Tax-Exempt Financing:What 501(c) (3) Organizations Need To Know

Presented by UMB, BKD & Baird Holm

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PARKER SCHENKEN

Executive Committee Member and Public Finance Chair, Baird Holm

Parker Schenken is in his twentieth year with Baird Holm LLP. He currently serves on the

firm’s Executive Committee and is the Chair of its Public Finance section. His practice

principally includes municipal law and public finance, including qualified 501(c)(3) conduit

financings. Parker also provides counsel in the areas of corporate finance, commercial

law, corporate law and real estate. Parker is a member of the National Association

of Bond Lawyers and is admitted to practice law in the states of Nebraska, Colorado

and Iowa. He has been included in the The Best Lawyers in America®; since 2007.

Fundamental Principles

IRC Section 103 – interest on a “state or local bond” is exempt from gross income for federal income tax purposes. Corresponding provisions of applicable state law may also provide for exemption from state income taxes.

Traditional Governmental Bonds – issued by cities, school districts, other public agencies for public projects.

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Bond Transaction Structure

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Simple Governmental Bond Structure

ISSUER BONDHOLDER

Fundamental Principles

Congress has extended benefits of tax-exemption “subsidy” to other sectors that involve non-governmental use – so-called “qualified private activity bonds”. IRC Section 141 and related sections.

One category of qualified private activity bond is a “qualified 501(c)(3) bond” described in IRC Section 145.

Qualified private activity bonds are often structured as “conduit” bond issues – in which the governmental issuer issues the bonds and then immediately loans the proceeds to the conduit user.

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Bond Transaction Structure

Credit Enhanced Conduit Bond Structure

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ISSUER UNDERWRITER DTC

BOND-HOLDERS

CONDUIT 501(c)(3)BORROWER

LETTER OF CREDIT BANK

TRUSTEE

LEASE/LOANAGREEMENT

REIMBURSEMENTAGREEMENT

BONDPAYMENT

Fundamental Principles

In order to have tax-exempt debt for the benefit of a non-governmental 501(c)(3) organization, you must utilize a qualified governmental conduit issuer, which may, for example, include:

A municipality under Neb. Rev. Stat. Sections 13-1101 et seq. or Iowa Code Chapter 419;A specialized authority, such as NIFA, NEFA, IFA, a Hospital Authority, etc.A direct loan from a bank or other lender to a 501(c)(3) organization is NOT tax-exempt.

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Areas of Legal Analysis

State Law – issuer must have the authority to issue the obligations for the identified purpose; other generally applicable state law requirements such as open meeting laws, laws relating to contracting and public bidding, laws relating to investment of public funds, etc., may be in play depending on the transaction.

Federal Tax Law – bonds must fall in a category of exempt obligations under federal tax laws (and, in the context of a qualified 501(c)(3) financing under Section 145, the organization must maintain its 501(c)(3) status).

Securities Law – tax-exempt financing likely results in the issuance of a security for purposes of federal and state securities law, applicable exemptions from registration must be identified, and other applicable securities law requirements must be satisfied.

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Economic Analysis

Since the bondholder is not paying tax on its interest income, it will charge interest which is lower than a traditional taxable borrowing – this translates into a lower interest rate charged to the 501(c)(3) borrower.

BUT – transaction costs (issuer fees, underwriting or bank fees, legal fees, etc.) are generally higher in a conduit tax-exempt transaction, and these upfront costs may counteract the interest savings – important to run a “true interest cost” type analysis.

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Limitations on Private Use

All financed property must be owned by the 501(c)(3) organization. Limitations on “private use” – 5% - which can result from:

“Management contracts” – including traditional management contracts but also very broadly defined to include things such as physician group contracts. See Rev. Proc. 97-13.Research contracts. See Rev. Proc. 97-14.Requirements/take-or-pay contracts.Leases for ancillary services (beauty shop, food service, etc.)Naming rights.Joint ventures.Any other arrangement resulting in a “special legal entitlement” to use of the financed property.

2% limitation on financing costs of issuance (NOTE: counts against 5% private use).

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Arbitrage/Rebate Requirements

As a general rule an issuer (or conduit borrower) cannot “profit” by earning a yield on proceeds of a tax-exempt issue which is higher than the yield on the bonds.

Can you earn it? (“Yield Restriction”)Can you keep it? (“Rebate” and applicable exemptions)Specific rules govern calculations of yields, allocations, etc.

A bond issue needs to comply at the time of issuance (i.e., reasonable expectations) and during the life of the issue (actual facts and deliberate actions).

