Dear Gnomes are People Too,
Hello, my name is Harry and this letter is in response to your request, in light of the trenchant analysis previously rendered on Schedule K (link to trenchant analysis), that I review the most recent draft of your Schedule K prior to filing your tax return with the Internal Revenue Service (“IRS”). As bond counsel for the 2012 issuance of qualified 501(c)(3) bonds (the “2012 Bonds”) that benefitted Gnomes Are People Too, a tax-exempt organization (“Organization”), I am uniquely qualified to review and comment on your Schedule K and I appreciate the opportunity to do so.
Since 2007, when filing their annual Form 990, organizations benefitting from qualified 501(c)(3) bonds have been required to include Schedule K, Supplemental Information on Tax-Exempt Bonds (“Schedule K”). Since the beginning of time (i.e., the first moment that filing tax returns was required), tax return preparers have prepared returns based on the prior year’s returns. This methodology is known to accountants as “SALY” or, to us commoners, the “same-as-last-year” method. Ordinarily, preparers will update each organization’s return to reflect changes that occurred during the year; however, for reasons that I do not fully understand, I have noticed that preparers oftentimes do not update the information reported in the Schedule K.
Your most recent Schedule K contains the same amounts and responses that were reported in each prior year’s filing. This has resulted in a number of questionable entries on your Schedule K that should be addressed. In the interest of brevity, I have highlighted the following three, which are a direct result of SALY accounting and could cause significant problems with the IRS going forward:
- Part II (all lines) does not reflect earnings on the construction fund, debt service fund, or other funds that have unspent proceeds;
- Part III (Line 4) does not reflect the average percentage of private business use that occurred during the reporting year; and
- Part III (Line 8) does not reflect bond-financed assets (including equipment) that were sold to a nongovernmental person other than a 501(c)(3) organization.
Proceeds (Investment Earnings)
The Schedule K instructions indicate that organizations should report “gross proceeds” on Line 4. Gross proceeds include proceeds and replacement proceeds (which is another topic for another time). “Proceeds” include sale proceeds but also investment proceeds and transferred proceeds of an issue. It is important to be able to identify proceeds, not only to accurately complete the Schedule K, but also because the same federal tax law limitations apply to investment proceeds as apply to sale proceeds of an issue.
Therefore, Line 4 of Part II should include investment earnings on tax-exempt bond proceeds deposited into accounts that generate earnings. It is very common for tax-exempt bond proceeds to be deposited into accounts that generate investment earnings. When the 2012 Bonds were issued, amounts in the construction fund were deposited in an interest bearing account and the earnings that accrued during the construction period should be reported on the Organization’s Schedule K. Similarly, a portion of the proceeds from the 2012 Bonds were deposited into a debt service reserve fund that has earned investment income which should also be reported on the Schedule K.
Going forward, the amount of gross proceeds reported in Part II should be updated every year to reflect investment earnings (e.g., proceeds) received during the year on amounts on deposit in the construction fund (for as long as it exists) and debt service reserve fund.
Private Business Use – During the Year
While issuing the 2012 Bonds, as part of our due diligence as bond counsel, we helped the Organization ensure that no more than 5 percent of the proceeds of the 2012 issue were used or expected to be used for any private business use (except in those rare cases where there would be little or no private payments or security). In accordance with the applicable Treasury Regulations, when I prepared the tax certificate, I quantified the Organization’s private business use by considering the entire life of the bonds (referred to in the Treasury Regulations as the “measurement period”) rather than looking at a single year. You may recall that the 2012 Bonds mature in 25 years and you expected that 100% of the proceeds would be used in a private business use for one year but that there would be no private business use thereafter. The calculation in the tax certificate accurately indicated that the Organization’s aggregate private business use over the life of the bonds was 4% (100%/25 years).
Confusingly, the instructions for Part III, Line 4 of the Schedule K state that organizations must report the average percentage during the reporting year of financed property that was used in a private business use. Applying the above example, the Organization should have listed 100% on Part III, Line 4 for year 1 and 0% for each year thereafter. Instead, the Organization has reported 4% of private business use in every year since the schedule was initially filed in 2012. The reason for this is likely that your tax return preparer initially reported the percentage listed in the tax certificate and the preparer then applied the SALY methodology in every year since. Such an approach is incorrect and the Organization may want to consider filing amended tax returns for prior years or explaining the change in Part VI, Supplemental Information, in the next year’s filing.
Sale of Bond-Financed Assets
On Part III, Line 8, an organization is asked to indicate whether it has sold or disposed of any bond-financed assets to persons other than 501(c)(3) organizations. Proceeds from the 2012 Bonds were used primarily to construct Building A; however, a portion of the proceeds financed various furniture and equipment located in Building A.
The tax law requires that 100 percent of assets financed with proceeds of qualified 501(c)(3) bonds be owned by organizations described in Section 501(c)(3) of the Internal Revenue Code (or by governmental entities). On our call yesterday, you mentioned that the Organization had sold a number of pieces of outdated (but whose useful life had not yet expired) equipment to private parties. Unfortunately, the 100 percent ownership requirement does not have a de minimis allowance; therefore, the sale or disposition of a single, inexpensive bond-financed asset (e.g., a personal computer, etc.) during its useful life could jeopardize the 2012 Bonds’ tax-exemption.
For this reason, it is vitally important that the Organization identify every asset that was financed with proceeds of the 2012 issuance and contact bond counsel prior to selling or otherwise disposing of any such assets.
Thank you for giving me the opportunity to review Gnomes Are People Too’s Schedule K. Let me know if I can be of any further assistance.
Bond Counsel (but not “Harry Bond Counsel”)