WASHINGTON -- The Internal Revenue Service has broken new ground by ruling that a nonprofit laboratory doing research for both public and private entities can be partly financed with tax-exempt bonds based on the mix of revenues derived from the lab's work.
The conclusion was reached in a recently published private letter ruling issued at the request of an unidentified 501(c)(3) foundation. Several bond lawyers yesterday said the ruling is positive and charts new ground.
"It's an enormous breakthrough in that the IRS historically has indicated that some physical separation between the private and public uses of a facility is necessary to finance the public portion with tax-exempt bonds," said Dean Weiner, a partner at O'Melveny & Myers in Los Angeles.
"This is the first ruling that I'm aware of that allows tax-exempt financing with joint public and private use of the same facility in the same way," he said.
Mr. Weiner said the ruling may be important for issuers who want to use tax-exempt bonds to finance output facilities, such as electrical or water generating plants, that have both public and private uses that cannot be physically separated.
IRS typically cautions against applying private letter rulings to any taxpayers other than those that requested them.
But an IRS official said yesterday that the ruling might have a broader application. "This is a mixed-use facility ruling that says that a revenue allocation test may be a reasonable method to allocate the proportionate benefit between governmental and private uses for bond financing when other more traditional and straightforward allocation methods don't work," he said.
The 501(c)(3) foundation that requested the ruling was described by the IRS in the letter ruling as "a nonprofit organization, which engages in biomedical and biochemical research, medical education, clinical, professional, and other services and hospital care."
According to the ruling, the foundation wanted to use tax-exempt bonds to construct a new building for its research division that would contain laboratories, seminar rooms, a dining area, and other facilities.
Much of the research to be done in the labs, the foundation said, would simultaneously be funded from and apply to both governmental and private entities. The foundation's research traditionally was funded with government grants and private, tax-deductible contributions. But in recent years, it has entered into research contracts with private companies.
The foundation asked the IRS to allow it to determine the portion of the new research building that could be financed with tax-exempt bonds based on the proportion of governmental and private revenues used to fund the research.
Under this approach, the foundation would be able to finance a portion of the new building with tax-exempt 501(c)(3) bonds and would not have to worry that the private research would cause the bonds to become taxable private-activity bonds.
In its ruling, the IRS noted that long-standing Treasury rules provide examples "for just one allocation method, the square-footage method, which allocates private and governmental use based on the number of floors in an office building devoted to each use."
"Using a fair-market-value or a per-procedure method would also provide a high degree of certainty in allocating use of facilities," the ruling said.
But the foundation argued that it would be unworkable and unreasonable to determine the amount of bond-financing based on either of these methods because the labs and lab workers could be engaged in research applicable to governmental and private projects at the same time.
The foundation asked the IRS to allow it to determine the amount of bond-financing that could be done based on governmental revenues and said it would even allow for a margin of error in such calculations.
For example, the foundation estimated that the gross revenues from private contracts were, and would continue to be, less than 15% of its gross research revenues. But the foundation would finance no more than 75% of the research facility with tax-exempt bonds.
The IRS said in the letter ruling that such an approach would be "reasonable," but said, "this approach is acceptable only because the foundation could not have used a method with a clearer relation to actual use, such as square-footage, fair-market-value or per-procedure method."