1. What is a 501(c)(3) organization?
501(c)(3) refers to a section of the Internal Revenue Code. Organizations whose purpose is "exempt" as permitted by Section 501(c)(3) of the Code (e.g. religious, charitable or educational) are provided a general exemption from federal income tax. In addition to meeting the statutory regulations of the Code, an organization must also file an Application for Recognition of Exemption and receive a determination of its exempt status from the IRS.
2. What is a tax-exempt lease or loan?
A form of financing wherein the interest component of the payments made by the sublessee/borrower is excludable from the gross income of the lessor/lender for tax purposes. See the answers to the questions above and below for differences in structure for a 501(c)(3) organization compared to financing transactions in which the obligor is a state or political subdivision thereof.
3. How are tax-exempt transactions structured for a 501(c)(3) organization?
A 501(c)(3) organization is not a political subdivision of the state and does not have one of the three criteria to allow it to issue tax-exempt obligations. These criteria are: police power, right of eminent domain, and taxing power.
Therefore, to construct a 501(c)(3) tax-exempt financing, you need a tax-exempt issuer--such as a city, county or state entity--to issue "on behalf" of the 501(c)(3) organization.
Most states have an "authority" set up to be issuers of bonds, industrial revenue bonds (IRB), or industrial development bonds (IDB) for non-tax-exempt entities. If the 501(c)(3) defaults, there is no further obligation on the part of the "authority." The authority only acts as a conduit to issue the tax-exempt obligation.
4. Are tax-exempt transactions structured as a lease or a loan?
Either. A lease purchase agreement between the lessor and an authority, as lessee, may be used. A sublease-purchase agreement from the authority, as sublessor, and the 501(c)(3) organization, as sublessee, is simultaneously put in place.
An alternative structure may involve the authority issuing a revenue bond or note with a financing agreement between the authority and the 501(c)(3) organization.
5. What can be financed on a tax-exempt basis?
Proceeds of a tax-exempt financing must be used for "capital expenditures" defined generally by reference to federal income tax principles. Capital expenditures do not include "working capital" items such as operating expense. Generally, capital expenditures include property, a project or a program.
6. How is the maximum term of financing determined?
The average maturity of tax-exempt bonds can not exceed 120% of the average reasonable expected economic useful life of the property, project or program being financed, per federal income tax regulations.
7. In a tax-exempt lease or loan, who is responsible for maintenance, insurance, property tax and other operating expenses?
A tax-exempt lease is a "net lease", i.e., the lessee is responsible for such expenses. In some cases, however, the lessee may contract with the equipment supplier to provide maintenance and other services.
8. What purchase option amount is common in a tax-exempt lease?
Typically, a dollar purchase option is used. Although the purchase option amount is not legally mandated, the general industry practice is to stipulate a nominal amount in order to avoid characterization of the tax-exempt lease as a true lease for federal tax purposes.
9. Who owns the equipment financed/leased in a 501(c)(3) tax-exempt transaction?
Legal title to the equipment rests with the sublessee/borrower. The obligation is secured by a "perfected" first security lien in the equipment.
10. What is the de minimus exception?
The de minimus exception is an exception to the general tax rules denying a deduction for interest on debt used to purchase or carry tax-exempt obligations. Under the de minimus (also known as "insubstantial holdings") exception, if the average amount of tax-exempt obligations is less than 2% of the average total assets of the corporation, the IRS will not infer that corporate debt can be traced to tax-exempt holdings.
11. What is arbitrage?
Arbitrage is the difference between the interest on obligations exempt from federal tax under the Internal Revenue Code and the yield on securities and obligations that are not exempt from federal tax, in which the proceeds of the tax-exempt financing are invested. The Internal Revenue Code imposes strict limits on arbitrage.
12. Is a public hearing necessary to consummate a tax-exempt financing with a 501(c)(3)?
In order to gain tax-exempt status, all 501(c)(3) financings are subject to a public hearing and approval by an elected official. The hearing process must define the maximum dollar amount, time frame and a general description of the property, project or program being financed.
13. Can tax-exempt financing be used to reimburse a 501(c)(3) for equipment previously purchased with cash?
In order to enter into a tax-exempt transaction involving any reimbursement of cash, the 501(c)(3) organization must first pass a reimbursement resolution declaring official intent to reimburse expenditures with tax-exempt proceeds. Once the resolution is passed, the proceeds of the tax-exempt offering may be used to reimburse for expenditures made up to 60 days prior to the declaration of official intent. In any event, the financing must be closed and the reimbursement made within 18 months after the date the expenditure was paid for or the date on which the property was placed in service, whichever is later.
14. Can tax-exempt financing be used to refinance existing debt?
Rules vary dependent on the form of financing used and whether a reimbursement resolution was passed. If equipment was acquired via lease it may be possible for the 501(c)(3) organization to purchase the equipment from the leasing company and finance the acquisition of the equipment with tax-exempt funds. If the equipment was previously acquired and paid for using tax-exempt funds, it may be possible to refinance the prior tax-exempt transaction with a subsequent tax-exempt transaction. If the equipment was acquired and paid for with proceeds of a taxable loan, the 501(c)(3) may be able to refinance the remaining principal balance with the proceeds of a tax-exempt lease or loan.
15. Is credit enhancement necessary in a 501(c)(3) tax-exempt transaction?
Bond insurance is used to insure payment on the stated maturity dates, and does not insure any risk other than nonpayment. Bond insurance or, in some cases, a Letter of Credit is often required in order to do a public offering or a pooled tax-exempt transaction. Private placements in which lenders or lessors hold the transaction for their own account typically do not require credit enhancement.
16. What are the characteristics of a public tax-exempt offering for a 501(c)(3)?
Public offerings are usually done for large issues ($15 - $250 million). SEC regulations govern disclosure since the debt is sold to the public. These transactions typically involve real estate as well as equipment and terms are as long as 30 years.
Because of the public disclosure and the size of the transactions, these tend to be very complex, time-consuming and involve many parties including an authority, underwriter, bond counsel, rating agencies, financial advisors, public accountants and a party to provide credit enhancement (bond insurer or letter of credit bank).
17. What are the characteristics of a 501(c)(3) tax-exempt pool?
Pools combine the tax-exempt financing needs of a group of hospitals or colleges and are typically equipment- or project-specific. Terms are shorter than a public offering, normally in the 5 to 10 year range. Pools must have a single credit rating and a AA credit rating gets the most attractive rates. Individual hospitals below AA will be normally required to get credit enhancement as a condition of participating in the pool. Interest rates are usually variable as opposed to fixed. Transactions can be complicated and timing unpredictable because of the number of hospitals utilizing the "pool" of funds.
18. How does a private placement work for a 501(c)(3)?
Private placements are utilized for issues ranging from as little as $500,000 to as much as $15,000,000. Investors may be companies like GE Capital or insurance companies, banks or individuals. Because it is a private transaction, no SEC involvement or official statement is required. Transactions typically are for 5 to 10 year terms and may involve a range of capital expenditures. Each investor has their own credit requirements. Private placements can usually be closed more quickly, with less fees and greater flexibility than a public offering or a tax-exempt pool.
