Private Business Use and the Limits on It
A governmental bond stops being one when too much of the financed property is used in a trade or business and too much of the debt service comes from that use. Both conditions must be met, which is why the analysis always runs on two tracks at once.
The rule in short
An issue is a private activity bond if it meets both the private business use test and the private security or payment test, or if it meets the private loan financing test. The use threshold is ten percent, reduced to five percent for use unrelated or disproportionate to the governmental purpose. A management contract meeting the conditions of the published safe harbor does not create private business use.
The exclusion of interest from gross income is available for bonds that finance governmental activity. Two tests police the boundary. The use test asks whether more than a permitted share of proceeds is used in a trade or business carried on by someone other than a governmental unit. The payment test asks whether more than a permitted share of debt service is secured by or derived from private property or payments. An issue becomes a private activity bond only if both are met.
Why both tests must be met
The conjunctive design is deliberate and it drives every structuring decision in the area. A city that leases part of a financed garage to a private operator has private business use, but if debt service comes entirely from a general tax levy and nothing about the lease secures the bonds, the payment test is not met and the issue remains governmental. Conversely, an issue paid from private receipts but used entirely for governmental purposes fails the use test and survives on that ground.
A third route exists and is disjunctive. An issue is also a private activity bond if it meets the private loan financing test, which looks at proceeds used to make or finance loans to nongovernmental persons and applies its own low threshold. Because a loan can be created without any transfer of property, that test catches arrangements the other two would miss, and it is measured independently of them.
What counts as use
Private business use is use, directly or indirectly, in a trade or business carried on by a person other than a governmental unit, and any activity carried on by a person other than a natural person is treated as a trade or business. Both actual and beneficial use may count. In most cases the test is met only where a nongovernmental person holds special legal entitlements to use the financed property, which typically arise from ownership, a lease, a management contract, an incentive payment contract, or an output-type arrangement.
Certain service arrangements are carved out of the management contract category altogether. Contracts for services solely incidental to the primary governmental function of a facility, such as janitorial work, office equipment repair or billing, are not treated as management contracts. Nor is the mere granting of admitting privileges by a hospital to a physician where the privileges are available to qualified physicians in the area. Contracts under which the only compensation is reimbursement of the provider's actual and direct expenses are treated the same way.
Use by the general public on the same terms available to everyone is not a special legal entitlement, which is why a public road or a municipal pool used by commuters and residents raises no issue. The analysis turns on preferential access rather than on the identity of the user, so a long-term reserved parking arrangement for a single business is treated differently from an hourly rate available to anyone who arrives.
Where the financed property is owned by a nongovernmental person, private business use follows from the ownership itself, and no analysis of contracts is needed. The regulations also treat an arrangement that is properly characterized as a lease for federal tax purposes as a lease regardless of what it is called, considering the degree of control exercised and whether the private person bears the risk of loss.
The management contract safe harbor
Contracting out the operation of a financed facility is the most common source of private business use, and the published revenue procedure supplies conditions under which a management contract does not create it. Compensation must be reasonable for the services rendered and must not give the service provider a share of net profits: no element of eligibility for, amount of, or timing of payment may be contingent on net profits or on both revenues and expenses of the managed property. The provider must not bear a share of net losses either.
Four further conditions apply. The term, including renewal options, must not exceed the lesser of thirty years or eighty percent of the weighted average reasonably expected economic life of the managed property. The governmental user must exercise significant control, shown by approving the annual budget, capital expenditures, dispositions, the rates charged and the general type of use. The governmental user must bear the risk of loss from damage or destruction. And the provider must take no tax position inconsistent with being a service provider.
| Arrangement | Ordinary treatment | Governing condition |
|---|---|---|
| Private ownership of financed property | Private business use | Follows from ownership itself |
| Lease to a private tenant | Private business use | Substance controls over the label used |
| Management contract within the safe harbor | Not private business use | Compensation, term, control, risk and relationship conditions |
| Use by the general public on equal terms | Not private business use | No special legal entitlement is conferred |
| Incidental service contracts | Generally not a management contract | Services solely incidental to the governmental function |
The payment side of the analysis
The payment test is met where payment of principal or interest on more than the permitted share is, under the terms of the issue or any underlying arrangement, directly or indirectly secured by an interest in property used for a private business use or in payments from such property, or derived from payments in respect of such property. The two limbs are separate: security alone suffices even where no private payments are actually applied to debt service.
