Tax-Exempt Bonds: What Your Organization Should Know About the Latest Compliance Initiatives

If your city is raising capital through municipal bonds, it’s not alone. Many local governments across Minnesota have issued bonds to fund infrastructure projects and more. As you likely know, interest paid to the holders of these bonds is exempt from federal income tax. However, this is true only if the issuer complies with both the yield restriction and rebate requirements of the Internal Revenue Code and Treasury Regulations.

With so much on the line, it’s important to stay up to date. Here’s what you should know about the latest compliance initiatives in this area.

Quarterly instead of annual updates

Each fall, the Tax-Exempt and Government Entities (TE/GE) branch of the Internal Revenue Service publishes a Program Letter that identifies initiatives to be used throughout the upcoming fiscal year. The purpose of this letter is to encourage and enforce compliance.

In the past, the TE/GE Program Letter was issued shortly before the start of the calendar year and was left unchanged for the next 12 months. Now, per the FY 2021 Program Letter, the TE/GE will share information regarding program initiatives and findings on a quarterly basis on the IRS website. (I’ve included the link to the web page at the end of this article.)

The recently updated web page lists several initiatives to be used by TE/GE to gauge issuers’ tax compliance. Among the initiatives cited are focused examinations of tax-exempt bonds to determine compliance with the yield restriction requirements.

Yield restriction compliance

Under the yield restriction requirements, issuers are permitted to invest proceeds from a tax-exempt bond issue at an unrestricted yield for a temporary period of time. The temporary period for proceeds used to finance capital projects is three years (in some instances it can be five years) if certain criteria are met. Failure to properly restrict the yield on investments after the temporary period can result in severe consequences—such as interest paid to bondholders being deemed taxable.

Helpful tips for avoiding yield restriction violations:

1. Time the issuance of tax-exempt bonds as close as possible to capital project expenditures.

2. Maintain a detailed accounting of tax-exempt proceeds used to finance capital projects. The accounting should reflect the initial receipt of bond proceeds, interest earned from investments purchased with bond proceeds, and capital expenditures financed by both.

3. Maintain a detailed accounting of investments purchased with bond proceeds.

4. Review the aforementioned accounting throughout the temporary period to ensure that bond proceeds, as well as interest thereon, are spent on capital expenditures prior to the expiration of the temporary period.

5. Document delays in construction and project expenditures. Rectify delays as soon as possible.

6. Have a plan to monitor yield restriction responsibilities in advance of issuing tax-exempt private activity bonds through conduit arrangements.

7. Seek advice from an arbitrage compliance expert as needed.

Additional compliance initiatives

Other compliance areas receiving heightened attention by TE/GE involve student loan bonds, public safety bonds, sinking funds, and variable rate bonds. TE/GE will execute strategies to determine if the Internal Revenue Code Section 144(b) requirements for student loan bonds have been satisfied.

Additionally, TE/GE will continue to pursue initiatives outlined in the FY 2020 Program Letter, including examinations of public safety bonds for private use concerns, over-funded sinking funds that impact the qualification of tax credit bonds, and the computation of rebate and yield reduction liabilities in connection with variable rate bonds.

Is your organization in compliance?

If you have questions about these latest updates or are unsure if your organization is in compliance, we can help. Contact us today.

Quarterly updates to the TE/GE Compliance Program and Priorities will be published here: https://www.irs.gov/government-entities/tax-exempt-government-entities-compliance-program-and-priorities 

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