WASHINGTON -- In an unprecedented move, the internal Revenue Service has started telling new 501(c)(3) organizations that they may have to reaffirm their status with the agency if they plan to issue tax-exempt bonds, IRS officials and private attorneys said last week.
But the attorneys warned that the new policy effectively means that all 501(c)(3) organizations will have to get a ruling on their tax-exempt status before they can issue more bonds.
The move, attorneys said, appears to be designed to prevent abusive health-care bond deals similar to recent well-publicized transactions in which a developer helped create a nonprofit 501(c)(3) organization to issue bonds to finance the purchase of his troubled nursing homes at an inflated price.
While several lawyers said they understand the IRS's need to curb such abuses, they argued that adopting a policy in which 501(c)(3) status will be granted only on a conditional basis to bond issuers is not the way to do it.
"It's outrageous that 501(c)(3) organizations have to go back to the [IRS] every time they want to issue bonds," said Erica Gut, a lawyer with Pepper, Hamilton & Sheetz in Philadelphia.
The new IRS policy came to light after lawyers representing organizations that were applying for 501(c)(3) status said they had received qualified "determination letters" that granted tax-exempt status, but said a new ruling would be needed if bonds were issued.
Allen Sparkman, a lawyer with Davis, Graham & Stubbs in Denver, said his client -- an organization formed to acquire a hospital with tax-exempt financing -- was granted tax-exempt status earlier this year only after the IRS thoroughly reviewed the proposed bond transaction. The IRS also told the organization that it would have to seek new rulings on its tax-exempt status for any future bond issues, he said.
A lawyer in New York City, who asked not to be identified, said a charitable organization he represented got the same treatment, but the IRS decided not to attach conditions to the determination letter granting 501(c)(3) status after they reviewed the bond transaction.
IRS officials confirmed the new policy in interviews last week, but said that it is evolving. Under the agency's current policy, one official said, a charitable organization that knows it is going to issue bonds -- but does not have the details of the deal pinned down -- would receive tax-exempt status but would be told to come back for another ruling before the bonds were issued.
A charitable organization that said it might issue bonds in the future, the IRS official said, would be told in the determination letter that it "may" want to seek another ruling on its status if it decides to issue bonds, the official said. "That puts the bond counsel on notice that the bonds could have an impact on the tax-exempt status of the organization," he said.
Charitable organizations that have already attained 501(c)(3) status should consider seeking new rulings when issuing bonds, he said, because they are currently required to obtain a new ruling for any activities that could effect their tax-exempt status.
Many tax and bond lawyers criticized the new policy, saying it effectively means all 501(c)(3) organizations will have to get a ruling on their tax-exempt status before they can issuing more bonds.
"It makes a 501(c)(3) determination letter too ambiguous to rely on," said the lawyer in New York. "They're giving you everything you need to be tax-exempt unless you issue debt. But for the charitable organization to issue tax-exempt bonds, it has to be a 501(c)(3) tax-exempt entity."
"For people with legitimate deals, it adds a lot to the process," said Todd R. Greenwalt, a partner at Vinson & Elkins and chairman of the American Bar Association's tax-exempt financing committee's task group on qualified 501(c)(3) bonds.
William Loafman, a partner at Washington, Perito & Dubuc, agreed. "It just seems sort of unnecessary because it forces people to go through a lot even for plain vanilla deals," he said. "The whole idea of having to go to the government before you do something, it's just not good policy in this area."
IRS officials said that they want to work with 501(c)(3) organizations to minimize inconvenience. "There may be some inconvenences," said the IRS official. "But we are willing to work with organizations to make sure that plain vanilla deals don't get caught up in an intense review. And we are treating these on an expedited basis."
But Mr. Greenwalt questioned the legal basis on which the IRS believes it can consider a charitable organization's bond plans before granting 501(c)(3) status. "501(c)(3) status is based on how you're organized and how you operate. It's irrelevant how you finance your activities," he said.
Ms. Gut agreed, "I know they've gotten some resistance to this because arguably it's outside their authority to go this far."
But the IRS official disagreed. He said that using bond financing for an acquisition would certainly have an impact on the organization and operations of a 501(c)(3) organization.
Ms. Gut and Mr. Loafman questioned whether the IRS was equipped to review all of these 501(c)(3) bond transactions.
"There must be another way to skin this cat," Mr. Loafman said. "If the [IRS] wants to police this, the 501(c)(3) people could send copies of their determination letters to the 103 [tax-exempt bond] audit group and they could cross-check the determination letters with the 8038 forms that issuers must submit when they issue bonds."
Most of the lawyers interviewed said they were not surprised that the IRS took some action designed to curb abuse in the health-care field. The agency warned it planned to do so in a notice issued in April 1990.
"Clearly they're doing it because of concern about abusive situations," said Mr. Loafman.
"All of us say we need to stop the abuse. But when they try to stop it and it affects one of our deals, we say, hey, what are you doing?" said Mr. Greenwalt.