Underlying arrangement is a broad phrase and it is meant to be. A payment obligation need not appear in the bond documents to count; an agreement collateral to the financing that in substance directs private money toward debt service is within the test. That reach is why counsel reviews service agreements, output contracts and development agreements alongside the indenture, since a covenant buried in an unrelated document can supply the payment element that the financing documents carefully avoided creating.
Measurement is done in present value terms against the debt service on the issue, which means a modest annual payment stream over a long term can carry more weight than a single large payment. Generally applicable taxes are excluded, so a private user's ordinary property tax bill does not count, while a special assessment imposed on identified beneficiaries requires closer examination against the regulations.
Curing a change that comes later
Expectations at closing govern, but a deliberate action taken afterward that causes the tests to be met is treated as if it had been expected. The regulations supply remedial actions that cure the result if their conditions are satisfied, commonly redemption or defeasance of the nonqualified bonds, an alternative qualifying use of the disposition proceeds, or an alternative qualifying use of the facility itself. Each requires that the original expectations were reasonable and that any disposition was for fair market value in cash.
Because remediation depends on tracing proceeds to specific costs, the allocation records made during construction determine whether a cure is available years later. Those same records support the computations described in the arbitrage and rebate rules. A change in status that cannot be cured produces a reportable event, described in the listed events and their ten business day period, and it disturbs the premise of the conclusion set out in what bond counsel actually opines on.
Points to carry away
- The use test and the payment test must both be met before an issue becomes a private activity bond.
- The general threshold is ten percent of proceeds, lowered to five percent for unrelated or disproportionate use.
- Private business use includes ownership, leases, management contracts and other special legal entitlements.
- A management contract satisfying the published safe harbor conditions does not create private business use.
- Remedial actions in the regulations can cure a later change in use if their conditions are met.
Questions readers ask
How does the reduced five percent threshold apply?
The statute substitutes five percent for ten percent where the private business use is not related to any governmental use financed by the issue, and also where the use is related but disproportionate to the governmental use it relates to. Disproportionate use is measured by comparing the proceeds devoted to the private use with those devoted to the governmental use it is related to, and counting the excess. The reduction applies to both the use test and the payment test, so a small unrelated arrangement can matter more than its size suggests.
Does a short-term arrangement create private business use?
Not necessarily. The regulations treat certain short-term arrangements as outside private business use, and general public use on the same basis as other members of the public is not a special legal entitlement at all. A negotiated arm's length arrangement of very limited duration, priced at generally applicable fair market value, may fall within an exception. The analysis is factual, so the terms of the arrangement, its length and the pricing method all have to be documented at the time.
What are the additional restrictions on qualified charitable bonds?
Where an issue finances property for a charitable organization, the applicable use test is modified rather than removed, and use by the organization in an unrelated trade or business counts against the limit alongside use by any other private party. The regulations apply the private activity bond rules to those issues with stated adjustments. The result is that an organization must monitor not only third-party arrangements but also its own activities in the financed space.
Sources
- 26 U.S. Code § 141 — Private activity bond; qualified bondSets the use, payment and loan tests and the reduced five percent thresholds.
- 26 CFR § 1.141-3 — Definition of private business useDescribes special legal entitlements, leases and management contracts as private business use.
- 26 CFR § 1.141-4 — Private security or payment testExplains how payments and security from private sources are measured.
- 26 CFR § 1.141-12 — Remedial actionsSets the conditions for curing a deliberate action that would otherwise cause a failure.
- IRS Rev. Proc. 2017-13 — Management contract safe harborStates the compensation, term, control, risk of loss and relationship conditions of the safe harbor.
- 26 U.S. Code § 145 — Qualified 501(c)(3) bondApplies a modified use test to bonds financing charitable facilities.
- 26 CFR § 1.145-2 — Application of private activity bond regulationsAdapts the private activity bond regulations to charitable issues.
Pinnacle Law Review is a publication, not a law firm. This article states general rules and cites its sources; it is not advice about any particular case, and the law differs by state and changes over time.
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