In 2005 the U.S. Internal Revenue Service (IRS) announced that it planned to audit qualified 501(c)(3) bonds issued about 10 years ago to measure compliance with ongoing requirements for use of proceeds. The IRS has now provided more details of the planned audit program. Beginning August 2006, the IRS will notify the issuers of between 20 and 30 qualified 501(c)(3) bond issues that their issues are under audit. The IRS will select from among those issued between May 1997 and the end of 1998. Two-thirds of the audits are expected to be hospital bonds, while the remainder are expected to be for economic development and 501(c)(3) housing projects.
We provide a detailed description of the requirements for use of qualified 501(c)(3) bond proceeds, the IRS bond audit and voluntary correction programs, and the steps that should be taken in an internal compliance review.
Section 501(c)(3) organizations with bonds issued between May 1997 and the end of 1998 should review those bond issues and usage records. These records should detail the use to which bond proceeds were originally put and demonstrate the proceeds (the bond-financed property) have been used appropriately since issuance. The IRS previously stated its plans to notify affected issuers of the audits around June 30 but in May delayed this notice for at least a month. The delay allows potentially affected organizations to review their bonds, identify any existing problems and bring problems to the IRS to initiate a voluntary correction action under the Tax-Exempt Bond Voluntary Compliance Program (VCAP) if necessary. The VCAP is not available once an issuer is notified that its bonds have been selected for audit. Section 501(c)(3) organizations should make sure their issuers are "up to speed" on this initiative.
The audit initiative will address record-keeping and accounting procedures, as well as a review of actual use (including any change in use from what was originally intended).
Record-keeping has long been an IRS concern. The IRS has indicated that it has been fairly forgiving of record-keeping deficiencies encountered during bond audits, but it will be less forgiving now that the need for records has been established. In fact, the IRS will audit bonds issued after May 1997 specifically because final regulations requiring lifelong measurement of the use of bond proceeds became effective in that month, making the need for long-term record-keeping evident. To further educate borrowers, in January 2004 the IRS published a list of FAQs on record retention requirements for tax-exempt bonds.
We can expect that during the audits the IRS will address such topics related to record-keeping as:
Are all bond proceeds properly accounted for?
Are lump-sum construction contract payments from the construction fund correctly traced to specific assets?
Is spending on common elements properly allocated?
Were the assets on which proceeds were spent covered by the initial public approval?
Was there a material change in actual spending from the planned spending on assets that was used to determine the maximum allowable weighted average maturity of the bonds?
The topics relating to post-issuance "actual use" involve evaluation of legal compliance issues associated with leases and contracts relating to bond-financed property. This includes compliance with the safe harbors set forth in revenue procedures 97-13 and 97-14 for "management" contracts and sponsored research. An additional aspect of actual use is documentation of compliance with the remedial action rules if the tax-exempt organization sells assets originally purchased with bond proceeds.
Of course, demonstrating post-issuance compliance also depends on adequate records of how property has been used since it was first placed in service. Demonstrating compliance with contract safe harbors depends on being able to produce all contracts in effect any time during the period since the property was first placed in service. Demonstrating compliance with rules for disposition of bond-financed property depends on knowing which property was actually acquired with bond proceeds and checking that information whenever there is a disposition of property.
Most tax-exempt hospitals and other tax-exempt organizations have qualified 501(c)(3) bonds outstanding, and the risk associated with non-compliance with private use rules could be significant. Even though section 501(c)(3) organizations that do not have bonds issued between May 1997 and the end of 1998 will not be targeted in the initial round of audits, these organizations should consider a focused review of outstanding tax-exempt bonds to prepare for future audits. Section 501(c)(3) organizations with bonds issued during the prescribed period should check all outstanding issues to see if they should apply for a VCAP request. An audit initially focused on bonds issued in the period could be expanded if the IRS finds systematic problems like weak record-keeping or post-issuance compliance monitoring that could affect all of the organization’s bonds.