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Post-Issuance Compliance Policies

IRS Form 8038

IRS Form 990, Schedule K

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Role of Bond Counsel

Unqualified Legal Opinion – but lawyers are not engineers, financial advisors, accountants or experts in health care operations. So the assistance of qualified professionals is critical, for example, in addressing:

501(c)(3) status (now including 501(r) as applicable).Covenant compliance.Satisfaction of “additional bonds” tests.“Agreed upon procedures” for financial disclosure.Allocation and accounting of private use.Determination of useful lives of assets (IRC Section 147)Arbitrage/rebate recordkeeping, analysis, reporting and returns

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Other Relevant Code Sections/Concepts

Public offering vs. private placement

Section 265 “Bank Qualification”

“TEFRA” public hearing and approvals

Information filings and returns (8038 Series)

Residential rental housing rules

Limitations on working capital financings

Fundraising and arbitrage/rebate implications

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SCOTT CRIST

Vice President, Public Finance, UMB

Scott Crist leads the UMB Healthcare Investment Banking Group. Over the course

of his tenure with UMB, Scott has worked with numerous colleges, hospitals and

other non-profit entities throughout the Midwest, with a specific emphasis on

publicly owned and not-for-profit community hospitals. Scott assists his clients in the

financing of large scale capital projects, ranging in scope from significant expansions

or renovations to new facility construction, utilizing tax exempt bond issues.

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This communication is provided for informational purposes only. UMB Bank, n.a. and UMB Financial Corporation are not liable for any errors, omissions, or misstatements. This is not an offer or solicitation for the purchase or sale of any financial instrument, nor a solicitation to participate in any trading strategy, nor an official confirmation of any transaction. The information is believed to be reliable, but we do not warrant its completeness or accuracy. Past performance is no indication of future results. The numbers cited are for illustrative purposes only. UMB Financial Corporation, its affiliates, and its employees are not in the business of providing tax or legal advice. Any materials or tax related statements are not intended or written to be used, and ‐cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. The opinions expressed in this email are those of the author and do not necessarily represent the opinions of UMB or UMB Financial Corporation. Future results may vary. Products offered through Investment Banking are: Not FDIC Insured, May Lose Value, Not Bank Guaranteed.

UMB Bank, n.a.Investment Banking Division1010 Grand BlvdKansas City, MO 64106866.651.9262

Disclosure

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Interest Rate Environment

Although tax exempt interest rates have increased from the historic lows we experienced over the past few years, they are still very attractive from a historical perspective.

Jun-94

Jan-95

Aug-95

Mar-96

Oct-96

May-97

Dec-97

Jul-9

8

Feb-99

Sep-99

Apr-00

Nov-00

Jun-01

Jan-02

Aug-02

Mar-03

Oct-03

May-04

Dec-04

Jul-0

5

Feb-06

Sep-06

Apr-07

Nov-07

Jun-08

Jan-09

Aug-09

Mar-10

Oct-10

May-11

Dec-11

Jul-1

2

Feb-13

Sep-13

Apr-14

2.00

2.50

3.00

3.50

4.00

4.50

5.00

5.50

6.00

6.50

7.00

Interest rates from 1994 - Present"A" Rated Revenue Bonds

10-year Maturity

Last 3.43%High (11/21/94) 6.63%Low (12/05/12) 2.48%Average 4.40%

Source: Bloomberg

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Bond Issuance

Many municipalities and 501(c)(3) organizations have taken advantage of these historically low interest rates to finance much needed capital projects, and refinance existing debt.

Over the last ten years, we have seen a heightened level of tax exempt bond issuance that corresponds to this period of low interest rates.

Included in this data is the increasing use of private placements as a method of issuing tax exempt bonds

2005 2006 2007 2008 2009 2010 2011 2012 20130

50,000,000,000

100,000,000,000

150,000,000,000

200,000,000,000

250,000,000,000

300,000,000,000

350,000,000,000

400,000,000,000

Tax Exempt Bond Issuance2005 - 2013

New Money Refunding

Source: Bond Buyer

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Private Placement

What is a Private Placement

A private placement involves the sale of tax exempt bonds directly to one or a few institutional investors (typically banks), rather than offering the bonds to the public through a public sale.

Because there is no public disclosure on the part of the Issuer during the private placement process, the buyer of the bonds is required to represent that they are an “accredited investor”, have conducted their own due diligence with regard to the borrower, and intend to purchase the bonds for their own account and not for re-sale to the public. The buyer must also represent that they understand they may not sell, transfer, or otherwise dispose of the Bond without receiving similar representations from a subsequent purchaser.

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Private Placement Trends

Over the past several years, there has been a growing trend among municipal and 501(c)(3) organizations to issue tax exempt bonds on a private placement basis, rather than through the public sale process.

Due to the private nature of these transactions, public data on the number of private placement bond issues is difficult to obtain. However, industry estimates have put the volume of tax exempt private placements for 2013 at $21.4 billion, which is up 690% from 2010*.

2005 2006 2007 2008 2009 2010 2011 2012 20130

5,000,000,000

10,000,000,000

15,000,000,000

20,000,000,000

25,000,000,000

Tax Exempt Private Placements

* Source: Bond Buyer

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Private Placement Trends

Two Reasons for Increased Private Placement Issuance

1.) Since 2009, as Letters of Credit have become more expensive for Issuers of variable-rate debt - primarily due to bank downgrades and increased capital requirements for contingent liabilities, many banks and Issuers have moved towards direct lending as an attractive alternative.

2.) With commercial loan demand at an extended low point during the last several years, and with investment yields near zero, many Banks are considering tax exempt loans with municipal and 501(c)(3) organizations as an attractive way to generate income.

