Earlier this summer, the Internal Revenue Service (IRS) tax-exempt bond office announced that it would check the post-issuance tax compliance practices of many tax-exempt charitable organizations with outstanding tax-exempt bonds. On August 21, 2007, the bond office announced a joint initiative with the IRS Exempt Organization Compliance Area (EOCA) and published the five-page Tax-Exempt Bond Financings Compliance Check Questionnaire, Form 13907, regarding the post-issuance tax compliance practices of tax-exempt organizations. The questionnaire will be sent to more than 200 tax-exempt organizations. The initiative and the questionnaire continue a trend of increased IRS scrutiny of tax-exempt bond post-issuance compliance, focusing particularly on record retention practices pertaining to such bond issues. The questionnaire indicates what information a tax-exempt organization should keep and be able to show to the IRS upon an examination of a tax-exempt bond financing.
The current compliance check is part of the second stage of the IRS compliance program for Section 501(c)(3) tax-exempt bond issues that began in August 2006. The first stage of that program was an audit of bond issues of 20 to 30 Section 501(c)(3) organizations. The IRS recently has indicated that it has found a significant pattern in its examinations, in which issuers and conduit borrowers are unable to produce adequate records to establish compliance with applicable requirements. Records to be retained include not only the legal documents from the bond issue, but also records of the initial and continuing investment of bond proceeds and use of the bond-financed assets.
The IRS states that it intends to use the current compliance check to measure several aspects of post-issuance tax compliance knowledge and practices, including record retention requirements, requirements for qualified use of bond-financed property, arbitrage yield restriction and rebate requirements, debt management policies and procedures, and awareness of voluntary compliance and educational resources. Unlike the 2006 audits, which focused on bonds issued between 1997 and 1998, the compliance check may include any charity that shows a tax-exempt bond balance on its 2005 Form 990. The IRS will use the information obtained from the compliance check to create and publish a report of its findings and recommendations for follow-up outreach or compliance initiatives. Earlier comments from IRS officials also indicated that the information collected will be used to determine whether follow-up examinations are necessary, and if so, what areas of significant noncompliance will be the focus of the examinations. Although the IRS is careful to explain that the current compliance check is different from an examination, it notes that it could determine, during or following a compliance check, that an examination is appropriate.
The compliance check questionnaire is divided into five sections, each focusing on a different aspect of post-issuance tax compliance, and particularly on record retention practices related to that area of compliance. Most questions are in yes/no or multiple choice format, although a few require written responses to specific requests.
Part I of the questionnaire asks general questions regarding the organization’s current tax-exempt status; its written procedures and guidelines intended to assure post-issuance tax compliance; the party who is primarily responsible for post-issuance tax compliance; and its written procedures and guidelines for situations in which more than one individual is tasked with post-issuance records retention. An example of the latter situation would be "management agreements" that are executed and retained in various departments. Part I requests a brief description of written procedures or guidelines, which should include, at least for more recent financings, a pre-issuance tax compliance or tax regulatory agreement or certificate. It also includes questions regarding training of compliance personnel and awareness of voluntary compliance options.
Part II focuses on general record-keeping, including record-keeping duration, medium of record-keeping, and a list of 17 specific records that should be maintained if applicable. Part III focuses on documentation for investments, and procedures and documents to assure arbitrage compliance. Part IV focuses on documentation of the bond-financed project and the allocation of bond proceeds to expenditures (including reimbursements) and continuing documentation of bond-financed assets transactions involving those assets. Part V focuses on private business use, both unrelated trade or business use and third party private use. It includes questions on entering into and maintaining copies of various types of agreements that could result in private use. The final question asks generally how the organization ensures that its bonds remain tax-exempt after issuance—an answer suggesting serious weakness presumably will cause a compliance check quickly to become an examination.
Section 501(c)(3) organizations with outstanding bond issues should review the compliance check questionnaire and be prepared to respond thoroughly and accurately to the IRS if selected for the compliance check. To prepare, organizations first should review their internal practices and then, if necessary, coordinate with the bond issuer and any other involved party to review record retention policies and practices. Even if an organization is not selected for the compliance check, preparing responses to the questionnaire may indicate areas of weakness and ideas for improvement, in order to ensure post-issuance tax compliance. A review of the questionnaire also might reveal actual post-issuance noncompliance that should be addressed before they are found in an IRS examination or in due diligence for a future bond financing.
In preparation for the compliance check, organizations with outstanding bond issues may wish to review prior IRS guidance regarding post-issuance record retention practices. In 2004, the IRS published a list of frequently asked questions (FAQs) intended to educate borrowers on appropriate record retention. The FAQs are available and reference specific provisions of the Internal Revenue Code and Treasury Regulations governing record retention. Every organization with outstanding bonds issues should note the following points, which are discussed in greater detail in the FAQs:
- Bond issuers, conduit borrowers and other parties to the bond issue (e.g., certain lessors) may be responsible for maintaining records related to the bond issue.
- At a minimum, record retention should satisfy applicable law and the documents governing the bond issue. It is important to note that the minimum legal documentation requirements may vary depending on the type of bond issue.
- Records pertaining to a bond issue must be maintained so long as the records are material.
- If the IRS determines that a bond issue is not compliant because appropriate records have not been maintained, there may be significant negative consequences.
- It may be possible to correct a failure with respect to a bond issue, including a record retention failure, through the Tax Exempt Bonds Voluntary Closing Agreement Program (TEB VCAP).
Organizations also may wish to review the Post Issuance Compliance Checklist recently submitted to the U.S. Treasury and the IRS jointly by the National Association of Bond Lawyers and the Government Finance Officers Association. This checklist addresses tax, securities and state law matters that will or may require post-issuance compliance actions.
In summary, the IRS intends to check the post-issuance compliance practices of more than 200 tax-exempt organizations that reported open bond issues on their 2005 Form 990, and will focus particularly on record retention practices of those organizations. Although the initial intent of the compliance check is to gather information and identify trends in record retention and compliance, the information gathered from the compliance checks may later be used for examination purposes. Tax-exempt hospitals, universities and other organizations who reported outstanding qualified 501(c)(3) bonds in 2005 should review the compliance check questionnaire and prepare responses as an internal check of procedures. Doing so should prove useful even if the organization is not selected by the IRS for its compliance check initiative. If during the course of its preparation for a compliance check response an organization determines that its record retention practices fail to meet legally imposed requirements (or that its records indicate post-issuance noncompliance), the organization should consider whether corrective action is necessary, and if so, the appropriate method for such correction, including TEB VCAP. If an organization receives an IRS compliance check questionnaire, it should consult with other parties involved in the bond issue, as well as counsel, before responding.