As the economy recovers, enrollments begin to improve, and “money” becomes cheaper, independent school boards have begun to once again consider the purchase of property, construction of new facilities, and renovation of existing property. Many options exist for securing the resources necessary to finance these projects. While many schools utilize taxable financing, schools recognized under Section 501(c)(3) of the Internal Revenue Code for exemption from federal income tax are eligible to borrow on a tax-exempt basis. As with all borrowing tools, there are pros and cons. In an effort to assist schools when considering the use of taxed and tax-exempt financing, this article provides an analysis of the method for evaluating the options available with a special focus on whether the more favorable interest rates provided by borrowing on a tax-exempt basis are worth the additional transactional costs and restrictions imposed by federal income tax law that comes along with tax-exempt debt.
From the outset, borrowing on a tax-exempt basis is more complicated than the typical bank loan. In order to qualify for tax exemption, the debt must be issued by a government entity with the proceeds being re-loaned to the school. Typically, the issuer of the debt is a state or local government entity (known as the “Issuer”) where the school and its proposed project are located. Such an arrangement is referred to as “conduit borrowing,” with the government entity typically assuming no obligation on the debt. Rather, the government issuer serves as a mere conduit to pass the loan proceeds on to the true borrower, the 501(c)(3) conduit borrower, and to remit the debt service payments from that borrower to the lender(s).
Taxable or Tax-Exempt? Evaluating Costs
A starting point in the analysis of whether to borrow on a tax-exempt or a taxable basis is a comparison of the difference in interest rates that can be expected to be available to the school. Generally speaking, the spread between tax-exempt and taxable interest rates is a function of the marginal tax rate on taxable interest income applicable to potential purchasers of the debt. Interest rates vary with a variety of factors, with principal considerations being the creditworthiness of the school (together with any parties that will guarantee or otherwise lend support to the school), what assets the school has available to pledge as collateral for the debt (such as campus real estate or endowment assets), and the term of the debt. Additional factors applicable to tax-exempt debt are the federal and state income tax rates that a debt holder foresees as being applicable to it over the term of the debt.
To be weighed against the potential interest rate savings realized by the school are the additional costs of issuing tax-exempt debt over those typically incurred in connection with the issuance of taxable debt (e.g., a conventional bank loan). As discussed further below, these costs include conduit issuer fees, the bank application, loan fees or an underwriter’s commission, various legal counsel costs, fees associated with retaining a trustee (if needed), and costs for drafting and printing offering documents in the case of a public offering of the debt. These transaction costs are a significant obstacle for transactions under $5,000,000 and remain a factor for larger transactions. A financial advisor can assist in quantifying the potential interest rate savings versus the various transaction costs and provide advice on the overall cost savings potential of pursuing tax-exempt financing.
Less quantifiable costs and burdens of tax-exempt financing are the ongoing compliance with federal income tax law requirements (discussed below). There also may be ongoing reporting requirements established by the lender, but these will generally be the same whether the debt is tax-exempt or taxable.
The debt issued by the conduit government issuer will typically be in the form of a bond or bonds, although other financing labels and structures also are used (e.g., tax-exempt leases). The simplest tax-exempt financing structures are bank placements. Here, the transaction resembles a conventional taxable bank loan in many respects. The structure is relatively simple because there is only one holder of the debt instrument – the bank – and it can exercise all administrative, oversight, and enforcement functions present in a lending transaction. Bank placements are frequently more cost-effective than other structures when the transaction size is below roughly $10 million.
In contrast, tax-exempt debt may be marketed to multiple bondholders in an effort to obtain a better interest rate via either a public offering or a private placement. Either approach is more complex than a direct bank placement because the debt is being sold to multiple bondholders and typically requires additional participants and documents. Because there will be multiple bondholders who are passive lenders, a bond trustee (usually the trust department of a bank) is needed to represent the interest of those multiple bondholders and to take on their collective responsibility for administering the bond terms. The bond trustee typically acts under a trust indenture (sometimes called a bond resolution), which spells out bondholder rights and establishes a framework for administration, oversight, and enforcement of the terms.
