What Is Private Business Use of Tax-Exempt Bonds?

Private business use of tax-exempt bonds is any use of bond-financed property, direct or indirect, in a trade or business carried on by someone other than a state or local government.¹ When enough of that use exists alongside enough private payment or security, the bonds get reclassified as private activity bonds, and unless they fit one of the qualified categories that keep the tax exemption, interest becomes taxable to every bondholder.² That is why issuers, bond counsel, and nonprofit borrowers spend so much energy on a concept most people outside public finance have never heard of.

What Counts as Private Business Use

The definition sweeps wider than most people expect. Any activity by an entity that isn’t a natural person — a corporation, LLC, nonprofit, even the federal government — is automatically a trade or business for this purpose.¹ Leasing space in a bond-financed building to a private company is the obvious case. A federal agency occupying the same space is the same analysis.

Use by the general public does not count, but the carve-out is narrower than it sounds. The property has to be genuinely available to all comers on the same basis.³ Anyone paying the posted toll on a bond-financed road is a general public user. A company that negotiates priority access, preferential pricing, or exclusive scheduling has stepped out of that category and into private business use, even if the public can still use the facility at other times.

The pivot point is whether any arrangement gives a nongovernmental party a special legal entitlement to the property that the public doesn’t share. A lease is the clearest example. So is a management contract, an output purchase agreement, or a naming-rights deal that conveys priority rights to capacity.³

The Two Tests That Must Both Be Met

Some private use is tolerated. A governmental bond issue becomes a private activity bond only when two separate quantitative tests are both met on the same bond issue.¹

The first is the private business use test. More than 10% of bond proceeds must be used for private business purposes.

The second is the private security or payment test. More than 10% of the debt service must be secured by property involved in the private use or paid from money derived from that private use.¹ Security includes any interest in the privately used property, like a mortgage or lien. Payments include rent from a private tenant, fees from a private utility purchasing output, or debt service paid by a conduit borrower.

Both tests have to exceed 10% independently. Bonds backed solely by a government’s general taxing power may pass the security prong even when a private tenant occupies space, because no private payments flow to debt service. In the opposite direction, bonds heavily backed by private payments can still fail to trip the use test if the government keeps enough of its own operational use.

When the Tighter 5% Threshold Applies

A 5% threshold replaces the 10% figure when the private use is either unrelated to the governmental purpose of the bonds or disproportionate to the government’s share of the financing.¹ Build a community center with bond proceeds, lease 6% of the floor space to an unrelated retailer, and the 5% test applies to that unrelated use even though 6% would sail past a 10% ceiling.

Output facilities get an additional dollar cap. When 5% or more of bond proceeds fund something like a power plant or gas distribution system — water facilities are excluded — the total nonqualified amount across all related tax-exempt issues for that project cannot exceed $15 million.¹ The ceiling prevents governments from stringing multiple bond issues together to gradually expand private participation in energy infrastructure past what any single percentage test would catch.

The Separate Private Loan Financing Test

The use-and-security analysis isn’t the only path to reclassification. A bond issue independently becomes a private activity bond if more than the lesser of 5% of bond proceeds or $5 million is used to make or finance loans to nongovernmental borrowers.¹ This test stands alone. An issuer could pass both 10% tests with room to spare and still lose tax-exempt status because too many proceeds flowed to private loans.⁴ The absolute $5 million cap makes the test especially dangerous for smaller issuers, where even a modest lending program can push a bond issue over the line.

Arrangements That Quietly Create Private Use

Most private business use problems don’t come from renting a whole building to a corporation. They come from routine operating arrangements that look ordinary until someone runs the analysis.

Management Contracts

Hiring a private company to operate a bond-financed facility can create private business use if the manager takes a share of net profits or absorbs too much operating risk. Revenue Procedure 2017-13 sets safe harbor conditions that keep a management contract from tripping the test.⁵ The core requirements: all payments to the manager must be reasonable compensation for services actually provided; no piece of compensation can depend on the facility’s net profits or on both its revenues and expenses; the contract cannot shift operating losses onto the manager; the term including all renewal options cannot exceed the lesser of 30 years or 80% of the property’s weighted average economic life; and the governmental or qualified user must retain significant control, including approval of annual budgets and capital expenditures.

