New Schedule K. 501(c)(3) organizations benefiting from tax-exempt bond financing are subject to a new requirement to make annual filings with the Internal Revenue Service ("IRS") demonstrating post-issuance compliance with the tax exempt bond rules. The organizations must provide detailed information on outstanding tax-exempt bond issues in a new Schedule K to IRS Form 990, Return of Organization Exempt from Income Tax. The IRS released the 2008 Form 990, including the new Schedule K, on December 20, 2007, after fi rst proposing it in June 2007 and making substantial revisions responding to extensive written comments. See: www.irs.gov/charities/index.html. For 2008 tax years, Schedule K will require only basic identifying information for each tax exempt bond issue issued after 2002 (Part I). Beginning with 2009 tax years, Schedule K will require additional detailed information on expenditure of proceeds (Part II), ongoing compliance with the private business use limits (Part III), and ongoing compliance with the arbitrage rules (Part IV). The delayed effective date will give the organizations a brief period of time in which to develop the basis for a positive response to specific questions regarding maintenance of records and engagement of counsel to assist in evaluating compliance with the requirements.

Upon releasing the new Schedule K, the IRS announced awareness of significant noncompliance with record keeping and record retention requirements relating to tax-exempt bonds for 501(c)(3) organizations, making it difficult for the IRS to determine whether the bonds remain tax-exempt throughout their life, and the IRS expressed concern about investment of the bond proceeds in ways that might circumvent the existing arbitrage rebate requirements. The new Schedule K addresses these concerns.

Part I – Bond Issues. 501(c)(3) organizations will identify their outstanding post-2002 tax-exempt bond issues in Part I of Schedule K, beginning with 2008 tax years. The organizations should begin considering how they will respond to the more detailed questions in Parts II, III and IV, which are printed in the 2008 Schedule K and will become mandatory beginning with 2009 tax years. The following paragraphs comment on selected questions in Parts II, III and IV.

Part II – Proceeds. In Part II of Schedule K, 501(c)(3) organizations will report, for each post-2002 tax-exempt bond issue, the specific dollar amounts representing the total proceeds of the issue, gross proceeds in reserve funds, proceeds in refunding or defeasance escrows, issuance costs paid from proceeds, working capital expenditures paid from proceeds, and capital expenditures paid from proceeds. This reported information by itself could signal noncompliance with the tax-exempt bond rules or a need for compliance with special rules that typically do not come into play. For example, if the amount of gross proceeds in reserve funds exceeds 10 percent of the issue price (reported in Part I), there could be noncompliance with the arbitrage rules or a need for compliance with special yield restriction or yield reduction payment requirements. If the issuance costs paid from proceeds exceed 2 percent of the issue price, the bond issue will appear to violate the limit on financed issuance costs. If working capital expenditures exceed 5 percent of the issue price, special last-out accounting requirements for the expenditure of the proceeds may be applicable.

Part II also asks whether there has been a final allocation of the proceeds. In many cases, bond proceeds and other funds are used to pay the total costs of a project, and it may be important from a tax compliance perspective which sources relate to which uses. For example, the total project may include private business use areas that are not eligible for tax-exempt bond financing such as private physician practice suites in a hospital-owned medical office building, or the organization may wish to treat the bond proceeds as expended prior to the other funds in order to qualify the bond issue for a spending exception from the arbitrage rebate requirements. Reasonable allocations to relate the bond proceeds on a consistent basis to eligible and timely expenditures are permitted, but generally only within a time period ending 18 months after the project is placed in service (or an expenditure is paid, if later). Accordingly, an organization's response in Part II should indicate that a final allocation of proceeds has been made, except in the case of newer bond issues. Part II asks further whether the organization maintains adequate books and records to support the final allocation of proceeds. Organizations should review their record keeping procedures and be prepared to answer this question affirmatively when Part II becomes mandatory.

Part III – Private Business Use. Part III asks, with respect to each outstanding post-2002 tax-exempt bond issue, whether the organization is a partner in a partnership or a member of a limited liability company ("LLC") owning property financed by the bond issue. The IRS has ruled privately on several occasions that particular partnerships and LLC's having only 501(c)(3) organizations as partners or members may be treated as "aggregates," and not as "entities," with the result that requirements for use and ownership of bond-financed property only by 501(c)(3) organizations remain satisfied. Bond counsel will generally have approved any such structures existing when the bonds are issued. However, any postissuance reorganizations could raise questions regarding ongoing compliance with the tax-exempt bond rules and should be discussed in advance with bond counsel. Part III asks further whether there are any lease arrangements, management or service contracts or research agreements that may result in private business use of bond-financed facilities. Any affirmative answer to these questions will signal possible noncompliance with the private business use limit, unless the amount of such use is de minimis as described below. In order to avoid private business use treatment, a management or service contract that delegates performance of functions of a facility, e.g., a contract for operation of a hospital's emergency department by a professional corporation comprised of physician specialists, must generally meet safe harbor requirements specified in Rev. Proc. 97-13, as amended, and a contract for sponsorship of research in a bond-fi nanced laboratory by private business or by the federal government must generally meet safe harbor requirements specified in Rev. Proc. 2007-47. In many cases, bond-financed facilities include private business use areas that do not qualify under those safe harbors, but the bond proceeds finance only a portion of the total cost and are allocated away from those private business use areas as described above, making a negative response to this question in Part III appropriate.

