As readers of this blog know, the version of the Tax Cuts and Jobs Act that was passed by the House of Representatives would not have allowed any private activity bond (including any qualified 501(c)(3) bond) to be issued as a tax-exempt bond after December 31, 2017.  The version of the Tax Cuts and Jobs Act passed by the Senate, and the version ultimately enacted into law, did not include this repeal of tax-exempt private activity bonds.   

We’ve previously explored (here) why the House wanted to eliminate tax-exempt private activity bonds and debunked the purported policy bases that were articulated by members of the House in support of the repeal of tax-exempt private activity bonds.  The need for exploration and debunking remains, in light of both the Republicans’ insatiable desire to enact tax cuts and the release by the Congressional Research Service of its report titled “Private Activity Bonds: An Introduction,” which appears to have been drafted to afford a policy rationale to eliminate the income tax exemption for interest paid on certain private activity bonds (which elimination would, of course, be used to cover the cost of income tax rate reductions).[1]  To discover the errors in CRS’s report, hit the jump.

Annie Belle still wants to know why.

The CRS report includes, among other items, the legislative history of tax-exempt private activity bonds, the policy issues that Congress confronts in respect of tax-exempt private activity bonds, and a table that shows the amount of each type of tax-exempt private activity bond that was issued in 2015.

According to the CRS report, qualified 501(c)(3) bonds accounted for 65.79% of the 101,886 tax-exempt private activity bond issues that were issued in 2015.  The CRS report does not provide the dollar volume of 2015 tax-exempt private activity bond issuance that was comprised of qualified 501(c)(3) bonds, but it’s safe to assume that qualified 501(c)(3) bonds also constituted roughly two-thirds of the par value of tax-exempt private activity bonds issued that year.  The CRS report helps to make plain that if Congress is looking for revenue to finance future tax cuts, qualified 501(c)(3) bonds are the “gold in them thar hills” that could be derived from the repeal of tax-exempt private activity bonds.

But this was already known.  What about the policy considerations that support the exemption for qualified 501(c)(3) bonds?  Not only does the CRS report ignore these considerations, it misstates how qualified 501(c)(3) bonds came to be.

The CRS report tells us that qualified 501(c)(3) bonds came into existence in 1968 with the passage of the Revenue and Expenditure Control Act of 1968 (the “1968 Act”).  Fortunately, copies of the 1968 Act are extant – one need not build a time machine and travel back to that turbulent year to ascertain the contents of the 1968 Act.  As detailed in the two following paragraphs, it is clear from any examination of the 1968 Act that Congress made no distinction between tax-exempt bonds issued for governmental purposes and tax-exempt bonds issued to benefit a 501(c)(3) organization – these bonds were treated identically, with no special category created for 501(c)(3) bonds.

The 1968 Act amended Section 103 of the Internal Revenue Code to add Subsection 103(c), which dealt with industrial development bonds.  Prior to the adoption of the 1968 Act, interest on any bond issued by a state or local governmental unit was exempt from federal income tax, regardless of how the proceeds of the bond issue were used.  The 1968 Act inserted Section 103(c)(1) to provide that, except as otherwise set forth in Section 103(c), interest on an industrial development bond issued by a state or local governmental unit was included in the gross income of the bond holder.  An industrial development bond was the functional equivalent of what is now known as a private activity bond.  Section 103(c)(2) defined “industrial development bond” to mean any obligation that “is part of an issue all or a major portion of the proceeds of which are to be used directly or indirectly in any trade or business carried on by any person who is not an exempt person (within the meaning of [Section 103(c)(3)]) . . . .”

This is where it gets interesting.  Section 103(c)(3) defined an “exempt person” to mean “(A) a governmental unit, or (B) an organization described in section 501(c)(3) and exempt from tax under section 501(a) (but only with respect to a trade or business carried on by such organization which is not an unrelated trade or business . . . ).”  You read that correctly.  Under the 1968 Act, bonds issued by a state or local governmental unit for governmental purposes and bonds issued by such a governmental unit for the benefit of a 501(c)(3) organization were treated exactly the same for purposes of the exemption from federal income tax – both were excluded from the scope of an industrial development bond.[2]  The 1968 Act did establish certain categories of tax-exempt industrial development bonds, but it did not create a category of industrial development bonds that could be issued on a tax-exempt basis if they were issued for the benefit of a 501(c)(3) organization.  Instead, the 1968 Act treated state or local bonds issued for the benefit of a 501(c)(3) organization exactly the same as state or local bonds that were issued for governmental use.  It is astonishing that the CRS report misstates this history so profoundly.

State or local bonds issued for the benefit of a 501(c)(3) organization were not treated as tax-exempt private activity bonds until the enactment of Sections 141 and 145 of the Internal Revenue Code by the Tax Reform Act of 1986.  But even then, Congress continued to recognize that, in the animal kingdom of tax-exempt bonds, qualified 501(c)(3) bonds are more like governmental bonds than private activity bonds.  In establishing qualified 501(c)(3) bonds as a new category of tax-exempt private activity bonds, the Joint Committee on Taxation noted on page 1158 of its General Explanation of the Tax Reform Act of 1986 that:

Congress recognized that section 501(c)(3) organizations in many cases perform functions which governments otherwise would have to undertake.  The use of the term private activity bond to classify obligations for 501(c)(3) organizations in the Internal Revenue Code of 1986 in no way connotes any absence of public purpose associated with their issuance.  Accordingly, the Act requires that any future change in legislation applicable to private activity bonds generally shall apply to qualified 501(c)(3) bonds only if expressly provided in such legislation.

The CRS report observes that a policy concern with tax-exempt private activity bonds is that such bonds raise the borrowing costs governmental issuers must incur to finance their governmental activities, and that the existence of private activity bonds “squeezes out” funds that would otherwise be available in the capital markets to finance governmental projects.  In other words, tax-exempt private activity bonds act to the detriment of governmental issuers while affording a subsidy to private actors.

In the case of qualified 501(c)(3) bonds, this ignores the foregoing explanation given by the Joint Committee back in 1986.  Qualified 501(c)(3) bonds did not and do not adversely affect governmental issuers, because these bonds finance activities that state or local governments would otherwise be expected by their constituents to provide (or, at a minimum, to fund).  This is why any legislation that would restrict private activity bonds will apply to qualified 501(c)(3) bonds only if such legislation expressly provides that it applies to qualified 501(c)(3) bonds.  Again, it is astonishing that the CRS reports lumps qualified 501(c)(3) bonds in with other tax-exempt private activity without any regard to, and without any mention of, the favorable status qualified 501(c)(3) bonds have compared to other tax-exempt private activity bonds, because qualified 501(c)(3) bonds finance activities that state and local governments would otherwise need to finance directly.

The CRS report concludes by stating that it “is intended to clarify part of the tax-exempt bond labyrinth.”  This is true in respect of qualified 501(c)(3) bonds only if one’s guide through the labyrinth is the Minotaur.  We plan to revisit the CRS report in future posts to examine other problematic aspects of that report.


[1] The CRS issued the original version of its report on private activity bonds on March 9, 2018, and it released an updated version of the report on July 13, 2018.

[2] To the extent that the benefitted 501(c)(3) organization did not use the proceeds of the bond issue to conduct an unrelated trade or business.