The Internal Revenue Service recently announced a second major audit initiative focusing on qualified 501(c)(3) bonds issued on behalf of tax-exempt organizations. Beginning this summer, between 2,000 and 5,000 surveys will be sent to tax-exempt organizations that reported tax-exempt bond financing on Form 990. These surveys are expected to request a broad range of information about post-issuance compliance, private business use, arbitrage, record retention and management practices.

The latest initiative follows a smaller IRS initiative, conducted in 2006, involving audits of qualified 501(c)(3) bonds issued on behalf of approximately 30 nonprofit hospital systems. According to the IRS, these 2006 audits revealed that many borrowers did not maintain records sufficient to substantiate that the actual use of bond proceeds satisfied the rules for maintaining the tax-exemption for such bonds, including allocating bond proceeds to particular investments and expenditures.

It is imperative that issuers and borrowers maintain adequate records substantiating that bond proceeds are used in accordance with the rules for maintaining tax-exemption for such bonds. In addition, these records are used to determine rebate and to demonstrate the lack of private use of bond-financed property. In the event of an audit, the IRS could challenge the tax-exemption of the bonds in the absence of these records. As a rule of thumb, issuers and borrowers should maintain records for at least three years after final maturity or earlier redemption date of the bonds (and, in the event that the bonds are refunded, for at least three years after final maturity or earlier redemption date of the refunding bonds).

Issuers and borrowers that have not maintained adequate records should work with counsel to develop record retention policies and other post-issuance compliance practices. In certain circumstances, it may be possible to recreate records substantiating the appropriate use of bond proceeds. Additionally, issuers and borrowers may be able to correct significant record retention and other post-issuance compliance failures through the IRS Tax Exempt Bond Voluntary Closing Agreement Program.