April-04

April-05

April-06

April-07

April-08

April-09

April-10

April-11

April-12

April-13

April-14

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

Commercial Loans Outstanding2004 to present

$ in

Bill

ions

Jun-94Jun-95

Jun-96Jun-97

Jun-98Jun-99

Jun-00Jun-01

Jun-02Jun-03

Jun-04Jun-05

Jun-06Jun-07

Jun-08Jun-09

Jun-10Jun-11

Jun-12Jun-13

Jun-140.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

3 Month Treasury Yields1994 - present

Source: BloombergSource: Federal Reserve Bank of St. Louis

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Private Placements

Advantages for Issuers

Less expensive and time consuming than a public sale No disclosure required other than what the Lender requests No Official Statement prepared No bond rating required Lower underwriting and legal fees

Greater flexibility with regard to structure and covenants to fit the needs of the individual borrower

Ability to lock in interest rates quickly and well in advance of when funds are needed Ability to utilize a draw note during construction to save interest expense for the

borrower Flexibility with regard to interest rate structure - including fixed, variable and re-setting

structures Greater flexibility with regard to prepayment provisions, financial covenants and

required reserves Monthly, quarterly, or semi-annual payment structures

Private Placements

Example Transactions

Bond Refunding for a Large 501(c)(3) Organization in Omaha Outstanding tax exempt bonds with a call date in September 2015 Client wanted to lock in an interest rate today to refund these bonds on their call date in

2015 without having to do an advance refunding UMB was able to lock in an attractive rate for the client along with savings of $1.3MM

Parking Garage Project for a Large City in Iowa City had a “AAA” rating with considerable experience issuing bonds in the public sale

market As part of a larger development project, the City agreed to purchase a parking garage from

the Developer upon completion of construction. The Developer wanted the City’s financing commitment in place prior to beginning

construction Through a private placement, we were able to finalize the financing structure with the City,

along with the method to be used to determine the interest rate 18 months into the future when the parking garage construction was completed.

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Private Placement

Typical Private Placement Terms

Types of Projects: New project financing, or refinancing of existing debt

Financing Size: $100K - $50MM

Financing Term: 1 – 15 years

Interest Rate: Fixed, Variable or Re-setting

Types of Security: Tax proceeds, Revenues, Mortgage, Guarantee Agreements or Lease Purchase financing

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Private Placement

Issuance Process

Issuer: For 501(c)(3) organizations, the issuance of tax exempt bonds involves a “conduit issuer” which is typically a political subdivision or municipal authority with the authorization under state statutes and the Internal Revenue Code to issue tax exempt bonds on behalf of 501(c)(3) organizations. As a conduit issuer, they have no liability for the repayment of the bonds, and typically assign over any rights or obligations they may have to a Trustee or the Lender.

Bond Counsel: A bond attorney will typically be engaged to draft the documents for the transaction, and give their opinion that the bonds have been validly issued under state statutes, and are tax exempt under the Internal Revenue Code.

Timetable: Depending upon the complexity of the transaction, the financing can usually be completed within 6 – 10 weeks

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JASON W. BOMBECK, CPA

Partner, BKD

Jason, a member of the BKD National Not-for-Profit Group, has more

than 17 years of public accounting experience, specializing in the trust and

estate and exempt organization areas. He oversees the Nebraska practice’s

tax services provided to foundations, membership and social service

organizations, as well as higher education institutions. Jason is also involved

with tax preparation and review, request for tax-exempt status, consultation

regarding sales and use tax issues, unrelated business income, excess benefit

transaction and use of charitable planning techniques in fundraising.

Tax Exempt Bonds

•Increased enforcement by IRS starting in 2012

•Targeted examinations based on information reported in Schedule K

•Increased correspondence audits

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Tax Exempt Bonds

Written post-issuance policies & procedures must be adopted prior to violation

Specify responsible officialDescription of training provided to such responsible officialFrequency of compliance checks (at least annually)Nature of compliance activitiesProcedures used to identify & elevate violationsProcedures for record retention

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Tax Exempt Bonds

Post-issuance compliance

Cost of issuance limitationReallocationDetermining amounts of private business useDisposals of bond-financed propertyArbitrageYield restriction requirementsRebate requirements

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Definition of Private Business Use

Use of property by any person other than governmental unit

Excludes use of financed property as member of general publicExcludes use by other 501(c)(3) organizations that is not unrelated trade or business useIncludes costs of issuance paid from proceeds

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Private Business Use Arrangements

OwnershipLeasesManagement contracts (Safe Harbors Rev. Proc. 97-13)Research agreementsUnrelated business income activities

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Tax Exempt Bonds

Post-issuance compliance

Have you adopted post-issuance policies?Who do you include on your tax-exempt bond team?Private business use calculations

Internal or externalSoftware utilization

Leases, management contracts

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IRS Form 990, Schedule K

IRS Form 990, Schedule K

Significant Sections on Schedule K

•Use of Proceeds•Private Business Use•Arbitrage

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Other Considerations

Forecast needed?

•Internal or external?

Debt service coverage

Covenants & definition

The information in BKD seminars is presented by BKD professionals, but applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor before acting on any matters covered in these seminars.

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THANK YOU

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