Part III requires, for each post-2002 tax-exempt bond issue, reporting of (i) the percentage of private business use of bond-financed property, (ii) the percentage of bond-financed property used by the organization itself in an unrelated trade or business activity, and (iii) the total of such use percentages under (i) and (ii). Any total exceeding 5 percent will signal likely noncompliance with the 5 percent de minimis limit for tax-exempt qualified 501(c)(3) bonds. The private activity bond regulations permit calculation of these percentages on the basis of averaging over a "measurement period" based on the final maturity date of the bond issue and the reasonably expected economic life of the facility. Instructions for Schedule K that are expected to be released in early 2008 may clarify whether that calculation, as a opposed to a "snapshot" of private business use and unrelated trade or business use in the reporting year, may be used for Schedule K. Uses of proceeds for payment of bond issuance costs, as reported under Part II, are treated by the IRS as private business use, and so they count against and reduce the otherwise available 5 percent limit. Organizations should note that unrelated trade or business activity by the organization may exist (a) regardless of any private business use by a third party and (b) regardless of any required recognition of unrelated business taxable income. For example, if a college regularly leases its auditorium for non-college events, bond proceeds used to provide the auditorium may count against the 5 percent limit even if no lessee ever uses the auditorium for any private business, and even if general tax rules may permit the college to exclude the lease income from its unrelated business taxable income absent debt financing.

Part III also asks (i) whether the organization routinely engages bond counsel or other outside counsel to review any management or service contracts or research agreements relating to the financed property and (ii) whether the organization has adopted management practices and procedures to ensure the post-issuance compliance of its tax-exempt bond liabilities. Organizations should evaluate their current practices and be prepared to answer these questions affirmatively when Part III becomes mandatory.

Part IV – Arbitrage. Part IV asks, separately for each post- 2002 tax-exempt bond issue, whether Form 8038-T has been filed, and whether the bond issue qualified for an exception from the arbitrage rebate requirements. Form 8038-T reports arbitrage rebate and yield reduction payments, which come due every 5 years and upon retirement of the bond issue. However, filing of Form 8038-T is not required if there is no accrued rebatable arbitrage or yield reduction payment liability. Certain 6-month, 18-month and 2-year spending exceptions relating primarily to the sale and investment proceeds of the bond issue provide relief in many cases from a payment requirement with respect to accrued rebatable arbitrage, but a payment and filing of Form 8038-T may be required even if the conditions of a spending exception have been met, e.g., with respect to arbitrage on a debt service reserve fund or deposits into a sinking fund other than a "bona fide debt service fund." Organizations should evaluate their arbitrage rebate and yield reduction payment liability at least every five years, even if the bond issue initially met the requirements of a spending exception.

Part IV also asks whether the organization or the governmental issuer of the bonds has identified a "hedge," e.g., an interest rate swap, with respect to the bond issue on its books and records. The current arbitrage regulations require timely identification, specifically by the governmental issuer, as one condition for "integration" of the hedge with the bond issue, such that the arbitrage yield limit is calculated taking into account both the bond payments and the hedge payments. By also asking whether the organization has identified a hedge, Part IV will help to identify cases in which the organization prefers not to treat a hedge as "integrated" with the bond issue, e.g., certain constant maturity swaps or fixed-to-variable swaps. The IRS retains authority to force "integration" (or vice versa) in appropriate cases.

Finally, Part IV requires, separately for each post-2002 tax exempt bond issue, identification of any guaranteed investment contract ("GIC") for the gross proceeds, including the name of the provider and the term of the GIC, and it asks whether the requirements of the regulatory safe harbor for establishing the fair market value of the GIC were satisfied. The IRS has long regarded GIC's as providing a particular opportunity for diversion of rebatable arbitrage to the GIC providers through price manipulations. Accordingly, the arbitrage regulations contain detailed requirements for competitive bidding of any GIC for gross proceeds of a tax-exempt bond issue, and organizations should consult with counsel regarding compliance with those requirements for any such GIC obtained either upon or after issuance of the bonds.

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.