David J. Kates
Much focus has been placed on current challenges in obtaining new tax-exempt financing. However, equally important is the attention necessary to properly manage existing debt issues and avoid pitfalls that could imperil tax-exempt status.
Any not-for-profit healthcare provider that has had tax-exempt bonds issued on its behalf should be concerned about recent IRS activity. Clear trends are emerging. From an analysis of IRS activity, it is apparent that the agency believes not-for-profit compliance procedures are generally deficient and that it wants such not-for-profit organizations, which we will refer to here as borrowers, to do more. The IRS's position is evident in regulations that it has promulgated recently and in its audit activity and information gathering initiatives, including the new Form 990.
The Refunding Regulations. On Dec. 19, 2005, the U.S. Treasury Department published regulations, called the Refunding Regulations, that changed the record-keeping and document retention policies for any borrower. In effect, these regulations require a borrower to keep records of all arrangements resulting in private business use of the bond-financed facilities as long as any tax-exempt debt issued on its behalf remains outstanding.
The Refunding Regulations generally require that private business use of bond-financed property during a look-back period must be combined with the private business use after the refunding to determine whether average private business use during the relevant measurement period exceeds the private use limit (generally 5 percent). Borrowers that do not retain records documenting the cost, location, and use of bond-financed property will find it difficult, if not impossible, to refinance their tax-exempt debt on a tax-exempt basis.
The IRS's audit initiative. Recently, the IRS also commenced an audit initiative that looked at 30 to 40 healthcare bonds issued between 1995 and 1998. The audit looked for private business use due to leases of facilities, management and service contracts, and sponsored and cooperative research agreements, and use of facilities and equipment in unrelated trade or business and by partnerships and joint ventures.
The new Form 990. In 2008, the IRS rolled out a new Form 990, including a Schedule K focused on tax-exempt bonds. In stating its reason, in part, for including the Schedule K and requirements for vast amounts of information, the IRS said that it "is aware of significant noncompliance with record-keeping and record retention requirements." For this reason, the new Schedule K requires detailed reporting on all outstanding bonds issued after Dec. 31, 2002, including detail on private use, compensation of third parties, and the borrower's policies and procedures. "Wrong" answers to some of the questions on Schedule K could result in an audit by the IRS.
What Borrowers Should Do
In light of this activity of the IRS, borrowers should take a number of steps to protect the tax-exempt status of their bonds, be able to refund existing debt, and minimize potential for an IRS audit. These steps include creating a bond compliance policy and manual, establishing the position of bond compliance officer, establishing record-keeping procedures, routinely asking bond counsel to review management and research agreements, conducting an internal audit of bond financed assets, establishing a deadline reminder system, and training staff.
Create a bond compliance policy and manual. This is one of the most important steps a borrower can take to ensure compliance and avoid an IRS audit (or at least make an audit less burdensome). A bond compliance policy should include a statement of the policies that the borrower intends to follow to make sure its bonds continue to qualify for tax-exemption. It also is important that the policy be spelled out in a manual that includes procedures the borrower will follow to ensure the policies are implemented. Schedule K of Form 990 asks whether a borrower has "adopted management practices and procedures to ensure the post-issuance compliance of its tax-exempt bond liabilities." A properly structured bond compliance policy and manual will allow a borrower to respond affirmatively. Borrowers that must answer "no" are far more likely to get audited.
Establish the position of bond compliance officer. A bond compliance policy and manual should include procedures to track the sale and use of bond-financed assets. For this purpose, a bond compliance officer is essential. The bond compliance officer's role should include:
- Possessing an understanding of the rules and regulations relating to the bonds
- Being fully familiar with the assets that are bond-financed
- Being able to monitor and respond to requests regarding the use of the bond-financed assets.
Everyday activities such as leasing assets, selling assets, and entering into research and management contracts should be run through the bond compliance officer for approval.
Establish record-keeping procedures. The bond compliance policy should also establish recordkeeping requirements and procedures. The IRS has stated that failure to keep proper records allows the IRS to presume private use. As noted above, without the proper record-keeping procedures, a borrower may not be able to refinance its debt on a tax-exempt basis. The borrower should retain documentation evidencing:
- A correlation between bond issues and financed facilities
- Allocation of bond proceeds to expenditures, including reimbursement of preissuance expenditures
- Nonbond proceeds expenditures and sources
- Bond proceeds expenditures
- Private use of bond-financed facilities
Records of private use include sale, lease, management, or other service contracts; nonqualified research contracts; any special legal entitlements; any unrelated business activity; and any activity that jeopardizes the 501(c)(3) status of the borrower. All records should be kept either in hard copy or electronic format allowing for complete access during the applicable period (generally ending three years after all of the bonds are redeemed, including any refunding bonds).
Routinely ask bond counsel to review management and research agreements. Another procedure that should be a part of the bond compliance policy is the routine review of management, service, and research contracts by bond counsel. Schedule K to the new Form 990 asks, "Does the organization routinely engage bond counsel or other outside counsel to review any management or service contracts or research agreements relating to the financed property?" Borrowers that answer "no" to this question could significantly increase their risk of being subject to an IRS audit. "Routine" can be as often as a review of every such contract before it is executed or could be a once-a-year review of all agreements entered into in the past year. A yearly review runs the risk of a required renegotiation of a contract that is found to be problematic.
Conduct an internal audit of bond-financed assets. Borrowers should conduct an internal review of their use of bond-financed assets, including a review of where the assets are located, whether they are still in use, whether they have been sold, and all leases and management contracts relating to all bond-financed assets.
Establish a deadline reminder system. Borrowers should establish a "tickler" system to remind them of certain deadlines, such as the dates by which they must calculate and file their arbitrage rebate payments.
Train staff. Finally, it is important to train employees. Employees throughout an organization make decisions almost daily that could affect the tax-exempt status of bonds. Every sale, lease, or trade-in of a piece of equipment or property could cause the bonds to become taxable. Employees at various levels outside of the bond "team" within an organization routinely make these decisions. Although the borrower should not expect every employee to know chapter and verse the rules and regulations related to the bonds, every employee should be able to spot issues before they can become a problem. With an understanding of some basic rules regarding tax-exempt finance, employees would know enough, for example, to ask the bond compliance officer if an action would cause a problem before it becomes one. A short, periodic training session (perhaps led by the borrower's bond counsel) should be sufficient to impart this level of knowledge.
Time to Take Action
Taking reasonable precautions now can help a not-for-profit healthcare organization avoid potentially difficult and expensive problems with its tax-exempt debt in the future. With the IRS's increased focus on the tax-exempt status of healthcare bonds, these ounces of precaution should prove invaluable.
David J. Kates, JD, is a partner, Jones Day, Chicago (email@example.com).
Steve Womack, FHFMA, CPA, is a principal, Spectrum Health Partners LLC, Brentwood, Tenn. and a member of HFMA's Tennessee Chapter (firstname.lastname@example.org).
Publication Date: Thursday, July 01, 2010