In 1978, responding to attempts by issuers and borrowers to set aside funds for investment above the yield on outstanding tax-exempt bonds, the IRS published regulations seeking to shut down the practice of establishing “sinking funds” in certain non-approved circumstances. These regulations have stood the test of time and remain in the regulations today. In this positive arbitrage environment, issuers, borrowers, underwriters and financial advisers should be alert to this regulation. The intended purpose of eliminating invested sinking funds was to end the practice of extending the duration of a tax exempt borrowing by establishing a sinking fund to produce earnings in excess of the bond yield instead of using these funds to pay down the tax exempt debt or fund the relevant capital project. The definition of a sinking fund is so remarkably broad that even the inadvertent creation of a sinking fund in certain circumstances can cause tax-exempt bonds to lose their exempt status retroactively. The sinking fund prohibition is broad because the IRS believed that the use of invested sinking funds, if left unchecked, could have resulted in nearly a 50 percent increase in the amount of tax exempt bonds outstanding.


Treas. Reg. Section 1.148-1(c)(2) states that a “[s]inking fund includes a debt service fund, redemption fund, reserve fund, replacement fund, or any similar fund, to the extent reasonably expected to be used directly or indirectly to pay principal and interest on the issue” (emphasis added). This regulation has been expansively interpreted by the IRS to generally include virtually any invested funds, whether or not created under the bond documents, reasonably expected to pay debt service on an issue of tax-exempt bonds even if the funds were not on hand at the time of bond issuance. Federal tax certificates executed in connection with the issuance of tax-exempt bonds typically recite that no funds other than those enumerated in such certificates will be used to pay debt service to establish that no invested sinking funds exist. Invested sinking funds (excluding those qualifying as bona fide debt service funds designed to match revenues with debt service within a bond year or as reasonably required reserve funds) are generally limited to a 30 day temporary period and are not permitted to be invested at a rate greater than one-thousandth of 1 percentage point above the bond yield after 30 days without causing the related bonds to lose their exempt status. In the current positive arbitrage yield environment, most sinking funds will likely be invested well above the bond yield for more than a 30 day period. Therefore, the effect of the creation of an inadvertent invested sinking fund can be severe.


Common examples of invested sinking funds may include the following types of funds to the extent that the issuer or borrower “reasonably expected” to use amounts from these funds to pay debt service on a tax exempt bond issue:

  • A portion of an unrestricted endowment fund reasonably expected to pay debt service on a tax-exempt bond issue.
  • An operations or maintenance and repair fund that has multiple purposes, including the payment of debt service.
  • A non-indentured commingled fund reasonably expected to pay debt service when due on outstanding tax-exempt bonds among other purposes.
  • Any non-indentured fund reasonably expected to pay debt service regardless of nomenclature whether or not specifically titled a debt service fund, replacement fund, sinking fund, or similar fund.
  • Excess deposits in a debt service fund not used primarily to match revenues with principal and interest payments within each bond year.

A fund or portion of a fund reasonably expected to pay debt service may be evidenced by pattern of conduct, governing board or finance committee action, establishment by resolution, ordinance or indenture, segregation of funds, and similar actions, based on all the objective facts and circumstances. Issuers and borrowers should exercise extreme caution in the creation of funds to pay debt service outside of a bona fide debt service fund and discuss any such plans with bond counsel.