Marketing the bonds to multiple bondholders requires underwriting or placement agent services, usually provided by an investment bank. The bonds will be sold pursuant to a securities offering prospectus, usually called an “Official Statement” for a public offering or a “Private Placement Memorandum” for a private placement. The underwriter or placement agent carries out its responsibilities under a bond purchase agreement or private placement agreement. Official Statements and Private Placement Memoranda are expensive to draft, because they require collective effort from lawyers for the issuer, the underwriter or placement agent, and the school, and are typically accompanied by legal opinions as to accuracy and compliance with securities laws. Drafting the portions of the Official Statement describing the school and its operations and finances is particularly time-intensive for the school’s lawyers and accountants in a first-time borrowing, and is a significant part of the transaction costs associated with the issuance of tax-exempt debt in the form of bonds offered to the public. Private Placement Memoranda are used when the bonds are sold only to sophisticated investors, and can be cheaper to draft because they provide a more cursory description of the bonds, the school, and the transaction.
For schools with a robust financial profile, achieving the lowest possible debt service costs for tax-exempt debt may be aided by obtaining a credit rating for the debt from one or more of the national credit rating agencies (including Standard & Poor’s, Moody’s, and Fitch) if that rating will help the underwriters obtain a lower interest rate from the purchasers of the bonds. Smaller schools or schools with weak credit ratings can sometimes achieve debt service savings by paying for credit enhancement in the form of a bond insurance policy or backing by a letter of credit issued by a financial institution. Credit enhancement lifts the rating on the bonds, thereby enabling a lower interest rate, in return for payment of the insurance premium or letter of credit fees. Determining whether credit enhancement strategies are cost-effective is usually the job of the underwriters and/or the school’s financial advisor.
The Typical Process
Most schools need committed financing sometime between the start of the project design phase and the start of construction. A tax-exempt financing transaction commonly requires a three- to six-month timeline, so financing activity should begin six to nine months ahead of the day when borrowed funds will be needed. Other factors typically affecting the timeline for school financing projects are the timing for zoning and construction approvals and the timeline for getting construction costs pinned down in a contract. However, before taking any action in connection with a tax-exempt financing, the school’s finance personnel should obtain preliminary approval from the board of trustees, the finance committee of the board, or other body or officer with authority to initiate a borrowing on behalf of the school. Federal income tax law generally requires that the school declare its intent to finance costs in a written declaration before actually spending money when any such spending will occur in advance of actual debt issuance. Most schools incur significant project costs well ahead of closing on their financing and reimburse themselves from bond proceeds at closing. Accordingly, as soon as the school commits itself to the funding of a project with tax-exempt debt, it should adopt a “declaration of intent” by resolution or other official action.
Another vital preliminary step is to coordinate any capital campaign for the project with the plans for tax-exempt debt financing. The reason this is essential is that the Internal Revenue Service requires a school to choose between financing an asset with targeted philanthropy or with tax-exempt bond proceeds, not both. For example, if a school finances a new gym with bond proceeds, then later gifts linked in the fundraising process to the gym must be used to pay off the bonds. Conversely, if gifts are in hand and earmarked for the gym, then the size of the bond-financed portion of the project must be reduced dollar for dollar. Capital campaigns for educational facilities frequently involve naming opportunities which link a donor’s funding to particular facilities by means of a naming plaque or other recognition acknowledging that a donor’s funds have assisted in providing particular classroom, athletic facility, etc. Such linkages of donations to capital projects can be highly valuable in the fundraising process, but may cause problems when tax-exempt financing is pursued. Early consultation with knowledgeable counsel can help the school make maximum use of both sources of funds without stepping afoul of Internal Revenue Service rules.
After completing its internal approval processes, a school’s next step is to identify and make an application to the appropriate conduit issuer. Often, schools have a choice of either local governments or specialized state bond lending authorities that could serve as the government issuer. However, there may be political and policy factors at play in the choice, and the school’s counsel is usually best situated to advise the school on the choice of issuer.
At this stage, the school is likely to be negotiating the basic financial terms of the loan transaction with the bank, the underwriter, or the private placement agent. Here again, it is critical to involve experienced tax-exempt finance counsel in the basic negotiation of terms. The issuer chosen by the school often wants to see a term sheet and a list of parties as part of the application process.
Once the issuer has been selected, the school must obtain and complete whatever form of application and questionnaire may be required by the issuer and its counsel. This is also the stage when the rough calendar for the bond transaction is laid out. Issuers often require a general application to establish eligibility for the issuer’s program and a separate tax diligence questionnaire to support the crucial opinion on the tax-exempt status of the debt. Once the application process is complete, the conduit issuer will then satisfy the “TEFRA” notice, hearing and approval process required by federal income tax law by means of publishing a notice of the proposed financing, followed by (a) the holding of a public hearing permitting public comment on the proposed financing, and (b) formal approval of the financing by a publicly elected official of the issuer following that hearing. Issuers have varying rules, procedures, and schedules for finance team meetings, public hearings, and formal approvals.
