AHLA: Tax Issues for Healthcare Organizations Tax-Exempt Bonds, Schedule K and Preparing for IRS Private Business Use Examinations October 15-16, 2012 Now, tell me exactly how you got these Schedule K numbers? 2 1
Introduction Focus on activities of 501(c)(3) Organizations that borrow on a tax-exempt basis Schedule K Annual Reporting IRS wants to know more information about your Bonds In IRS fiscal year 2010, there were approximately 915 examinations of outstanding tax-exempt debt Schedule K provides the IRS with information as to whether borrowers are satisfying the Federal tax law requirements The IRS recently announced that they will begin auditing Schedule K In the event of an IRS bond audit or a Schedule K audit, it will be necessary for borrowers to provide clear and convincing information to support their Schedule K reporting 3 Table of Contents I. Overview of Private Business Use Rules II. 2011 IRS Schedule K III. Examples of Private Business Use and How to Measure It 4 2
I. Overview of Private Business Use Rules 5 Overview 501(c)(3) Bonds At least 95% of the net proceeds of the bond issue must be used in a manner related to the exempt purposes of the Section 501(c)(3) organization No more than 5% of the net proceeds of the bond issue can be used for a private use or an unrelated trade or business use. For this purpose, costs of issuance of the bonds paid with bond proceeds is treated as a private use 6 3
Overview 501(c)(3) Bonds Private Use Use of bond financed property in a trade or business by other than a 501(c)(3) organization or a State or local government Examples: Lease of bond financed space to a for-profit entity for use of a hospital cafeteria Certain management contracts (e.g. contracts with non employee medical professionals) Certain sponsored research contracts 7 Overview 501(c)(3) Bonds Unrelated Trade or Business Use Use of bond financed property by a 501(c)(3) organization in an unrelated trade or business activity Unrelated trade or business use involving bond financed property will generally constitute private use even if it does not give rise to a liability for unrelated business income tax 8 4
Private Use Exceptions Management Contract Guidelines IRS Rev. Proc. 97-13 Provides framework for contracts with non-employees/outside providers for various services involving the use of bond financed property Contracts with non-employees Professional corporations Cafeteria operations Outsourcing of certain operations to third parties 9 Private Use Exceptions Research Contract Guidelines Revenue Procedure 2007-47 Permits certain types of research to be conducted within bond financed space without resulting in research sponsor being treated as private user Applies only to basic research any original investigation for the advancement of science not having a commercial objective 10 5
Private Use Exceptions Corporate Sponsored Research Any license or other use of resulting technology by the sponsor is permitted only on the same terms the 501(c)(3) organization would permit that use by an unrelated non-sponsored party (i.e., the sponsor must pay a competitive price) The price paid by the sponsor must be determined at the time the license or other resulting technology is available for use The sponsor may have exclusive use of the license or resulting technology 11 Private Use Exceptions Industry or Federally Sponsored Research Agreements A single sponsor or multiple sponsors agree to fund basic research The 501(c)(3) organization determines the research to be performed and the manner in which it is to be performed Title to any patent of product lies exclusively with the 501(c)(3) organization Sponsor(s) get nothing more than a non exclusive right to use product of that research 12 6
Private Use Exceptions Research Contracts Federal Government Rights Under the Bayh-Dole Act The rights of the federal government mandated by the Bayh-Dole Act will not cause a research agreement to fail the safe harbor 13 Private Use Exceptions Incidental Contracts or Arrangements Small physical use of space ATM, kiosks, vending machines, laundry facilities Cannot exceed 2.5% of proceeds or space of facility Contract for services supporting organization activities Janitorial services Equipment repair Billing activities or similar services 14 7
II. 2011 IRS Schedule K 15 p. 16 8
p. 17 Schedule K - Part I - Identification of Bond Issues Name of Issuer Issuer EIN CUSIP # Date Issued Issue Price Description of Purpose Defeased On behalf of Issuer Pooled Financing 18 9
