Jay Alberstadt is a senior partner with MacDonald Illig. He concentrates his practice in the areas of real estate, commercial and economic development, and conventional and tax-exempt financing.
Jenna Bickford is a partner with MacDonald Illig. She represents clients across a number of practice areas including Business Transactions, Real Estate, Government Services and Public Finance, and Health Care.
If you can lend me money and not pay tax on the interest I pay you, you’ll give me a lower rate, right? Sounds simple enough. This basic principle underlies the complex web of Internal Revenue Services (IRS) regulations governing the issuance of tax-exempt debt for the benefit of 501(c)(3) organizations. While such financings survived the 2017 tax reforms, are they still worth the issuance costs associated with such transactions? For most nonprofit borrowers, the answer remains a fairly resounding “yes.”
Although national average issuance costs for publicly-traded bond issues are around 1 percent of the amount of the bonds, they can approach 8.5 percent for issues under $5 million, according to research published by the Haas Institute at the University of California, Berkeley. This is because many of the issuance costs do not vary in proportion to the size of the bond issue. Consequently, we see very few publicly traded bond issues in amounts below $5 million, as the issuance costs are prohibitive for most nonprofits.
For capital projects of up to $10 million, there is an alternative to a public bond issue. The tax code provides for “bank-qualified” tax-exempt debt (“BQ Debt”). Since the Tax Equity and Fiscal Responsibility Act of 1986 (“TEFRA”), banks have generally been prohibited from deducting their carrying costs associated with funds invested in tax-exempt debt. Excluded from this prohibition is BQ Debt.
To qualify, such debt must be issued by a municipality or municipal authority on its own behalf or for the benefit of a 501(c)(3) organization. The issuer must designate the borrowing as BQ Debt and, with certain exceptions, limit to $10 million the total debt issued for the calendar year. A bank lender of BQ Debt is both exempt from paying income tax on the interest received and able to deduct 80 percent of the associated carrying cost expense. In our experience, the issuance costs associated with BQ Debt of $2 million or more average around 2 percent of the amount of the debt that the IRS allows to be used to pay such costs.
The impact of tax reform on BQ Debt results from the reduction in the maximum corporate tax rate from 35 percent to 21 percent. For example, if you borrow $2 million at a fixed rate for 20 years with issuance costs of 2 percent (i.e., $40,000), how much money can you save by before and after tax reform by going tax-exempt?
As the numbers crunched below illustrate, while the post-tax reform savings are reduced by more than $150,000, those savings still exceed $200,000 over the life of the loan. For most nonprofits, this is still real money.
CALCULATION OF BQ DEBT SAVING BEFORE AND AFTER TAX REFORM
Prior to tax reform, the BQ Debt interest rate would be calculated as follows:
• Calculate TEFRA Penalty: Bank Cost of Funds x Non-Deductible Portion of Carrying Costs x
Maximum Tax Rate (e.g., 2% x 20% x 35% = 14 basis points)
• Calculate Interest Rate: [Taxable Rate x (100% – Maximum Tax Rate)] + TEFRA Penalty (e.g.,
[5.00% x 65%] = 3.25% + 14 bp = 3.39%)
Following tax reform, the calculation would be:
• Calculate TEFRA Penalty: 2% x 20% x 21% = 8 basis points
• Calculate Interest Rate: [5.00% x 79%] = 3.95% + 8 bp = 4.03%
• Taxable: $2,000,000 at 5% for 20 years = $3,167,786
• Pre-Tax Reform BQ Debt: $2,000,000 at 3.39% for 20 years = $2,756,750
Total savings: $3,167,786 – $2,756,750 = $411,036 – $40,000 = $371,036
• Post-Tax Reform BQ Debt: $2,000,000 at 4.03% for 20 years = $2,916,300
Total savings: $3,167,786 – $2,916,300 = $251,486 – $40,000 = $211,486
For more information, contact MacDonald Illig Attorneys at 814/870-7600.