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Tax Exempt Borrowing Basics – A Quick Reference Guide to Tax-Exempt Bonds

Tax-exempt debt provides a valuable financing option for governmental and tax-exempt entities, but typically involves complicated, precise structures and language. Below is a general reference guide for those new to tax-exempt bonds.

Who can borrow using tax-exempt bonds?

Governmental entities and 501(c)(3) non-profit organizations, as well as private entities, in certain circumstances. Only governmental issuers can issue tax-exempt bonds. Non-profit entities may borrow using tax-exempt debt, but virtually all must do so via a “conduit financing” with a governmental entity. In a conduit financing, the governmental entity issues the bonds, then loans the bond proceeds it receives to the non-profit entity. There are typically one or more designated entities in each state that provide this service for non-profit entity financings.

What are tax-exempt bonds? Tax-exempt for whom?

Investors – whether banks, bond funds or individuals – buy and hold the bonds. The purchase price paid is used to finance projects of the governmental or non-profit entity. The investor holding the bond typically receives interest while the bond is outstanding and is repaid the principal amount of the bond over time. Those holding the bonds generally do not have to pay federal (and sometimes state) income tax on the interest they earn on the bonds.

What is the benefit to borrowing using tax-exempt debt?

Because the holders of the bonds do not have to pay tax on the interest they receive, they are willing to accept a lower interest rate. In other words, tax-exempt financing allows governmental entities and tax-exempt borrowers to borrow at lower interest rates.

Are there other requirements?

Bonds are not deemed tax-exempt solely because the borrower is a governmental or tax-exempt entity. There are many complicated rules that must be followed both as the financing is structured and after the bonds are issued. These rules include restrictions on how the borrowed funds can be used, restrictions on how the borrowed funds can be invested, deadlines for spending the borrowed funds, as well as certain recordkeeping and reporting requirements.

What is involved in obtaining tax-exempt financing for non-profit organizations?

Non-profit organizations typically apply for assistance from the appropriate state governmental entity that will issue the bonds and loan the funds received to the non-profit borrower. The proposed issuance is discussed at a public meeting of the issuer. After issuer approval, the governmental issuer and the non-profit borrower work with attorneys, financial advisors, as well as other professionals to structure and document the financing.

Bondholder(s) The investor(s) who hold the bonds.
Borrower The entity that uses the funds received from selling the tax-exempt bonds.
Issuer The governmental entity that issues the bonds. The Borrower and Issuer may be  separate entities or the same entity. See “Who can borrow using  tax-exempt bonds?” above.
Proceeds of the Bonds The money received by selling the tax-exempt bonds, as well as any property purchased with such funds.
Bond Counsel The law firm that guides the issuance of the bonds and provides a written opinion that interest on the bonds qualifies as tax-exempt.
Borrower’s Counsel The law firm that represents the Borrower.
Bond Opinion The written opinion of Bond Counsel that interest on the bonds qualifies as tax-exempt.
Tax Certificate or Tax Regulatory Agreement A document in which the Borrower and/or Issuer state(s) facts and make(s) representations that Bond Counsel relies on in giving the Bond Opinion.
Loan Agreement/Bond Indenture/Loan and Trust Agreement The document(s) stating the terms and conditions of an Issuer’s loan of the proceeds to the Borrower, and the Borrower’s use of the proceeds.
Post Issuance Compliance Procedures Customized, written procedures that each Issuer and Borrower of tax-exempt debt should have in place to comply with Internal Revenue Service guidance and to ensure  that the bonds remain tax-exempt for the entire time they are outstanding.

This article is a brief overview of tax-exempt bonds. Please contact the Nonprofit Group Chair Malcolm Farmer III if you would like more information. You can also follow Hinckley Allen on LinkedIn and Twitter for the latest news and updates.