WASHINGTON -- Legislation may be needed to overcome a conflict between two sections of the tax code that would be disastrous for 501(c)(3) bonds if left unresolved and carried to an extreme, an IRS official said this week.

"We're aware of the issue. We've been looking at it. But we haven't come to any clear resolution of it," said Marcus Owens, director of the Internal Revenue Service's exempt organizations technical division. "It may be that it's something that Congress is going to have to take a look at.

"It's not a panic situation," he stressed.

At issue is Section 514 of the code, which says that when nonprofit organizations invest borrowed funds and make money, the profit is treated as unrelated debt-financed income that is subject to the unrelated business income tax, or UBIT.

This conflicts with Section 103 of the code, which permits tax-exempt bond proceeds to be put into reserve funds or escrows and invested without generating taxable income or threatening the tax-exempt status of the bonds.

If Section 514 were strictly applied to 501 (c)(3) bonds without regard to the bond provisions in Section 103, bond proceeds put into temporary construction funds, reserve funds, or refunding escrows and invested would generate interest that would be taxed as unrelated business income.

As a result, the tax-exempt status of the bonds could be called into question under another tax law provision that says at least 95% of the proceeds of 501(c)(3) and other taxexempt private-activity bonds must be used for the exempt purpose of the bonds.

IRS officials became aware of the conflict between the two code sections more than a year ago, after it came to light in an audit of a 501(c)(3) organization.

Marvin Friedlander, an official with the IRS' exempt organizations branch, stunned bond lawyers meeting in Orlando, Fla., in early 1993 by telling them that the IRS was wrestling with the issue of whether 501(c)(3) bond reserve funds that were invested for profit were serving a charitable purpose. Friedlander said the IRS was studying the issue.

Early last month, the U.S. Tax Court handed down a decision in Southwest Texas Electric Cooperative Inc. v. Commissioner of Internal Revenue that Owens said "underscores the service's basic interpretation of how Section 514 works" and "heightens the uncertainty" about how that section fits with Section 103 of the code.

The case did not involve tax-exempt bonds but dealt with a similar situation. The Southwest Texas company, a nonprofit rural electric distribution cooperative, took out a construction loan from the Agriculture Department's Rural Electrification Administration and invested part of the money in Treasury notes to earn a profit.

The court found that the notes were debt-financed property and that the interest earned was taxable unrelated business income.

"If they hadn't borrowed the money, if they had invested their own money, it would not have been taxed," Owens said.

But the cooperative invested borrowed funds, much like tax-exempt bond issuers invest the proceeds from tax-exempt bond financings in reserve funds or escrow accounts, he said.

The question for the IRS, Owens said, is ,'how do you create some sort of harmony" between Sections 514 and 103 of the code.

Owens stressed that IRS officials want to resolve the conflict between the code sections.in a way that does not wreak havoc with the 501(c)(3) bond market.

But they have been unsuccessful so far in finding a solution.

The recent tax court decision may Spur added interest in the issue, which may have to be addressed by Congress rather than the Treasury Department or the IRS, he said.

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