WASHINGTON -- The IRS recently told field agents to avoid raising red flags during audits of 501(c)(3) organizations if they discover bond reserve funds or escrow accounts that could potentially violate rules on unrelated business income, an agency official said this week.

The directive comes as Internal Revenue Service officials are struggling to find a way to reconcile an apparent conflict between Section 514 of the IRS code, which governs unrelated business income of 501(c)(3) organizations, and tax rules that permit issuers to invest bond reserve funds and escrow accounts in taxable securities.

"We are telling our agents, 'Don't raise it until it's resolved,'" Marvin Friedlander, a branch chief in the IRS's exempt organizations branch, said in a brief interview.

Under Section 103 of the tax code, which governs tax-exempt bonds, proceeds of bond sales may be placed in reserve funds or escrow accounts and invested without being deemed to have generated taxable income or threatening the tax-exempt status of the bonds.

But Section 514 treats investments made by private, nonprofit organizations with borrowed money as unrelated business income and subject to tax.

In 1993, IRS officials acknowledged that Section 514 could be interpreted to treat the interest generated by reserve fund investments as unrelated business income. If that were the case, a 501(c)(3) organization with a reserve fund would be in danger of violating the tax law rule that 95% of the proceeds of those organizations must be used for the exempt purpose of the bond.

IRS officials first acknowledged the conflict between the two tax cede sections early last year, but the need to resolve that conflict intensified in August when the U.S. Tax Court issued a decision in Southwest Texas Electric Cooperative v. Commissioner of Internal Revenue.

In the case, a nonprofit rural electric cooperative received a loan from the Department of Agriculture's Rural Electrification Administration and invested part of it in Treasury notes to earn a profit. The tax court ruled that the notes were debt-financed property and subject to the tax on unrelated business income.

Although the Southwest Texas decision did not involve tax-exempt bonds, the circumstances of the case are similar to situations where issuers of 501(c)(3) bonds invest bond proceeds that have been placed in temporary construction funds, reserve funds, or refunding escrow accounts, IRS officials said.

In September, an IRS official reiterated the service's concerns about the code conflict during a speech to the D.C. Bar Association. "This is a very sensitive area," said Jay Rotz, who is executive assistant to the director of the IRS' exempt organizations division. "This is something that is going to have to be looked at in depth."

Rotz and other IRS officials have said that regulations may not be enough, and Congress may have to pass legislation to resolve the conflict between the two code sections.

This week Friedlander said that after the Southwest Texas decision, officials in the IRS' national office decided that for the time being, field agents should not raise Section 514 issues when auditing a 501(c)(3) organization with a bond reserve fund that has been invested.

"We're not going to confront organizations" about the Section 514 problem while IRS officials are still trying to find a solution, Friedlander said. "This is an issue we would rather resolve" so that agents are not delving into a murky area during audits.

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