Schedule K - Part II - Use of Proceeds Some of the information for Part II should be on IRS Form 8038 Other information for Part II is based on actual post-issuance facts 2011 version of Schedule K contains more elaborate questions than previous versions 19 Schedule K - Part II - Use of Proceeds New questions on 2011 Schedule K Line 1: Amount of Bonds retired Line 2: Amount of Bonds legally defeased Line 5: Capitalized interest from proceeds Line 6: Proceeds in refunding escrows Line 8: Credit enhancement from proceeds Line 11: Other spent proceeds Line 12: Other unspent proceeds 20 10
Schedule K - Part II - Use of Proceeds Other Important Questions Line 7: Issuance Costs from proceeds (Why?) Line 9: Working Capital Expenditures from proceeds (Why?) Line 13: Year of Substantial completion (Why?) 21 Schedule K - Part II - Use of Proceeds Line 16 - Has the Final Allocation of Proceeds Been Made? A final allocation must be done no later than 18 months after the later of: (i) the date of the expenditure, or (ii) the date the property is placed in service (in any event, no later than 60 days after the fifth anniversary of the issue date) Important in transactions in which non-bond proceeds need to be used to finance private use space which does not fit within the permissible bad money portion of the bond issue (generally 3%) 22 11
Schedule K - Part II - Use of Proceeds Line 17 - Does the Organization Maintain Adequate Books & Records to Support the Final Allocation of Bond Proceeds? What Are the Records to be Maintained? Basic records relating to the bond transaction, including the trust indenture, bond resolution, loan agreements, and bond counsel opinion Documentation evidencing expenditure of bond proceeds Documentation evidencing use of bond financed property by public and private sources such as copies of management contracts, research agreements, and lease agreements Documentation pertaining to the investment of bond proceeds 23 Schedule K - Part II - Use of Proceeds How Long Should Records be Kept? As long as the bonds are outstanding, plus 3 years If the bonds are refunded, need to retain records for the life of the original bonds and refunding bonds, plus 3 years 24 12
Schedule K - Part III - Private Business Use Question 2 - Are there any lease arrangements that may result in private business use of bond-financed property? Question 3a - Are there any management or service contracts that may result in private business use of bond-financed property? Question 3b If Yes to line 3a, does the organization routinely engaged bond counsel or other outside counsel to review any management or service contracts relating to the financed property? Answer should be Yes 25 Schedule K - Part III - Private Business Use Question 3c - Are there any research agreements that may result in private business use of bond-financed property? Question 3d If Yes to line 3c, does the organization routinely engaged bond counsel or other outside counsel to review any research agreements relating to the financed property? Answer should be Yes 26 13
Schedule K - Part III - Private Business Use Question 4 - Enter the percentage of financed property used in private business use by entities other than a 501(c)(3) organization or a state or local government Calculation Required: % Instructions: Do not include any use relating to management or research contracts that the organization has determined to meet the IRS safe harbor rules 27 Schedule K - Part III - Private Business Use Question 5 - Enter the percentage of financed property used in a private business use as a result of unrelated trade or business activity carried on by your organization, another 501(c)(3) organization or a state or local government Calculation Required: % 28 14
Schedule K - Part III - Private Business Use Question 7 - Has the organization adopted management practices and procedures to ensure the post-issuance compliance of its tax-exempt bond liabilities? Answer should be Yes 29 Schedule K - Part IV - Arbitrage Question 1 - Has a rebate analysis been performed and an IRS Form 8038-T filed? Question 3a - Has the organization or the governmental issuer entered into a qualified hedge with respect to the bond issue? Question 4a - Were the proceeds invested in a Guaranteed Investment Contract (GIC)? 30 15
Difference in Annual Reporting Requirements v. General Tax Principles Schedule K private use activities measured over a 12 month reporting period (annual snap shot) Federal Tax Principles generally, private use activities measured over the entire life of the bonds, plus any refunding bonds Observation An organization could have a situation where the reported private use for Schedule K purposes is significant while at the same time the bond issue remains tax-exempt under general federal tax law principles 31 III. Examples of Private Business Use and How to Measure It 32 16