The safe harbor applies to any management contract entered into on or after January 17, 2017, and issuers can apply it retroactively to older contracts.⁶ A contract that falls outside the safe harbor isn’t automatically a violation, but it forces a facts-and-circumstances analysis most issuers would rather avoid.

Research and Output Agreements

Research agreements create private business use when a nongovernmental sponsor keeps exclusive rights to intellectual property developed in a bond-financed lab. If the university or government keeps ownership of the results and the sponsor gets a nonexclusive license, private use is less likely. The question is whether the sponsor walks away with proprietary benefits the public doesn’t share.

Output contracts create private use when a private purchaser has a contractual right to a share of a facility’s capacity. A fixed-fee agreement giving a private power company 20% of a municipal plant’s output means 20% of the facility is serving a private purpose for the duration of that contract.

How Private Use Is Measured Over Time

Private business use is tracked over the term of the bonds or the economic life of the financed property, whichever is shorter. It’s based on actual facts, not the issuer’s intentions at closing.³ An issuer that honestly expected full governmental use on the day bonds were sold can still face reclassification years later when circumstances change.

A “deliberate action” is any action within the issuer’s control that causes the tests to be met. The IRS doesn’t ask whether the issuer intended to violate the rules; it asks whether the issuer voluntarily entered the arrangement.⁷ Signing a 15-year lease with a private tenant in a bond-financed building is a deliberate action, even if the issuer believed in good faith the lease was permissible. The deliberate action happens on the day the binding contract is signed.

That’s why compliance is a rolling obligation. A building financed with 30-year bonds means tracking every tenant, every management arrangement, and every operational change for three decades. The private use percentage isn’t a closing-day calculation.

What Happens When Bonds Are Reclassified

Failing the tests doesn’t automatically make interest taxable. It converts the bonds into private activity bonds, and some categories of private activity bonds still qualify for tax exemption.¹ These “qualified bonds” include exempt facility bonds under IRC Section 142 (covering airports, docks, mass transit, water and sewage systems, solid waste disposal, qualified residential rental projects, broadband, carbon capture facilities, and several other categories),⁸ qualified 501(c)(3) bonds, qualified mortgage and veterans’ mortgage bonds, qualified small issue bonds, qualified student loan bonds, and qualified redevelopment bonds.

To keep tax-exempt status, a qualified private activity bond has to satisfy the state-by-state volume cap under IRC Section 146 and meet other conditions under IRC Section 147, including limits on land acquisition, maturity length, and public approval.¹ A private activity bond that doesn’t fit any qualified category, or that exceeds the volume cap, produces fully taxable interest.

Fixing a Violation

A deliberate action that trips the private use limits doesn’t necessarily mean permanently taxable bonds. Treasury regulations allow remedial actions that preserve tax-exempt status if the issuer acts promptly.⁹ The catch: they’re available only if the issuer reasonably expected on the issue date that the private use tests would not be met. An issuer who knowingly structured bonds around private use can’t invoke them later.

Redeeming or Defeasing the Nonqualified Bonds

The cleanest fix is retiring the portion of bonds that financed the excess private use. Callable bonds get redeemed outright. If they can’t be called, the issuer sets up a defeasance escrow within 90 days of the deliberate action, funded to cover principal, interest, and any call premium through the earliest call date.¹⁰ The escrow must be irrevocable and can’t be invested in higher-yielding obligations or in investments where the obligor is a user of the bond proceeds.

One important limit: defeasance doesn’t count if the period between issue date and first call date exceeds 10½ years.¹¹ Issuers with long non-call periods have to be especially careful in the early years of a bond issue, because if a violation happens, this remedy isn’t available.

Changing the Use or Selling the Property

Instead of retiring bonds, the issuer can change how the property is used. Bringing the privately used space back to governmental use resolves the problem. If the property is sold to a governmental unit at fair market value, the sale proceeds have to be applied to a governmental purpose within two years of the deliberate action.¹⁰ If it’s sold to a private party, the proceeds have to redeem or defease the nonqualified portion, and the sale has to be arm’s-length for fair value.

