., The Supreme Court's Federal Tax Jurisprudence 405-09 (American Bar Association, 2010); Michael H. Simonson, "Determining Tax Ownership of Leased Property," 38 Tax. Law. 1, 3 ("The ultimate inquiry into the tax ownership question involves an assessment of whether a lessor stands to realize a significant economic gain or to incur a meaningful economic loss with respect to the leased property").

If a limited liability company will own property financed with proceeds of an issue of qualified § 501(c)(3) bonds, the ownership test of I.R.C. § 145(a)(1) will generally be satisfied if (1) the sole member of the limited liability company is a single § 501(c)(3) organization, IRS Priv. Ltr. Rul. 200124022 (March 13, 2001), and (2) the limited liability company does not elect to be treated as a corporation under the "check-the-box" regulations, Id.; Treas. Reg. § 301.7701-3. Notwithstanding that the limited liability company, and not the § 501(c)(3) organization borrower, would own the financed property, a single-member limited liability company that does not elect to be treated as a corporation under the check-the-box regulations is a disregarded entity for federal tax purposes, Treas. Reg. § 301.7701-3(a) ("an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner"); see also Treas. Reg. § 301.7701-3(b) ("unless the entity elects otherwise, a domestic eligible entity is . . . [d]isregarded as an entity separate from its owner if it has a single owner"), with the result being that any property owned by the limited liability company is treated as being owned by the § 501(c)(3) organization that is the sole member of the limited liability company. See Treas. Reg. § 301.7701-3(a).

Arrangements whereby one or multiple § 501(c)(3) organizations seek to own property financed with proceeds of an issue of qualified § 501(c)(3) bonds through co-ownership arrangements raise issues. Fact patterns whereby two or more § 501(c)(3) organizations propose to own property jointly create the possibility that the § 501(c)(3) organizations have created a partnership that cannot be a § 501(c)(3) organization for federal tax purposes, or whereby multiple § 501(c)(3) organizations are members of a single LLC, require additional analysis by bond counsel to confirm that the ownership requirement of I.R.C. § 145(a)...