The IRS has issued Announcement 2015-02, which allows issuers of qualified 501(c)(3) bonds to pay a small penalty to protect the tax status of the bonds where the conduit borrower lost its 501(c)(3) status because it failed to file returns with the IRS for three straight years. It’s welcome relief from a particularly nasty rule, but it will only apply to a very narrow subset of the tax-exempt bond world.

Announcement 2015-02 provides relief from the harsh 100% 501(c)(3)/governmental ownership requirement that applies to qualified 501(c)(3) bonds.

Let’s back up for a second. Every ounce of property that is financed with an issue of qualified 501(c)(3) bonds must be owned by a 501(c)(3) or by a state or local governmental entity. No ifs, ands, or buts about it. So, if a 501(c)(3) that owns property financed by an issue of qualified 501(c)(3) bonds loses its 501(c)(3) status for even one second, then the entire bond issue technically becomes taxable. It’s an incredibly harsh rule – the equivalent in the tax-exempt bond world of knocking in the 8-ball early, or of fumbling out of bounds in your opponent’s end zone. Announcement 2015-02 provides some relief from this harsh rule.

The Announcement won’t protect a qualified 501(c)(3) bond issue from all of the different problems that could cause a 501(c)(3) to lose its status. It applies only to a 501(c)(3) that lost its 501(c)(3) status because it didn’t file the required Form 990 for 3 years in a row. Section 6033(j) of the Code provides that the 501(c)(3) will automatically lose its 501(c)(3) status as of the due date for filing the third return.

However, Section 6033(j) also allows the 501(c)(3) to apply for reinstatement. (See Rev. Proc. 2014-11.) If the 501(c)(3) can show the IRS some reasonable cause for why it didn’t file the returns, then the IRS has the discretion to reinstate the 501(c)(3)’s status retroactively. For these fortunate 501(c)(3)s, any qualified 501(c)(3) bonds issued for their benefit are safe.

But for other 501(c)(3)s that lost their (c)(3) status for failing to file Form 990 for three straight years, the IRS will reinstate their (c)(3) status only on a prospective basis, if at all. For these unfortunate 501(c)(3)s, there will therefore be some period during which the organization was not a 501(c)(3). This means that during this period any property financed by qualified 501(c)(3) bonds and owned by the organization will fail the 501(c)(3)/governmental ownership requirement. So, those bonds will technically lose their tax-exempt status.

The Announcement provides relief for 501(c)(3)s that can only get prospective reinstatement of their 501(c)(3) status.

Announcement 2015-02 prevents this calamity. To get the benefit of Announcement 2015-02, an issuer must do two things: (1) sign a closing agreement and provide a copy of the reinstatement letter, and (2) pay $500 for each calendar month (including partial months) between the day that the organization lost its 501(c)(3) status and the day on which it was reinstated. The borrower must also sign the closing agreement, which makes sense – the borrower will also almost certainly have to pay the issuer back.

The issuer must submit the payment and paperwork within one year of the date on which the borrower’s 501(c)(3) status is reinstated. If the reinstatement is dated before December 30, 2014, then the parties have until December 30, 2015 to send in the paperwork and the money. If the loss of 501(c)(3) status affected more than one bond issue issued by a single issuer, then these bond issues can be combined in a single closing agreement.

The closing agreement appears to be fairly similar to the closing agreements that are currently being used in VCAPs and audits. But, as was pointed out in Naomi Jagoda’s recent article on this subject ($), it does unfortunately contain an annoying provision requiring the issuer and 501(c)(3) borrower to search their souls and confess if they are aware of any other reason unrelated to the automatic revocation of 501(c)(3) status that the bonds fail to qualify as qualified 501(c)(3) bonds. This provision is similar to one that has recently begun popping up in Information Document Requests in IRS audits. Note also that there appear to be two erroneous references to “Announcement 2014-02,” which presumably are intended to refer to Announcement 2015-02.

Finally, several caveats, although by this point we’re stacking improbabilities upon improbabilities. There’s no relief for organizations that have had their 501(c)(3) status revoked more than once. Also, there’s no relief for bonds that are already under audit. If bonds were issued for the benefit of multiple 501(c)(3)s, and more than one of those 501(c)(3)s loses its 501(c)(3) status for failure to file Form 990 for three straight years, the parties should use separate closing agreements for each of these borrowers (and probably also buy a lottery ticket . . . or avoid lightning storms).

A Few Thoughts

All in all, this Announcement is a good thing. The 100% ownership requirement is nasty business. The Announcement won’t affect the vast majority of 501(c)(3)s that have used qualified 501(c)(3) bonds, because most of these entities are sufficiently diligent in meeting their non-profit responsibilities and have tax advisers that won’t allow them to forget filing their Form 990 for three years in a row. The 501(c)(3)s that trip over this rule are likely to be smaller, less sophisticated organizations. The IRS should be applauded for keeping the penalty small and easy to calculate and the associated paperwork easy enough to decipher so that it won’t be a huge burden on these 501(c)(3)s.

It’s inevitable that the IRS is going to increasingly use these standardized, mini-VCAPs for rifle-shot issues as adjuncts to the broader VCAP system. It advances their stated goal of efficiency through standardization, and it’s a great deal for them financially. The standardized VCAP in Announcement 2015-02 stands in stark contrast to the infamous student loan bond VCAP announced in Announcement 2012-14, which short-circuited a complicated legal question and effectively denied issuers the opportunity to argue their case. These standardized VCAPs are more appropriate in situations like the one described in Announcement 2015-02, where there is a clear violation of an unambiguous legal rule. While Announcement 2015-02 isn’t likely to change many lives, it’s the thought (and the precedent) that counts.