Fourth Quarter 2000

Using Tax-Exempt Bonds To Finance Capital Projects And Enhance Financial Stability

Holland & Knight Newsletter
James F. Millea

Schools, colleges, universities and other educational institutions that have qualified as organizations described in Section 501(c)(3) of the Internal Revenue Code are eligible to use tax-exempt bonds to finance capital and operating costs. Exempt educational institutions usually look to contributions from alumni and other donors to finance new libraries, dormitories, classrooms and other major projects. However, a carefully designed capital campaign can take advantage of both low interest rate, tax-exempt bond financing as well as donations to enhance the overall financial stability of the institution.

An institution is eligible for tax-exempt bond financing if it does not have readily available dedicated assets to finance the project. An exception is generally made for the endowment held by such an institution even if the endowment could be depleted to provide financing. The endowment is permitted to act as security for bond financing although that arrangement may effect the rate of return on certain assets in the endowment.

If the borrower receives a restricted donation that must, by its terms, be used to finance a capital project, those funds must be contributed to the bond fund and used to retire outstanding bonds as quickly as possible. Thus, an educational institution issuing tax-exempt bonds for a capital project will normally require the redemption of the bonds with the proceeds of any gift that is restricted to financing that project.

Restricted gifts occur when the donor wants to ensure that the gift is used for an appropriate purpose. Frequently, the donor is encouraged to restrict the use of a gift in exchange for an opportunity to have his or her name connected with a particular project. If, however, the capital campaign is structured in a way to provide recognition for the donation while eliminating the direct connection between the gift and the project, the institution can increase the size of its endowment and take advantage of the low interest, tax-exempt financing.

There are three requirements to achieve this result. First, the institution must be able to establish that it needs to borrow the proceeds of a tax-exempt bond to finance the construction of a project. If a donor previously has given a substantial restricted sum, the institution must reduce the amount of borrowing by the amount of that restricted gift. Second, the institution should prepare capital campaign literature that does not encourage restricted gifts but indicates instead that gifts of particular sizes will be recognized with appropriate naming opportunities. Even a substantial gift can be recognized with the naming of a building in honor of the donor without a legal requirement that the proceeds of the gift be used to finance the construction of that building. Finally, the institution must have a permanent endowment for the general financial stability of the institution rather than for financing particular projects. However, the income from this endowment can be used by the institution to service the debt on the tax exempt financing. Moreover, a substantial gift to the endowment can provide additional revenues that can assist in retiring the outstanding debt. When the debt is retired, the capital remains in the endowment, providing an extended benefit to the institution.

The key aspect to severing the connection between the gift and the bond finance project is the elimination of any legal requirements on the part of the institution to use the gift to pay for a particular project. Donors will often take a personal interest in a project undertaken by an institution. However, even if the donors have made a substantial contribution to the endowment, provided that there is no requirement that those proceeds be used for a project, the donors’ involvement in the project, including the review of plans and ultimately the naming of the project, does not eliminate the potential financial benefit.

Even though unrestricted giving provides a greater benefit to the institution, donors occasionally will insist on the use of funds for a particular project. In that instance, the bonds will have to be reduced or retired when the donation is made. A clear presentation of the benefits of unrestricted giving can lead donors who intend to help the institution to the maximum extent possible to make unrestricted gifts and provide a double benefit.

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