Unrelated Business Income Should Be Reviewed In 501(C)(3) Bond Issues

Marcus S. Owens, the retiring director of the Exempt Organizations Division of the Internal Revenue Service, departed with a warning to organizations described in sec. 501(c)(3) of the Internal Revenue Code. In his last speech as director, he noted that unrelated business taxable income reported by 501(c)(3)'s had dropped precipitously between 1997 and 1998, from $486 million to $173 million, even though more returns were filed. He reported that the IRS is curious about the drop and that the stage is set for a greater focus by the IRS on unreported unrelated business taxable income. He speculated that the decline might be the result of aggressive advice being given in light of the general vagueness of the unrelated business income tax statutory and regulatory guidance.

Mr. Owens' warning should set off alarms in the tax-exempt bond financing community as well. For an IRS audit that finds unreported income can have a catastrophic result for a tax-exempt bond financing.

Consider: An audit by the IRS of a 501(c)(3) entity that uncovers unreported unrelated business taxable income, usually results only in additional taxes and - possibly - penalties being assessed against the 501(c)(3) entity. However, if the facility that gave rise to the unrelated business income uncovered in the audit was financed with tax-exempt bonds, the bondholders may discover that their bond issue was taxable. This unfortunate result stems from sec. 145(a)(2)(A) of the Internal Revenue Code. That provision permits tax-exempt financing for 501(c)(3)'s with respect to their activities that do not constitute unrelated trades or business. So that the result of the audit could have consequences far beyond taxes and penalties assessed with respect to the unrelated business income.

The lesson? A 501(c)(3) entity that uses tax-exempt bonds to finance a facility, will have to be certain that the tax-exempt bond financed portion of the facility will not be used for activities that will generate unrelated business income. The facilities for such activities cannot be financed with tax-exempt bonds. Further, there is very little room for error. Only 5% of the proceeds of the tax-exempt issue can be used for so-called "bad" purposes, and 2% of that 5% was probably used for issuance costs. So there isn't much leeway. If your 501(c)(3) has contributed some of its own capital to the facility, you will also want to make sure that it has allocated that capital to the "bad" portion of the facility within the required time; that the allocation was consistent with the allocation made for arbitrage purposes; and that everything has been completed before the IRS agent makes his visit.

These materials are intended to furnish general information and should not be relied upon as advice in specific situations.

Robert S. Price, Esquire
Saul Ewing LLP
Centre Square West
1500 Market Street, 38th Floor
Philadelphia, PA 19102
215-972-7839 Fax: 215-972-1905
Email: rprice@saul.com
Web: www.saul.com