(This Has Nothing to Do with Geometry, Art Class, or Parenting of Young Children)
Lawyers profess a love of clarity while making their living from a lack of clarity. Lawyers nobly use phrases such as “black letter law” and “bright line test”. Lawyers ask regulators and courts for clear and concise rules that are easily followed. Regulators and courts strive to provide them. But life is typically more complicated and thankfully (at least from the lawyer’s perspective), that is when lawyers are often necessary. But the goal of clarity must nonetheless be vigorously pursued.
As previously described on this blog, the IRS recently released Proposed Regulations (81 Fed. Reg. 8870) regarding the definition of a political subdivision (“Proposed Regs”), which is a prerequisite to being eligible to issue tax-advantaged bonds. The Proposed Regs expand the requirements for a political subdivision to include a requirement that, in the judgment of the federal government (to be implemented by the IRS), the state or local entity must serve a governmental purpose.
The Proposed Regs say that whether or not a state or local entity serves a governmental purpose is based on a number of factors. Included among these is “. . . whether the entity operates in a manner that provides a significant public purpose with no more than incidental private benefit.” (Emphasis Added.) Where does this standard come from? It is not in the Code, any existing Treasury Regulations or any case law or other authority that discusses whether an entity is a political subdivision eligible to issue tax-advantaged bonds.
The Preamble to the Proposed Regulations provided only one citation to support this new requirement. The Preamble cites Rev. Rul. 90-74 (1990-2 C.B. 34, September 4, 1990) and notes that Rev. Rul. 90-74 applies an “incidental private benefit” standard for purposes of whether income is included in gross income under section 115(1) of the Code.
Section 115(1) pertains to separately incorporated entities that, by their very nature, are not political subdivisions. Worse, the Preamble introduces the citation with the signal “Cf.,” which means, as any user of the Blue Book system of legal citation can tell you, the authority doesn’t directly support the assertion that the author is making. It’s the equivalent of saying “eh; close enough.” Worse still, and perhaps fittingly, Rev. Rul. 90-74 also grafted on this “only incidental private benefit” requirement to the 115(1) analysis without citing any authority for doing so.
One of the two principal authors of the Proposed Regs is Tim Jones and the author of Rev. Rul. 90-74 is also Tim Jones. The 26-year gap between Rev. Rul. 90-74 and the Proposed Regs is a tribute to Tim Jones’ longevity as a terrific lawyer and the consistency of his thought process. Longevity and consistency are admirable traits in the view of this blogger. We appreciate his efforts to begin this discussion. But that does not mean we have to agree with his conclusions that there should be a private benefit standard or that such a standard should be so low as to be “incidental” as opposed to excessive, unreasonable, or disproportionate to the governmental purpose, as determined by the state or local entity.
For purposes of determining what is or is not a political subdivision, where is the line that separates incidental private benefit from excessive private benefit? The Proposed Regs have no examples. What does the reference to Rev. Rul. 90-74 tell us?
In Rev. Rul. 90-74, the IRS examines the question of whether the income of a casualty insurance pool of counties in a particular state will be exempt from federal income tax. Code Section 115(1) states that income is excluded from gross income if (i) it is derived from an essential governmental function and (ii) accrues to a state or political subdivision. Rev. Rul. 90-74 goes on to state that the determination of what is an essential governmental function depends on the facts and circumstances. The phrase “facts and circumstances,” a common phrase in the law, is the antithesis of a bright line. The use of that phrase is recognition by courts and regulators that they simply cannot write rules that anticipate every fact pattern.
In talking about incidental private benefits, Rev. Rul. 90-74 makes two related statements. First, the ruling states: “Except for the incidental benefit to employees of the participating political subdivisions described in the preceding paragraph, no private interests participate in or benefit from the operation of X [the casualty insurance pool]. Accordingly, X performs an essential governmental function.” Second, in the holding, the ruling states that the income of X will not be included in gross income because “private interests do not, except for incidental benefits to employees of the participating state and political subdivisions, participate in or benefit from the organization.” Is “incidental” really that low of a threshold in the context of whether an entity is a political subdivision?
Rev. Rul. 90-74 only tells us that a group of political subdivisions can form an insurance pool that protects their employees without having more than incidental private benefit. It does not provide much guidance about where the line is between incidental private benefit and excessive private benefit for purposes of determining what is or is not a political subdivision.
Virtually every economic development project undertaken by a political subdivision provides a benefit to a private party by the very nature of economic development. How much benefit to the private party is more than incidental? Is every political subdivision whose purpose is economic development no longer a political subdivision? That cannot be the intended result. Thus, the reference to Rev. Rul. 90-74 is not particularly helpful in the context of when an entity is a political subdivision.
Although the IRS has issued several private letter rulings that hold that economic development organizations do not have more than incidental private benefit for purposes of the Section 115(1) exclusion (see [not Cf.], for example, PLR 201308010), only the organization that received a ruling can cite it as precedent, and otherwise private letter rulings are only meaningful as indicators of the IRS’s position, which these Proposed Regs have thrown into great doubt.
As the bond community prepares comments on the Proposed Regulations, while very appreciative of Tim Jones’ efforts to launch the discussion, it will either need to argue that a private benefit test is flawed and should be removed or it will need to describe as clearly as possible the way to draw the bright line between necessary and reasonable private benefit and excessive private benefit and it will need to do that in a manner that protects economic development entities that have always held the status of political subdivisions.