A Tax-exempt Bond Primer for 501(c)(3) Organizations
| Publication year | 2019 |
| Author | Johnny Hutchinson |
Johnny Hutchinson
Johnny devotes his practice to tax-exempt bonds, including 501(c)(3) bond financings. He handles tax issues arising before and after a tax-exempt bond deal closes. Johnny writes for Squire Patton Boggs's Public Finance Tax blog and is the chairman of the Tax Law Committee of the National Association of Bond Lawyers.
Any maturing 501(c)(3) organization will at some point have to decide whether to borrow in the tax-exempt market to finance the capital projects that will promote its mission. Although tax-exempt debt usually carries a lower interest rate than taxable debt, it also brings with it additional costs, in the form of various legal restrictions on how you can use the project and the rather unpleasant experience of having to deal with tax lawyers.
This article is aimed at 501(c)(3) organizations that have not borrowed in the tax-exempt debt market before, to prepare you for the federal tax aspects of your first deal. However, for our readers who are seasoned veterans of the tax-exempt borrowing process, before you close the browser window or turn the page, remember the admonition of the great muni bond tax lawyer Vince Lombardi— "Excellence is achieved by mastery of the fundamentals." Stick around—you, too, might find something useful here.
As always, a little planning goes a long way. Your first (or your fiftieth) tax-exempt debt deal can bewilder you, but there are some simple things to do before you begin that will smooth the path. We will begin there—first, what are the pre-transaction steps on the tax side? Next, we will talk about some of the tax papers you will be looking at in the transaction and discuss how to work effectively with your lawyer and the tax lawyer for the state or local issuer of the debt. We will end the article by talking about the unique post-closing responsibilities for the money that you borrow and the project that you build with the tax-exempt debt.
The first step is to make sure you have retained counsel that has experience in representing 501(c)(3) organizations in qualified 501(c)(3) bond issues. One good indication will be whether the firm has one or more members on the National Association of Bond Lawyers ("NABL"). The tax-exempt debt market standard is that investors will insist on an opinion that interest on the bonds is tax-exempt (not "more likely than not is," not "should be," not "you know, just, like, might be"—is). This opinion is typically given by counsel for the issuer, often referred to as "bond counsel."1 To support the unqualified bond counsel's opinion, the market standard likewise is for counsel to the 501(c)(3) organization to provide an opinion that the 501(c)(3) organization is a 501(c)(3) organization. Counsel for the 501(c)(3) organization will also render various other opinions. In some jurisdictions, one of these additional opinions will be that the use of the project by the borrower will be "related" to the organization's exempt purpose. Bond counsel relies on this opinion. NABL prepared a very good report in 2014 on some of the issues relating to this opinion, which would be worth your time (or at least your counsel's time) to read. NABL members can find it on NABL's website (nabl.org) under the "Research" tab and the "Formal Reports & Model Documents" heading.
Your counsel will need to understand how your organization was created, the contours of its exempt purposes, and how it operates to pursue those exempt purposes. These facts will form the basis of the 501(c)(3) opinion. In addition to these tax matters, you will want to make sure that your counsel has experience working with bond counsel in a tax-exempt debt transaction, so that they can adequately explain to you the representations and covenants you will need to provide to bond counsel in connection with the transaction. But more on that later. If your first tax-exempt debt issuance will be your first major borrowing of any kind (tax-exempt or taxable), you will of course want to make sure that your counsel also has experience in a debt transaction.
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Most 501(c)(3) organizations don't have enough cash on hand to pay for a capital project of any substantial size. You will have to borrow to pay for most of it. However, as you begin to talk to bankers and advisors and to investigate how you are going to pay for the project, you might want to use some existing cash to pay initial project costs, with the intent of using the proceeds of a borrowing later to "reimburse" yourself. Once you're at this point, if there is...
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