Beginning with the 2008 tax year, private schools, colleges and universities that borrow through the issuance of tax-exempt bonds are subject to an additional information reporting requirement with the Internal Revenue Service (IRS). This new reporting requirement, Schedule K to IRS Form 9901, filed annually with the IRS, may impose a significantly increased reporting burden on private schools, colleges and universities that borrow on a tax-exempt basis.
New Schedule K to IRS Form 990
With certain limited exceptions, private schools, colleges and universities described in section 501(c)(3) of the Internal Revenue Code are required to file an annual information return with the IRS, IRS Form 990. Effective beginning with tax years ending in 2008, private schools, colleges and universities will be required to file a new schedule to the IRS Form 990, Schedule K, if they have borrowed through the issuance of tax-exempt bonds and more than $100,000 of the bonds remain outstanding. For years ending in 2008, private schools, colleges and universities are only required to provide certain basic information about their outstanding tax-exempt bonds, including the name of the bond issue, the date the bonds were issued and the purpose of the financing. Thus, for tax years ending in 2008, completing Schedule K should require little additional effort beyond what was previously required. However, that changes dramatically beginning with tax years ending in 2009.
Schedule K greatly increases the information reporting requirement imposed on private schools, colleges and universities for tax years ending in 2009 and beyond. Beginning with 2009, private schools, colleges and universities will be required to provide the IRS with, among other information, the following with respect to each outstanding tax-exempt bond issue issued after December 31, 2002:
- the amount and type of expenditures financed with the proceeds of the bond issue
- whether the bond issue refinanced prior debt of the organization
- whether a final allocation of tax-exempt bond proceeds has been made under the federal tax rules
- whether there are any arrangements with respect to the bond-financed assets that may result in "private business use" or "unrelated trade or business use"2
- whether the organization has adopted policies and procedures to monitor compliance with the federal tax rules applicable to tax-exempt bonds
- whether the organization identified a hedge with respect to the bond issue
- whether the bond issue satisfied an arbitrage rebate exception
For many private schools, colleges and universities, compliance with the new Schedule K reporting requirement will prove to be difficult.
Reporting "Private Business Use" and "Unrelated Trade or Business Use"
Among the more complicated aspects of Schedule K is the requirement that section 501(c)(3) organizations identify and report the amount of "private business use" and "unrelated trade or business use" within their outstanding bond issues.
Private schools, colleges and universities that borrow on a tax-exempt basis generally do so through the issuance of "qualified 501(c)(3) bonds" by a governmental entity. In North Carolina, the North Carolina Capital Facilities Finance Agency issues bonds on behalf of private schools, colleges and universities. Pursuant to the Internal Revenue Code, interest on qualified 501(c)(3) bonds is exempt from federal taxation if, among other requirements, 95% or more of the net proceeds3 of the bond issue are used for a qualified purpose, and not for either a private business use or an unrelated trade or business use of the borrower.
Private business use generally means direct or indirect use in a trade or business carried on by any person other than a governmental unit. Unrelated trade or business use means use of bond-financed assets that is not in furtherance of the exempt purpose of the section 501(c)(3) organization using the property. Examples of arrangements which may give rise to private business use or unrelated trade or business use of tax-exempt bond-financed assets include leases of space to third parties, contracts with a cafeteria manager or bookstore operator, and research agreements. Proceeds of a bond issue used to pay the costs of issuance of the bond issue are also treated private business use, meaning that the vast majority of tax-exempt bond financings for private schools, colleges and universities are permitted less than 5% private business use/unrelated trade or business use.
Schedule K requires that section 501(c)(3) organizations report to the IRS on an annual basis the amount of private business use and unrelated trade or business use financed or refinanced with the proceeds of each outstanding tax-exempt bond issue issued after December 31, 2002 to the tenth of one percent (0.1%). If a bond issue has financed or refinanced a number of projects, or if the borrower has arrangements with multiple third parties, calculating the amount of private business use and unrelated trade or business use financed by the bond issue could be difficult. While many private schools, colleges and universities have systems in place to monitor private business use and unrelated trade or business use of tax-exempt bond-financed assets, this new reporting requirement goes well beyond what was previously required of private schools, colleges and universities, both in terms of prior filings with the IRS and (almost certainly) what is mandated under documents executed in connection with the closing of the bond issue.