How to Measure Private Use Non-profit borrowers often lack the technical expertise to properly navigate through the annual private use calculations... 33 How to Measure Private Use 34 17
Examples of Potential Private Use of Bond-Financed Property Cafeteria Contracts Gift Shops Non-Employee Contracts Outside Parties Physician Groups Leases of Property Research Agreements Food Court Starbucks Certain Parking Agreements Use by other 501(c)(3) Organizations Central Utility Plant 35 How to Measure Private Use Fundamentals - getting started to complete Part III of Schedule K Identify property financed by each issue of outstanding bonds issued after 12/31/02. Was the original bond issue refunded? If so, by what bond issue? Who uses that space? How much space are they using and for how long? Is there any private use or unrelated trade or business use? Did the 501(c)(3) allocate equity to any portion of the facility? What records support the allocation of bond proceeds and/or equity to that facility? 36 18
How to Measure Private Use 4 Primary Methods Square footage Time of use Time/space analysis Revenues Under the applicable tax regulations, the measurement of private use must be reasonable. Determining what method is most appropriate may require professional judgment. 37 How to Measure Private Use Private Use Example $100 million bond issue which financed 3 facilities Emergency Room Renovation - $25 million Research Building - $50 million 10 - Story Hospital building with Cafeteria - $25 million 38 19
How to Measure Private Use Emergency Room Renovation Example Users: General Public Non-employee physician management contract (PC) Contract does not meet Rev. Proc. 97-13 39 How to Measure Private Use Emergency Room Renovation Example (cont.) Observations regarding physician use Non-employee physician use spans entire renovation Some employee doctors and nurses also use the ER space when examining and admitting patients 40 20
How to Measure Private Use Emergency Room Renovation Example (cont.) Main hospital square footage - 1 million square feet Emergency room square footage - 55,000 square feet Hospital annual revenues - $300 million Emergency room annual revenues - $6 million 41 How to Measure Private Use Emergency Room Renovation Example (cont.) Q: How do you measure private use? A 365 days = 100.0% 365 days B 55,000 sq. ft. = 5.5% 1,000,000 sq. ft. C $6,000,000 = 2.0% $300,000,000 42 21
How to Measure Private Use Research Building Users: Hospital Employees Hospital has 1,000 research contracts within bond financed space Under intake review process, 75 contracts do not meet Revenue Procedure 2007-47 43 How to Measure Private Use Research Building Example (cont) All research takes place concurrently Substantially all the lab equipment will be continuously available for both good and bad research The identity of researchers at the location of research will undergo change over time 44 22
How to Measure Private Use Research Building Example (cont.) How do you measure private use: Time? Square Footage? Revenues? 45 How to Measure Private Use Research Building Example (cont.) Measure Private use based on Research Revenues Private Use Research Revenues $150,000 Total Research Revenues $ 2,000,000 Private business use $150,000 = 7.5% $2,000,000 * Annual calculation required based on present value 46 23
How to Measure Private Use Hospital Building with Cafeteria Example Hospital is used 365 days a year Users: Visitors/Faculty Sodexho operates cafeteria under management contract Building is 10 stories 9 Floors of Beds 1 Floor Cafeteria 47 p. How to Measure Private Use Hospital Building with Cafeteria Example (cont.) Sodexho Management Contract All Revenues to Sodexho Sodexho pays $100,000 per year to Hospital (Lease?) 1 Floor Cafeteria Questions: Was equity allocated to the Sodexho space? Do Hospital records support an equity allocation? 48 24
p. How to Measure Private Use Hospital Building with Cafeteria Example (cont.) Assume each floor costs $2.5 million Use by Sodexho 100% x $2.5 million = $2,500,000 Total = $2,500,000 Cafeteria - $2,500,000 = 10.00% $25,000,000 49 p. How to Measure Private Use $100 million bond issue which financed 3 facilities Summary Project Name Private Use (%) Bond Proceeds Spent on Project Private Use Cost Figure Research Building 7.50% $50,000,000 $3,750,000 Hospital Building with Cafeteria 10.00% $25,000,000 $2,500,000 Emergency Room Renovation 100.00% $25,000,000 $25,000,000 Total $31,250,000 Net Sale Proceeds $100,000,000 Private Use (%) 31.25% 50 25
p. 51 p. Contact Information Ed Oswald Orrick 202-339-8438 eoswald@orrick.com John V. Woodhull Crowe Horwath LLP 312-899-7005 john.woodhull@crowehorwath.com 52 26