The Bond Buyer's Nov. 9, 1994, article ("IRS Field Agents Told Not to Press Issues Involving Reserve Funds of 501(c)(3) Entities") reports that IRS field agents have been instructed not to raise Section 514 questions when auditing "qualified 501(c)(3) bonds" with a reserve fund that has been capitalized with bond proceeds.
We welcome the demonstrated sensitivity toward the potential impact on the market. However, we are concerned that the article may be leaving the public under the impression that the taxability question under sections 512 and 514 could affect the tax status of bond interest under Section 103. We believe this is absolutely not the case.
Section 145(a) limits the amount of proceeds of a qualified 501(c)(3) bond that may be devoted to nongovernmental use or to use in "unrelated trades or businesses, determined by applying Section 513(a)." Unlike sections 512 and 514, which define "income," however, Section 513(a) defines "activity" which is considered unrelated. This section has nothing to do with whether the income generated by that activity is subject to taxation. Without regard to whether reserve fund earnings constitute taxable income, it is clear that Congress condoned the use of bond proceeds to capitalize such funds. Neither Section 512 nor Section 514 has relevance to sections 103 or 145. Indeed, it is a long-settled proposition that issuers cannot ignore unrelated activity under the private-use test by claiming that income from the activity escapes tax pursuant to an exception under Section 512 or offsetting losses on another activity.
We realize that some of the exceptions contained in Section 514 rely upon Section 513(a). But we believe this is not on point. In addition, Section 148(d) makes clear that a "qualified 501(c)(3) bond" is entitled to fund a reserve fund with bond proceeds. To apply, by analogy, an exception to Section 514 as a basis for any conclusion regarding the use of bond proceeds under Section 103 is inappropriate. The Code and the legislative history are clear.
In summary, there is a needless uncertainty created by a good-faith IRS attempt to provide "relief" from what we believe is a phantom question. We hope that the IRS will act quickly to remove this cloud. We recognize that no official announcement was made by the IRS regarding this subject; but there have been statements which make clear the concerns of IRS personnel. While we also think there are strong arguments that the investment of a reserve fund does not give rise to unrelated income tax in the first instance, we hope that the IRS will not delay any action until resolution of this question, or more importantly, fail altogether to correct the erroneous impression raised by these statements and the article.
We trust that the IRS will make absolutely clear that even if reserve fund earnings are ultimately found to be taxable, this outcome will have no effect on taxability of bond interest under Section 103.
McCall, Parkhurst & Horton
Mintz, Levin, Cohn, Ferris
Glovsky and Popeo
William M. Loafman
Whitman Breed Abbott & Morgan