As set forth above, Schedule K requires that section 501(c)(3) organizations review all arrangements that "may" give rise to private business use, disclose whether any such arrangement(s) exist and calculate the amount of private business use of the financed assets to the tenth of one percent (0.1%). Compliance with this portion of Schedule K will require a complete record of the allocation of tax-exempt bond proceeds of a bond issue, knowledge of all arrangements impacting bond-financed space that may give rise to private business use, the ability to apply the rules for determining whether an arrangement results in private business use (including the safe harbors for, and exceptions to, the private business use rules found in the Internal Revenue Code and Treasury Regulations), and the ability to measure the amount of private business use within the bond issue under the private use measurement rules set forth in the Treasury Regulations, again, to the tenth of one percent (0.1%).4
A similar review must be undertaken of arrangements that "may" result in use of tax-exempt bond financed facilities that is unrelated to the organization's tax-exempt purpose. As with private business use, a private school, college or university completing Schedule K will be required to provide the IRS with the amount of any unrelated trade or business use to the tenth of one percent (0.1%).
Monitoring is Key
Schedule K requires private schools, colleges and universities to provide the IRS with a significant amount of new information. Be aware that some of the required information will necessitate having to draw legal conclusions about arrangements impacting bond-financed space. For many organizations, even those with active monitoring programs in place, compliance with the Schedule K reporting requirement will require outside legal assistance. Indeed, the IRS asks as part of Schedule K whether the borrower "routinely engages bond counsel" with respect to arrangements impacting tax-exempt bond-financed property.
A private school, college or university subject to Schedule K should begin thinking immediately about how and whether it can meet this new reporting requirement. We advise borrowers to set up a monitoring system so the they can properly and confidently supply the information requested by the IRS in Schedule K. Those private schools, colleges and universities with active post-issuance tax compliance programs should consider consulting with outside counsel and their auditors to ascertain whether the monitoring systems in place are sufficient to comply with Schedule K, and to determine whether there are desired improvements that might make compliance with Schedule K more efficient. Private schools, colleges and universities that do not already have active post-issuance tax compliance programs in place should seriously consider implementing such a program as soon as possible. The IRS has demonstrated both in Schedule K and in recent tax compliance questionnaires distributed to section 501(c)(3) borrowers that it is interested in ensuring that all borrowers have adequate policies and procedures in place to comply with the federal tax law and that borrowers consult with legal counsel regarding their outstanding tax-exempt bonds on a regular basis.
How We Can Help
Parker Poe is ready to help private schools, colleges and universities in meeting their Schedule K reporting obligation. Working with you, we will customize a plan to meet your particular needs. In addition to other services we offer, we can assist you in monitoring and reporting private business use and unrelated trade or business use within your outstanding tax-exempt bond issues, and with responding to inquiries regarding the allocation of your tax-exempt bond proceeds. We are also able to assist private schools, colleges and universities in developing and implementing post-issuance tax compliance policies and procedures to ensure compliance with the federal tax law, including policies and procedures that will allow borrowers to readily identify and track private business use and unrelated trade or business use within a bond issue, track the allocation of bond proceeds to projects, and identify and track the records relevant to substantiating the tax-exempt status of a bond issue should the IRS audit the financing. Please contact a member of the Parker Poe Public Finance Group with any questions, or if you would like to discuss how Parker Poe can assist your organization.
- Colleges and universities that qualify as "governmental" borrowers by virtue of their relationship with the State of North Carolina are not subject to the IRS Form 990 filing requirement. This article uses the term "private schools, colleges and universities" to mean only to those organizations described in section 501(c)(3) of the Internal Revenue Code that borrow on a tax-exempt basis through the issuance of bonds by the North Carolina Capital Facilities Finance Agency.
- This requirement does not apply to tax-exempt bonds issued to refund bonds issued prior to January 1, 2003.
- "Net proceeds" generally means the price at which the bonds were sold and any investment earnings thereon, minus any proceeds deposited in a reasonably required reserve fund.
- The law in the area of what constitutes private business use, and how to account for and allocate proceeds of a bond issue to different uses, is constantly evolving. For example, the Treasury Regulations in the area of allocating and accounting for proceeds of a tax-exempt bond issue for private use purposes are currently in proposed form. The rules, therefore, in place today may not be the rules in place once those Treasury Regulations are finalized.