The Finance Team
A variety of professionals will typically be engaged in connection with the issuance of the conduit debt on behalf of the school. The conduit issuer will have personnel responsible for assisting with the issuance process and will have retained outside counsel to represent it in connection with the issuance (“bond counsel” and/or “issuer’s counsel”).
In the case of a private placement of tax-exempt debt with a single bank being the sole lender, that bank will usually retain its own internal or external counsel (“bank counsel”). Alternatively, if the debt is to be publicly offered with the assistance of an underwriter, the underwriter will typically retain its own counsel (“underwriter’s counsel”) to assist in the negotiation of the bond purchase document and the offering statements for the sale of the bonds to the public. Occasionally, the parties may consent to have a single counsel represent two of the parties, so as to reduce the overall counsel fees and create efficiencies in the issuance process. For example, a single counsel might serve as bond counsel to the issuer and as counsel to the school. In such a situation, the issuer would still typically have its own “issuer’s counsel” retained for a much more limited role than that performed by bond counsel.
The school will retain its own legal counsel (also known as “borrower’s counsel”). The school’s counsel must be familiar with the unique aspects of the tax-exempt financing process and be capable of giving the opinions required to support the tax-exempt status of the debt. If real estate and construction will be financed, or if the school is a charter school, then borrower’s counsel will need competency in these areas as well.
Frequently, the school will engage a financial advisor. If involved, an underwriter may be a source of financial advice; however, an underwriter’s advice may be accompanied by a disclaimer of fiduciary responsibility to the school. This is why many schools retain their own financial advisor, whose compensation does not depend on effectuating the transaction. If interest rate swaps or hedges will be used, the school may be able to rely on its financial advisor to serve as swap advisor or, depending on the competencies of the financial advisor, may need to retain a separate swap advisor. The conduit issuer also may have its own financial advisor.
The role of the school’s accountant will depend on the financing structure chosen. A simple loan structure may only require copies of the audited financial statements. Bonds sold in a public offering will be accompanied by the school’s audited financial statements with the consent of the auditor and appropriate diligence procedures. Auditors also may consult on financial covenant and feasibility issues. Additionally, the school’s accountant may assist the school with tax-related calculations and certifications necessary to support the school’s tax compliance certificate as required by bond counsel.
The market requires that tax-exempt bonds be accompanied by an opinion of bond counsel supporting the tax-exempt status of the interest payable on the bond and assuring that the bond was properly issued. Bond counsel typically requires and relies upon the school’s counsel for an opinion as to the school’s tax-exempt status, among other things. Depending on the nature of the project and the structure of the transaction, there may be other important opinions about licenses and accreditation, regulatory compliance, securities disclosure, and the like. Each party’s counsel will generally issue an opinion as to the authority of the party that it represents to undertake the transaction, the validity of the approvals of that party to enter into the transaction, and other relevant matters. Each counsel will impose its own diligence and certification requirements on the parties to the transaction as it deems necessary to support the rendering of its opinion.
Sale and Closing
For a private placement, the sale and closing are typically combined as one event. A term sheet or letter committing the parties to the terms of the financing may be agreed to in advance.
For publicly sold bonds, the sale and closing components are two distinct events typically separated by one or two weeks. All parties work together to prepare the primary document, the Official Statement, which details the terms of and security for the bonds and is used by the underwriters to market the bonds to potential purchasers. Of primary concern to the school will be the portion of the Official Statement (typically titled as “Appendix A”) describing the school, its educational niche, its history of applications, acceptances and enrollments, and its financial condition in detail, so as to give the potential lenders the facts necessary to evaluate the ability of the school to repay its debts. After a period of marketing using the Preliminary Official Statement, together with any other strategies that the underwriters believe will advance the sale of the bonds, the underwriters will formally conduct the sale of the bonds on a date established in the offering materials.
Once the pricing and any other open terms of the bonds are finalized by completion of the sale, the final form of documents, incorporating the interest rates and other terms of the debt resulting from the sale of the debt, will be prepared for signing on the closing date. Subsequently, on the closing date, all of the bond documents will be completed and signed. Most importantly for the school, the funding will occur such that net bond proceeds after payment of issuance costs are available for the use of the school.
