Non-profit organizations have the opportunity to finance the acquisition or renovation of property where they do their good works using qualified 501(c)(3) bonds, which often provide better financing terms and rates than those available from traditional lenders. The proceeds of qualified 501(c)(3) bonds may also be used by the non-profit organization for working capital or to acquire other kinds property, within certain limits.
To be eligible for qualified 501(c)(3) bond financing, the non-profit organization must be exempt from taxation under section 501(a) of the Internal Revenue Code. The organization also must qualify as an “exempt organization” under section 501(c)(3). The organization must maintain its exempt status as long as the bonds are outstanding.
A non-profit organization that shares a building with a for-profit entity may still be eligible for qualified 501(c)(3) bonds. Such a “mixed use” or “multipurpose” facility may be financed in part with qualified 501(c)(3) bonds. The portion that is bond financed must be used by the exempt organization for its exempt purposes or by a governmental unit. The portion used by the private entity must be financed with taxable financing or sources other than bond proceeds. The allocations between the different uses of the facility must be made in proportion to the benefits derived, directly or indirectly, by the various users of the facility. The allocations of the bond proceeds and other sources of funds, and the use of the facility by various parties, must be reasonable and consistently applied.
At least 95% of the net proceeds of the bonds must be used to finance facilities owned and used by the exempt organization or a governmental unit for its related activities. As with other types of qualified private activity bonds, qualified 501(c)(3) bonds have some inherent private use. Use by an exempt organization in its related activities counts as a “good use.”
What about the other 5% of net proceeds? No more than 5% of the net proceeds of the bond issue may be used for any private business use, known as “bad use.” If the exempt organization uses the bond proceeds or bond-financed facilities in an unrelated trade or business activity, it is considered bad use. Costs of issuing the bonds are included in the 5% permitted private business use.
Although exempt organizations cannot use the bond-financed facilities for an unrelated trade or business, or “bad use,” they may contract with a private party to provide services, which may result in private business use. The typical example would be a management contract with a private party to operate a portion of the facility. Fortunately, the IRS has provided safe harbors regarding management service contracts.
With respect to debt service on qualified 501(c)(3) bonds, no more than 5% of the payment of the debt service on the bonds may be directly or indirectly:
- secured by an interest in property used or to be used for a private business use, or
- secured by payments in respect of such property, or
- to be derived from payments in respect of property, or borrowed money, to be used in a private business.
Of course, interest and principal payments made by the exempt organization are not included, because the exempt organization is treated as a governmental unit.
Qualified 501(c)(3) bonds are not subject to state volume limits, but the aggregate outstanding face amount of qualified 501(c)(3) bonds that may be allocated to an exempt organization is limited to $150 million. Capital expenditures incurred by a 501(c)(3) organization may be financed with proceeds of tax-exempt bonds without regard to the $150 million limitation. And, this limitation does not apply to qualified hospital bonds.
The general rules regarding private activity bond rules are applicable to qualified 501(c)(3) bonds, including limits on the average maturity of the bonds, limits on the types of facilities that can be financed, notice and approval requirements, limits on costs of issuance, change in use rules, arbitrage and rebate rules, and advance refunding rules.