managers of the credit counseling organization, reportedly have siphoned off commercial profits of the exempt organization to the for-profit entity, and then been used to pay significant salaries and dividends to the for-profit's employees and owners. Many organizations have been charging consumers substantial fees for services, in some cases based on potential savings a consumer might derive from being placed on a debt management plan, with some initial advance fees equaling the entire first month's payment under the plan. Boards of directors often do not represent the communities the organizations are supposed to serve. The proposal's additional organizational and operational requirements are designed to address these reported areas of abuse and concern. The proposal subjects both types of exempt organizations (charitable or educational and social welfare) to many of the same requirements, but makes certain distinctions with respect to the fees that may be charged by each to lowincome persons, and the extent to which an organization may conduct debt management plan activities. More stringent requirements for charitable or educational organizations apply because such status generally has heightened standards when compared with social welfare organizations described in section 501(c)(4). The material aspects of the proposal are consistent with the legal and factual conclusions reached by the IRS in its legal memorandum released in July 2004.735 In that memorandum, the IRS concluded that many credit counseling organizations do not qualify for exemption under section 501(c)(3) because of operation for a substantial nonexempt purpose, substantial private benefit, and private inurement. The memorandum stated that the marketing of debt management plans is "by far the most substantial activity" of many organizations the IRS has reviewed. The proposal addresses debt management plans by imposing strict fee limits on the amount consumers may be charged for such services, and limiting the amount of such activities that may be conducted on an ongoing basis (i.e., no more than 10 percent of total activities if a charitable or educational organization, no more than 50 percent if a social welfare organization). The 10-percent limit applicable to charitable and educational organizations comports with the traditional levels of such activity before the dramatic growth in the industry. 736 Two areas discussed in the IRS memorandum are not explicitly addressed in the proposal. First, the memorandum concluded that if debt management plan activity of an organization is insubstantial, income from such activities should be examined on a case by case basis to determine whether such income should be taxed as unrelated business income. The proposal does not modify the treatment of debt management plan income as unrelated business income, and relies on present law to determine whether an organization's income from such activities should be taxed. Thus, under the proposal, an organization that conducts its debt management 735 736 Credit Counseling Agencies, ILM 200431023 (July 13, 2004). For all such organizations, the proposal prohibits charging any fee based in whole or in part on a percentage of the consumer's debt, the consumer's payments to be made pursuant to a debt management plan, or on projected or actual savings to the consumer resulting from enrolling in a debt management plan. For an organization described in section 501(c)(3), no more than nominal fees may be charged for such services if provided to low-income persons. In all cases, debt management service fees must be waived if they would work a financial hardship. activities in accordance with the proposed requirements could be subject to the unrelated business income tax on none, some or all of its income (if any) derived from such activities, depending upon its facts and circumstances. Second, the IRS noted that service arrangements between a credit counseling organization and unrelated organizations could raise private benefit issues. The proposal addresses related party service arrangements by prohibiting them, but does not explicitly limit or prohibit such arrangements with unrelated service providers. Although service arrangements with unrelated providers may raise private benefit issues, the proposal relies upon the generally applicable private benefit doctrine to address such arrangements.737 Similar unrelated business income tax and private benefit concerns exist throughout the exempt organization sector, and arguably any reforms in these two areas should be applied more broadly across the exempt sector. The proposal attempts to address those areas that have contributed to the erosion of exemption standards in the credit counseling industry. Some might argue that the proposal unfairly targets a particular industry, and that the exempt status rules for credit counseling organizations should be the same as for other types of exempt organizations. However, the Code contains various special exemption standards for a particular type of industry or organization. For example, the Code provides special exemption standards for cooperative hospital service organizations (sec. 501(e)), cooperative service organizations of operating educational organizations (sec. 501(f)), certain amateur sports organizations (sec. 501(j)), certain child care organizations (sec. 501(k)), and charitable risk pools (sec. 501(n)), in order to be treated as a charitable organization described in section 501(c)(3). Further, some might argue that imposing supplemental exemption standards on the credit counseling industry is appropriate where, as is the case here: (1) the nontax regulation of an entire industry is dependent upon whether the organization is exempt as a charitable or exempt organization; (2) systematic abuses have been reported by Congress and the IRS with respect to much of the industry; and (3) prior attempts by the IRS to prevent erosion of traditional exempt standards were rejected by the courts. 737 If it is determined that additional requirements should be put in place for service arrangements with unrelated providers, perhaps principles similar to those employed in the management contract rules used to determine private use of tax-exempt bond financed facilities could be employed. Rev. Proc. 97-13, 1997-1 C.B. 632, as modified by Rev. Proc. 2001-39, 2001-2 C.B. 38 (addressing types of fee arrangements and other contractual terms that may be used in such management services arrangements without violating the private use requirement). IX. TAX-EXEMPT BOND PROVISIONS A. Impose Loan and Redemption Requirements on Pooled Financing Bonds (sec. 149) Present Law In general 738 Το Section 103 generally provides that gross income does not include interest received on State or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the State or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). qualify for the tax exemption, the Code imposes requirements that apply to all State and local bonds. Arbitrage restrictions, for example, limit the ability of issuers to profit from investment of tax-exempt bond proceeds. In addition, the exclusion from income for State and local bonds does not apply to private activity bonds, unless the bonds are issued for certain permitted purposes. The Code also imposes requirements that only apply to specific types of bond issues. For instance, pooled financing bonds (defined below) are not tax-exempt unless the issuer meets certain requirements regarding the expected use of proceeds. Pooled financing bond restrictions At times, State or local bonds are issued to provide financing for the benefit of a third party (a “conduit borrower"). Pooled financing bonds are issues in which the proceeds are used to make or finance loans to two or more conduit borrowers, unless the conduit loans are to be used to finance a single project.740 The Code imposes several requirements on pooled financing bonds if more than $5 million of proceeds are expected to be used to make loans to conduit borrowers. For purposes of these rules, a pooled financing bond does not include certain private activity bonds. 