Federal Tax Law Requirements
Federal income tax law imposes a variety of requirements as conditions to the exempt status of the interest payable on tax-exempt debt. The following is an overview of several of the more significant of those requirements of federal income tax law. Additional requirements, beyond those discussed here, will apply depending on the nature of the school’s project. Various exceptions and unique rules apply in connection with each of these requirements.
All property to be financed with tax-exempt debt must be owned by a tax-exempt 501(c)(3) organization. At least 95% of the financed property must be used by the school in fulfillment of its tax-exempt purposes. The 95% requirement leaves a 5% allowance (often referred to as the “private business use allowance”) that must cover (i) issuance costs funded from debt proceeds, and (ii) any uses of bond proceeds either in an unrelated trade or business activity of the borrower or by third parties that are not themselves tax-exempt 501(c)(3) organizations.
Typical uses that may give rise to private business use subject to the 5% limitation include any unrelated trade or business activity of the borrower (regardless of whether that activity is operated at a loss), together with leases of unneeded space in a financed facility to a private business, or retention of private managers to operate food service facilities, bookstores, or other financed assets. Even temporary uses by for-profit entities running summer camps or athletic programs can be problematic.
When a potentially prohibited private use is a result of a management and other professional service contract involving bond-financed facilities, relief from “private business use” status may be found in IRS rules that provide “safe harbor” guidelines. These guidelines provide combinations of compensation, term, and termination provisions, which, if complied with, ensure that private business use will not be considered to result from such management and service contracts. In addition, various exceptions to the restrictions on private use are available for short-term usage arrangements and for access to facilities that are “open to the general public,” which exceptions may apply to programs of limited duration that make use of facilities on evenings or weekends or during the summertime.
No more than 2% of the debt proceeds can be used to pay the transaction costs incurred in connection with issuing the bonds. As noted, such “issuance costs” also count against the 5% allowance for private business use. If issuance costs exceed the 2% limit, then the school will need to fund them out of its own equity or take on a separate, taxable borrowing (often called a “taxable tail”) to fund the excess together with any other costs of the project not qualifying for inclusion in the sizing of the 501(c)(3) bonds. Some schools elect to pay all costs of issuance with equity to preserve the full 5% allowance for private business use. Such an approach can be valuable for preserving flexibility for future unexpected private business uses involving the bond financed project that may arise.
In the case of a school that is affiliated with a religious organization, the proposed capital project may include components that are exclusively sectarian, such as adding a new chapel and related offices for religious staff, making renovations to such spaces, or purchasing furnishings and equipment for them. Often the usage in a religious-affiliated school will not be so discrete, such as where classrooms are used for teaching a range of general education curriculum during the weekdays, but may be used on weekends and evenings for meeting and classes with a strictly religious focus. Each such fact pattern will require discussion with bond counsel for the issuer as to the extent to which the costs of any such components having religious affiliated usage can be financed with tax-exempt bond proceeds.
The various requirements of federal income tax law generally must be satisfied both at the time of initial issuance of the 501(c)(3) bonds and so long as any portion of the debt is outstanding. Both the conduit governmental issuer and the school should adopt written procedures detailing how and by whom such post-issuance compliance will be conducted.
For 501(c)(3) organizations benefitting from outstanding tax-exempt debt, an additional Form 990 schedule must be filed annually so long as the debt is outstanding – Schedule K, Supplemental Information on Tax-Exempt Bonds. The information required to be reported on Schedule K includes detailed listings of uses of proceeds, statistics on private business use, and arbitrage compliance facts. While some schools may have finance officers that are comfortable completing the return on their own, others will need the assistance of outside advisors to ensure proper understanding of the questions being asked and accurate completion of the responses.
Weighing the Alternatives
Historically, 501(c)(3) schools have found the benefits of tax-exempt debt to outweigh its costs and burdens. In the current economic environment, with interest rates at historically low levels, the valuation requires close scrutiny, as the margin of savings between taxable and tax-exempt interest rates may not merit the additional costs and burdens of pursuing tax-exempt debt, particularly for smaller borrowings. The services of a financial advisor, either through the school’s regular banking relationship manager or a professional dedicated to advising in this area, can be invaluable in assisting with this evaluation. The school’s legal counsel also may have expertise in tax-exempt finance and be a vital member of the team tasked with evaluating the financing options available to 501(c)(3) organizations.
For more information, please contact the authors Caryn G. Pass, Walter R. Calvert or Davis V.R. Sherman.