With the federal government’s increased scrutiny of nonprofit organizations and their tax-exempt status, the impact of losing tax-exempt status must be considered when these organizations are interested in issuing tax-exempt bonds. Access to the tax-exempt market is crucial for nonprofit organizations, including colleges, universities, hospitals, and health care systems, to fund necessary capital projects. The purpose of this article is to highlight areas in which nonprofit organizations are facing heightened scrutiny and how these organizations must ensure compliance with IRS rules and regulations to continue issuing tax-exempt bonds.
As background, certain nonprofit organizations may issue tax-exempt bonds for capital projects through a conduit issuer under Section 141 of the Internal Revenue Code. The publication “Tax-Exempt Bonds for 501(c)(3) Charitable Organizations” (Publication 4077, Rev. 9-2019) from the IRS provides an outline of critical compliance requirements for nonprofit organizations to not only issue tax-exempt bonds but also to maintain those tax-exempt bonds. Once the tax-exempt bonds are issued, the nonprofit organization must file Schedule K with the IRS Form 990 on an annual basis while the bonds are outstanding.
Disclosures in Official Statements
In general, tax-exempt bonds are described in an official statement, a public document that provides an overview of the borrower, the capital projects to be financed with tax-exempt bond proceeds, and relevant risks relating to the repayment of such tax-exempt bonds. There is typically a qualification found in the Official Statement which states that the failure of the nonprofit organization to maintain its tax-exempt status as a “501(c)(3) organization” and to conduct its activities (especially the activities relating to the capital projects financed with tax-exempt bond proceeds) in a substantially related manner to the nonprofit organization’s charitable purposes could result in the bond interest (which a bondholder will receive) being taxable. In certain situations, this taxable interest may be retroactive to the date on which the bondholder purchased the bond.
The conversion of a tax-exempt bond to a taxable bond may also affect the nonprofit organization’s ability to continue paying the bonds as they become due. For example, if a nonprofit organization included a budget for debt service and relied on being able to make the debt payments at a 5% interest rate, and the interest rate suddenly changes to 8%, the increased interest payments might render the nonprofit unable to pay.
A nonprofit organization may risk losing its tax-exempt status by failing to comply with the IRS rules and regulations governing its day-to-day operations. Any operations that are not related to the nonprofit organization’s charitable purposes and any operations that may result in the private benefit of individuals could impact the nonprofit organization’s tax-exempt status. In addition, the IRS has publicly stated that it will closely scrutinize any transactions between nonprofit organizations and for-profit organizations.
In addition to the standard disclosure provisions in official statements, there has been an increase in disclosures on this topic to inform bondholders about the additional proposed legislation and considerations facing nonprofit organizations. For example, some additional disclosures include language informing prospective bondholders that the activities of nonprofit organizations have been subject to increased scrutiny by federal, state, and local agencies, including the IRS and various local taxing authorities.
These agencies are reviewing the charitable activities of nonprofit organizations and determining whether they are sufficient to continue granting the organizations tax-exempt status (from federal, state, and local taxes, including real estate taxes). Some of the proposed legislation would restrict the definition of charitable activities and impose taxes on activities previously considered charitable. The potential conversion of some of these activities from charitable to taxable status may also affect whether nonprofit organizations can meet certain debt service requirements.
Heightened compliance concerns and responses
As nonprofit organizations face increased scrutiny, ensuring good governance and continued compliance is essential to maintaining tax-exempt status. The IRS has provided guidance on compliance with 501(c)(3) requirements in “Tax-Exempt Status for Your Nonprofit Organization” (Publication 557, Rev. January 2025). This publication outlines various ways nonprofit organizations must ensure compliance with IRS rules and regulations, including their charitable activities, governance, and reporting requirements. This is a great resource for senior staff, organizational leadership, and board members to review.
To maintain this tax-exempt status, it is important for nonprofit organizations to conduct regular governance reviews and policy updates, and to obtain early legal consultation on a routine basis. Organizational leaders need to remain current with changing rules and regulations.
Conclusion
As public and federal government scrutiny increases, nonprofit organizations and their advisors must rethink how they structure, maintain, and defend their tax‑exempt classifications before governance or regulatory issues limit access to critical tax-exempt funding options.
