Tax-exempt bond financing is best suited for capital projects in excess of $2 million.
By Nathan A. Adams IV
If you could finance your next large construction project at three points less than a commercial lender would ordinarily charge without additional risk or gimmickry, wouldn’t you do so? Tax-exempt bond financing is the vehicle that secular nonprofit organizations traditionally have used for this purpose, but until recently, the Establishment Clause was thought to bar religious nonprofit organizations from equal treatment, thereby disadvantaging churches from offering services at the same rate. This is no longer the case.
Tax-exempt bond financing, as a matter of federal law, is available for acquisition, construction, renovation, financing projects relating to schools, housing and dormitories, healthcare, athletics and recreation, parking, nursing homes and other social services. (Sidebar sets forth the requirements.) Facilities dedicated exclusively to religious endeavors such as worship centers or chapels, do not qualify under existing precedent but courts have increasingly recognized that federal law is not an obstacle to other efforts to integrate faith and practice in facilities financed with revenue bonds.
Some states have constitutions or laws that are more restrictive than federal law about how bond proceeds are expended. For example, California permits religious schools to participate in bond financing, but not for classrooms where the information and coursework primarily promotes religion. Georgia, Alabama and a few other states prohibit tax-exempt bond financing for facilities used for “sectarian instruction” and “religious worship.” In a few other states, it is not yet clear whether churches can benefit from tax-exempt bond financing.
The good news is that in some instances the restrictions enacted in state law can be mitigated, circumvented, declared or challenged. The limitations may be mitigated by skillful project planning; for example, by ensuring that bond proceeds are expended exclusively on administrative, athletic or similar support facilities. The restrictions may be circumvented by issuing bonds in another state where explicitly permitted. If state law is unclear or prohibits tax-exempt bond financing, it may be declared or challenged by a court in a bond validation proceeding.
Lesser rate of return
Tax-exempt bond financing involves no public funds or pledge of credit. The financing is exclusively with private dollars. Investors accept a lesser rate of return for their bonds in exchange for a tax exemption. The government’s role is exclusively to facilitate the transaction through the creation of an instrumentality for borrowing upon more favorable terms than otherwise would be available. In Hunt v. McNair, the United States Supreme Court referred to this as government acting like a “mere conduit.” The public bond authority provides a mere tax exemption, which from the founding of the Republic has been deemed constitutional under federal and state law.
Although it seems complex, a tax-exempt bond transaction involves basically a triangular relationship: (1) the recipient of bond proceeds; (2) a quasi-governmental bond issuer or conduit, which generally has incentive to issue the bonds and may assist with a bond issuance or validation proceeding and (3) the underwriter, which purchases and markets the bonds to the public or a private placement agent, which makes a private offering of the bonds to select investors. Ordinarily, the bonds must be approved by the bond issuer and the public body with jurisdiction over the area where the facility receiving the bonds is located. Depending on the area, these authorities may be more or less sympathetic.
Invest in the project
Bonds may be purchased by any member of the public if through an underwriter, or by designated investors if by a private placement agent. Either way, an additional feature of tax-exempt bond financing is that those associated with a church get the opportunity to invest in the project. It offers an important vehicle for churches to encourage donors to participate in the mission of the organization and reduce their costs to provide essential social services. For their part, investors get the chance to receive a commercial rate of return for a project they support.
In addition to the primary participants in the bond transaction, bond counsel must be hired by the church to help structure the deal, ensure adequate disclosure to investors concerning the risks of the investment and render an unqualified opinion regarding the legality of the bonds, which, according to the National Association of Bond Lawyers, requires bond counsel to be “firmly convinced … that, under the law in effect on the date of the opinion, the highest court of the relevant jurisdiction, acting reasonably and properly briefed on the issues, would reach the legal conclusions stated in the opinion.”
Traditional ways of thinking die hard, so be sure to secure counsel familiar with recent developments in case law affecting religious institutions and committed to facilitating the achievement of your religious mission. Bond counsel will frequently negotiate the terms of the bond issuance and will be central to mitigating the scope of restrictive covenants placed on use of the proceeds. Bond counsel normally have incentive to seek representations from a prospective borrower that its use of facilities will be largely secular, whereas churches may have good reason not to compromise their intended use of facilities. At the least, a church will want to define carefully any limitations on its use of bond proceeds in a manner informed by its theological tradition.
Banks can participate
Banks may also participate in a tax-exempt financing as a trustee for bond holders and, sometimes, to insure investors’ payment of principal and interest. So many professionals are essential to the process that, as a rule of thumb, tax-exempt bond financing is best suited for capital projects in excess of $2 million with at least a 20-year term. Larger principal amounts work with shorter amortization schedules; e.g., $5 million over a five-year term. To reach this threshold or to reduce the cost of a bond validation proceeding, religious institutions can pool their financing needs in a single bond offering, so that, for example, Heritage Preparatory School participates in the offering in the amount of $1.5 million and the Salvation Army, for $0.5 million.
The primary obstacle obstructing churches from engaging in bond financing in some states has to do with so-called “Blaine amendments,” included in many state constitutions. They are more restrictive than the federal Establishment Clause about so-called “aid” passing to religious organizations. Fortunately, most courts have held that bond financing is not aid, but a service paid for by the transaction participants or the equivalent of a tax exemption.
Although some obstacles and uncertainties remain in the law, churches should seriously investigate tax-exempt bond financing as a matter of due diligence and sound stewardship principles if they have a significant financing need for nonprofit facilities with a secular counterpart. By exercising this right to tax-exempt bond financing, churches will not only save money, but also level the playing field in a manner that will benefit other religious institutions by challenging a decades-old pattern of discrimination against them due merely to their faith.
Nathan A. Adams IV is senior counsel with Holland & Knight, LLP in its national Religious Institutions practice in Tallahassee, FL. [hklaw.com]
Essential elements of tax-exempt financing
- The user of bond proceeds must be a 501(c)(3) organization in good standing throughout the term of the bonds.
- All property to be provided by the net proceeds of the bond issue must be owned by the organization or a governmental unit.
- Substantially all of the bond proceeds (95 percent) must be used to further the exempt purposes of the user.
- Issuance costs to be financed with the proceeds of a qualified bond may not exceed 2 percent of the proceeds of the bond issue.
- The average maturity of the bond may not exceed 120 percent of the average reasonably expected economic useful life of the facility financed with bond proceeds.
- The bond issuance must be publicly approved at a noticed, but rarely attended public hearing sponsored by the issuer.
- Unspent bond proceeds are invested within tax guidelines.