The Voluntary Closing Agreement Program

When standard remedial actions aren’t available or can’t fully cure the problem, the IRS runs a Voluntary Closing Agreement Program that lets issuers come forward, disclose the violation, and negotiate a resolution.¹² The resolution usually involves a closing agreement payment calculated on the amount of nonqualified bonds and the tax benefit received by bondholders.¹³ The minimum payment is $2,500. Waiting costs money: a request submitted within six months of the deliberate action carries a lower payment than one submitted between six and twelve months later, and payments climb from there.

Extra Rules for 501(c)(3) Bonds

Qualified 501(c)(3) bonds are a carve-out within the private activity bond framework, giving nonprofit hospitals, universities, and similar organizations access to tax-exempt financing.¹⁴ The central mechanic: the 501(c)(3) organization is treated as a governmental unit for its exempt activities. A nonprofit hospital using a bond-financed building for patient care isn’t generating private business use.

Use by anyone else, though, doesn’t get that pass, and the numeric limits are tighter. No more than 5% of net proceeds can go to private business use, and no more than 5% of debt service can be secured by or paid from private payments.¹⁴ All property financed with net proceeds has to be owned by the 501(c)(3) organization or a governmental unit. Because issuance costs are counted against the 5% ceiling, the actual room for private use is even smaller than 5% suggests.

Use by the 501(c)(3) itself still counts as private business use if it involves an unrelated trade or business — an activity not substantially related to the exempt purpose. A university gift shop selling branded merchandise to alumni may generate unrelated business income under IRC Section 513, and the square footage of that shop counts against the 5% allowance if it sits in bond-financed space.¹⁵ With a 5% ceiling, small commercial activities add up quickly.

Non-hospital 501(c)(3) organizations face one more constraint. Total face amount of outstanding tax-exempt bonds benefiting a single such organization can’t exceed $150 million, aggregated across every issuer.¹⁴ A large university approaching that ceiling has to track all outstanding tax-exempt debt before asking any government authority to issue more on its behalf.

Management contracts for 501(c)(3) bond-financed facilities have to meet the same Revenue Procedure 2017-13 safe harbor conditions that apply to governmental bonds.⁵ A contract that fails treats the entire managed facility as being used by the private manager, which can burn through a 5% ceiling in a single arrangement. Nonprofit hospitals outsourcing cafeteria, parking, or specialty medical services to for-profit operators are the most common places this shows up.

Ongoing Monitoring Isn’t Optional

These rules govern bonds for as long as they’re outstanding, which routinely means 20 to 30 years. The IRS expects issuers to adopt written post-issuance compliance procedures covering periodic due diligence, a named responsible official, record retention that substantiates compliance, and processes for identifying and correcting problems quickly.¹⁶ A tenant turnover in year 18 of a 30-year bond can create a violation just as easily as one in year two, and an issuer that has stopped paying attention is the one most likely to miss the 90-day defeasance window and lose the remedial action option altogether.

1
Office of the Law Revision Counsel. 26 USC 141 – Private Activity Bond; Qualified Bond
2
Office of the Law Revision Counsel. 26 US Code 103 – Interest on State and Local Bonds
3
eCFR. 26 CFR 1.141-3 – Definition of Private Business Use
4
eCFR. 26 CFR 1.141-5 – Private Loan Financing Test
5
Internal Revenue Service. Revenue Procedure 2017-13
6
Internal Revenue Service. Private Business Use – Management Contracts
7
Internal Revenue Service. TEB Self-Correction – Some Basic Concepts
8
Office of the Law Revision Counsel. 26 US Code 142 – Exempt Facility Bond
9
eCFR. 26 CFR 1.141-12 – Remedial Actions
10
Internal Revenue Service. Sale or Disposition of a Bond Financed IRC Section 501(c)(3) Facility
11
GovInfo. 26 CFR 1.141-12 – Remedial Actions
12
Internal Revenue Service. TEB Voluntary Closing Agreement Program
13
Internal Revenue Service. 7.2.3 Tax Exempt Bonds Voluntary Closing Agreement Program
14
Office of the Law Revision Counsel. 26 US Code 145 – Qualified 501(c)(3) Bond
15
GovInfo. 26 US Code 513 – Unrelated Trade or Business
16
Internal Revenue Service. TEB Post-Issuance Compliance – Some Basic Concepts