The Issue Spot - Governmental Bonds - Private Benefit Limitations
The Issue Spot
PUBLIC FINANCE IN FOCUS
Governmental Bonds : Private Benefit Limitations
Current tax law distinguishes between ( i ) bonds that finance property and activities that primarily support state and local governments and the general public ( “ governmental bonds ”) and ( ii ) bonds that are issued predominantly for private purposes (“ private activity bond ”).
In the mid-20th Century , the federal government began to scrutinize the use of tax-exempt bonds by state and local governments to finance private projects that did not serve a traditional public purpose . While certain categories of tax- exempt “ qualified private activity bonds ” can be used to finance various specific projects ( e . g ., affordable housing ) despite significant private benefit , interest on private activity bonds that purport to be governmental bonds generally is taxable . Thus , an issuer of governmental bonds must guard against running afoul of the limits placed on private benefit .
This Issue Spot focuses on the private use limitations placed on governmental bonds . These limitations are separated generally into what are known as the “ private business test ” and the “ private loan financing test .” If either the private business test or the private loan financing test is met , interest on the bonds will be taxable . As a result , issuers of governmental bonds must understand these tests to avoid an unintended ( and potentially costly !) mistake .
The Private Business Test
The Private Business Test has two parts – ( i ) the “ private business use test ” and ( ii ) the “ private payment or security test .” If both of these tests are met with respect to an issue of governmental bonds , the bonds will be declared to be private activity bonds and , therefore , will lose their tax-exempt status . Conversely , if the issue meets the private business use test but fails the private payment or security test ( or vice versa ), then the bonds will not lose their taxexempt status ( i . e ., this is an instance where failing a test is a good thing ).
The Private Business Use Test
Generally , the private business use test will be met if more than 10 percent ( and in certain limited circumstances , 5 percent ) of the proceeds of the issue or the property to be financed by the issue is used , directly or indirectly , by