Limit the Potential for a Tax-Exempt Bond Audit
By Brenda Booth
Nonprofits with outstanding tax-exempt bond issues need to pay careful attention to completing the information they provide with their Form 990 tax return, as the Internal Revenue Service may use that information to decide whether to conduct an audit.
All 501(c)(3) organizations with outstanding tax-exempt bond issues with outstanding principal greater than $100,000 as of the last day of the tax year and issued after December 31, 2002, must file Schedule K annually as part of their IRS Form 990.
Schedule K requires organizations to provide detailed information on their outstanding tax-exempt debt, including specific data on:
- Qualified use of proceeds and financed property.
- The amount of private business use and unrelated trade or business use of bond-financed property.
- Management practices and procedures to ensure post-issuance compliance with bond rules.
- Arbitrage issues, including whether the issuer entered into a qualified hedge with respect to the bond issue.
Guidance from an outside tax expert is prudent, even necessary, to enable nonprofits to properly complete Schedule K because the requested information is complex and certain detail is required. Providing inaccurate responses could expose an organization to a bond audit, which could ultimately mean paying an IRS settlement to maintain tax-exempt status.
The IRS Tax Exempt Bonds division (TEB) performs approximately 100 bond audits annually, focusing on a distinct market sector each year.
For the fiscal year that began October 1, 2012 TEB is focusing most closely on nonprofit hospitals and aims to conduct 30 to 40 audits of such organizations. In 2013, TEB has indicated that it may focus on universities and research centers. Of course, that doesnt mean organizations beyond these market segments are out of the IRS crosshairs as any nonprofit with tax-exempt debt outstanding is still a potential target.
According to TEB, post-issuance compliance has emerged as one of the biggest problems in these examinations. These tax-advantaged bonds (tax-exempt, tax credit, and direct pay) are bonds that receive preferential tax treatment. Issued by or on behalf of state and local governments, such bonds are subject to applicable federal tax requirements both at the time of issuance and as long as the bonds remain outstanding. An issuer or other partys failure to comply with any applicable federal tax requirement with respect to tax-advantaged bonds jeopardizes the preferential tax status of those bonds.
That means issuers are obliged to actively monitor compliance throughout the entire period their bonds remain outstanding. This due diligence improves the issuers ability to identify non-compliance and prevent violationsor quickly correct identified violations (when prevention is not possible)to ensure the continued tax-advantaged status of the bonds.
According to the IRS, issuers should adopt written procedures, applicable to all bond issues, which go beyond reliance on tax certificates included in bond documents provided at closing. Establishing and following these written procedures helps issuers identify and resolve noncompliance on a timely basis in order to preserve the preferential status of tax-advantaged bonds. Usually, issuers that have established and followed comprehensive written procedures to promote post-issuance compliance are less likely to violate the federal tax requirements related to their bonds.
To ensure compliance throughout the life of the bond, written procedures should contain provisions for:
- Completing due diligence reviews at regular intervals
- Identifying the official or employee responsible for review
- Training the responsible official/employee
- Retaining adequate records to substantiate compliance
- Establishing procedures reasonably expected to identify noncompliance in a timely manner
- Creating procedures that ensure the issuer will correct noncompliance in a timely manner
To help promote post-issuance compliance, TEB administers a Voluntary Closing Agreement Program (VCAP) to assist issuers in resolving federal tax violations related to their bonds. An issuer is likely to receive more favorable resolution terms under TEB VCAP than it would for tax violations discovered during a bond audit.
In addition, an issuer that identifies a violation in accordance with the implementation of its written post-issuance compliance procedures is likely to receive more favorable treatment in resolving its tax violation under TEB VCAP than if the issuer has not implemented such procedures.
Brenda is a manager in the Not-For-Profit & Education Practice at CBIZ Tofias. Contact her at 617-761-0729 or BBooth@cbiztofias.com.