United States: Tax-Exempt Financing For Tax-Exempt Organizations: Is Your Organization Eligible? Would The Benefits Outweigh The Costs?

Last Updated: June 25 2013
Article by Walter R. Calvert and Davis Sherman

Organizations qualified 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.  If your organization is considering incurring debt, this article can assist in your evaluation of 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 exempt organization.  Typically, the issuer of the debt is a state or local government entity (known as the "Issuer") where the exempt organization 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 your organization.  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 borrower (together with any parties that will guarantee or otherwise lend support to the borrower), what assets that borrower has available to pledge as collateral for the debt, 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 a 501(c)(3) conduit borrower 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 for the benefit of your lenders, but these will generally be the same whether the debt is tax-exempt or taxable.

Financing Structure

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 borrower, and are typically accompanied by legal opinions as to accuracy and compliance with securities laws.  Drafting the portions of the Official Statement describing the borrower and its operations and finances is particularly time-intensive for the borrower'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 borrower, and the transaction.

Credit Enhancements

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.  Borrowers 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 borrower's financial advisor.

The Typical Process

Most borrowers 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.  However, before taking any action in connection with a tax-exempt financing, the borrower's finance personnel should obtain preliminary approval from the organization's board of directors or trustees, the finance committee of such a board, or other body or officer with authority to initiate a borrowing on behalf of the organization.  Federal income tax law generally requires that the borrower 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 borrowers incur significant project costs well ahead of closing on their financing and reimburse themselves from bond proceeds at closing.  Accordingly, as soon as the borrower 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.

After completing its internal approval processes, a borrower's next step is to identify and make application to the appropriate conduit issuer.  Often, borrowers 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 borrower's counsel is usually best situated to advise the borrower on the choice of issuer.

At this stage, the borrower 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 borrower's counsel in the basic negotiation of terms.  The issuer chosen by the borrower 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 borrower 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 borrower.  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 borrower.  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 borrower will retain its own legal counsel ("borrower's counsel").  The borrower'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, then borrower's counsel will need competency in these areas as well.
Frequently, the borrower 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 borrower.  This is why many borrowers retain their own financial advisor, whose compensation does not depend on effectuating the transaction.  If interest rate swaps or hedges will be used, the borrower 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 borrower'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 borrower'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 borrower's accountant may assist the borrower with tax-related calculations and certifications necessary to support the borrower'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 borrower's counsel for an opinion as to the borrower'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 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 borrower will be the portion of the Official Statement (typically titled as "Appendix A") describing the borrower, its purposes, and its financial condition in detail, so as to give the potential lenders the facts necessary to evaluate the ability of the borrower 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 borrower, the funding will occur such that net bond proceeds after payment of issuance costs are available for the use of the borrower.

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 borrower and its 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.  Alternatively, the financed assets may be held by a wholly owned limited liability company or other entity which is "disregarded" as an entity separate from its sole member for federal income tax purposes (in other words, for federal income tax purposes, the two entities are viewed as one - the sole member).  At least 95% of the financed property must be used by the borrower 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, and the retention of private managers to operate food service facilities, gift shops, bookstores, or the like.  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.

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 borrower 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.  Many borrowers 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.

Post-Issuance Compliance

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 borrower 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 borrowers may have staff members 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) organizations 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 borrower's regular banking relationship manager or a professional dedicated to advising in this area, can be invaluable in assisting with this evaluation.  The borrower'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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.