741 A pooled financing bond is not tax-exempt unless the issuer reasonably expects that at least 95 percent of the net proceeds will be lent to ultimate borrowers by the end of the third year after the date of issue. The term "net proceeds" is defined to mean the proceeds of the issue less the following amounts: (1) proceeds used to finance issuance costs; (2) proceeds necessary to pay interest on the bonds during a three-year period; and (3) amounts in reasonably required reserves. 742 An increase in interest rates or anticipated changes in Federal income tax laws may not be used as a basis for the issuer's reasonable expectations regarding the lending of proceeds to borrowers. Moreover, the legislative history to the pooled financing provision states the "investment of bond proceeds in guaranteed investment contracts which do not permit significant draw downs to originate loans during the three-year period will be prima facie evidence that the reasonable expectations test is not satisfied."743 An issuer's past experience regarding loan origination is a criterion upon which the reasonableness of the issuer's expectations can be based. As an additional requirement for tax exemption, all legal and underwriting costs associated with the issuance of pooled financing bonds may not be contingent and must be substantially paid within 180 days of the date of issuance. Arbitrage restrictions on tax-exempt bonds 744 To prevent the issuance of more Federally subsidized tax-exempt bonds than necessary; the tax exemption for State and local bonds does not apply to any arbitrage bond. An arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire higher yielding investments or to replace funds that are used to acquire higher yielding investments. In general, arbitrage profits may be earned only during specified periods (e.g., defined "temporary periods") before funds are needed for the purpose of the borrowing or on specified types of investments (e.g., "reasonably required reserve or replacement funds"). Subject to limited exceptions, investment profits that are earned during these periods or on such investments must be rebated to the Federal Government ("arbitrage rebate"). The Code contains several exceptions to the arbitrage rebate requirement, including an exception for bonds issued by small governments (the "small issuer exception"). For this purpose, small governments are defined as general purpose governmental units that issue no more than $5 million of tax-exempt governmental bonds in a calendar year. 745 Pooled financing bonds are subject to the arbitrage restrictions that apply to all taxexempt bonds, including arbitrage rebate. Under certain circumstances, however, small governments may issue pooled financing bonds without those bonds counting towards the determination of whether the issuer qualifies for the small issuer exception to arbitrage rebate. In the case of a pooled financing bond where the ultimate borrowers are governmental units with general taxing powers not subordinate to the issuer of the pooled bond, the pooled bond does not 745 The $5 million limit is increased to $15 million if at least $10 million of the bonds are used to finance public schools. 746 count against the issuer's $5 million limitation, provided the issuer is not a borrower from the pooled bond. However, the issuer of the pooled financing bond remains subject to the arbitrage rebate requirement for unloaned proceeds. 747 Reasons for Change 748 A number of pooled financing bonds have been issued recently under which few or no loans were made to conduit borrowers from bond proceeds. A common feature of these transactions is the use of non-binding demand surveys that fail to adequately identify potential borrowers or evaluate current financing needs. Many of these transactions involve large issuances by small local governments that receive a fee to act as the issuer of the pooled financing. Because these local governments do not borrow proceeds from the pool, present law permits them to issue pooled financing bonds without those bonds counting towards the determination of whether they qualify for the small issuer exception to arbitrage rebate. These transactions result in greater issuance of tax-exempt bonds than necessary to finance current governmental activities, diminishing the utility and value of the tax subsidy. Description of Proposal In general The proposal imposes new requirements on pooled financing bonds as a condition of taxexemption. First, the proposal imposes a written loan commitment requirement to restrict the issuance of pooled bonds where potential borrowers have not been identified ("blind pools"). Second, in addition to the current three-year expectations requirement, the issuer must reasonably expect that at least 50 percent of the net proceeds of the pooled bond will be lent to borrowers one year after the date of issue. Third, the proposal requires the redemption of outstanding bonds with proceeds that are not loaned to borrowers within the expected loan origination periods. Finally, the proposal eliminates the rule allowing an issuer of pooled financing bonds to disregard the pooled bonds for purposes of determining whether the issuer qualifies for the small issuer exception to rebate. Borrower identification Under the proposal, interest on a pooled financing bond is tax exempt only if the issuer obtains written commitments with ultimate borrowers for loans equal to at least 50 percent of the net proceeds of the pooled bond prior to issuance. For purposes of the proposal, a loan commitment exists only if: (a) the issuer is committed to lend bond proceeds to the borrower identified in the commitment, and (b) the borrower has applied for, and agreed to execute, a loan in an amount certain to finance a specifically identified project and, as part of that application, 746 Sec. 148(f)(4)(D)(ii)(II). 747 748 Treas. Reg. sec. 1.148-8(d)(1). See Susanna Duff Barnett, "Tax Enforcement: Florida Health Agency Settles Over Pooled Bond Issues," The Bond Buyer, (October 26, 2004), at 5. |