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, by someone other than a state or local government in a trade or business.¹ It matters because interest on state and local bonds is exempt from federal income tax only so long as the financed property predominantly serves a public purpose.² When private use crosses the thresholds Congress drew in Section 141, the bonds get reclassified as private activity bonds, and the interest can become taxable to every bondholder unless the bonds fit a narrow set of qualified categories.

What the Definition Actually Covers

The definition sweeps wider than most people expect. Any activity by an entity that is not a natural person counts as a trade or business for this purpose, including corporations, LLCs, nonprofits, and even the federal government. A private tenant leasing space in a bond-financed building is the obvious case. A federal agency occupying the same space triggers the same analysis.

Use by the general public does not count, but the exception is narrower than it sounds.³ The property has to be genuinely available to everyone on the same basis. A driver paying the posted toll on a bond-financed road is a general public user. A trucking company that negotiates priority access, preferential pricing, or guaranteed scheduling has crossed into private business use, even if the public can use the road at other times.

The decisive question is whether an arrangement conveys a special legal entitlement to a nongovernmental party. That entitlement can take the form of a lease, a management contract, an output purchase agreement, or any other right to use the property that the public does not share.³ Priority rights to capacity, even without a formal lease, are enough.

The Two 10% Tests

Private use alone does not reclassify a bond issue. Two prongs have to be met at the same time: the private business use test and the private security or payment test.¹

The use test is met when more than 10% of bond proceeds are used for private business purposes. The security or payment test is met when the payment of principal or interest on more than 10% of the proceeds is secured by property involved in the private use, or is derived from payments connected to that private use. Security includes any interest in the privately used property, such as a mortgage or lien. Payments include rent from a private tenant, fees from a private utility buying output, or debt service paid by a conduit borrower.

The split matters in practice. Bonds backed solely by the government’s general taxing power, with no private payments flowing to debt service, can fail the use test and still clear the security test. The reverse is also possible. Both prongs have to independently exceed 10% before the bonds become private activity bonds.

When 5% Is the Ceiling Instead

A lower 5% threshold applies when the private use is unrelated to the governmental purpose of the bond issue, or is disproportionate to the government’s own share of the financing.¹ A government that builds a community center and leases 6% of the space to an unrelated private retailer would clear the 10% test but fail the 5% unrelated-use test.

Output facilities face an additional cap. When 5% or more of bond proceeds fund an output facility such as 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 dollar ceiling blocks governments from using successive issues to expand private use of energy infrastructure past what a percentage test alone would catch.

The Separate Private Loan Test

A different path leads to the same reclassification. A bond issue becomes a private activity bond if more than the lesser of 5% of proceeds or $5 million is used to make or finance loans to nongovernmental borrowers.¹ This test stands on its own. An issuer can satisfy both 10% tests comfortably and still lose tax-exempt status by lending too much of the proceeds.

Direct and indirect lending both count. A few arrangements are excluded, including loans financing government tax assessments, certain nonpurpose investments, and qualified natural gas supply contracts.⁴ The absolute $5 million cap makes the test particularly sharp for smaller issuers, where even a modest conduit loan program can push an issue over the line.

Arrangements That Routinely Create Private Use

Most private use problems do not come from leasing an entire building to a corporation. They come from operational arrangements that look routine until someone applies the rules to them.

Management Contracts

Hiring a private company to run a bond-financed facility can create private business use if the manager shares in net profits or bears too much operating risk. The IRS set out safe harbor conditions in Revenue Procedure 2017-13 that, when satisfied, keep a management contract from triggering the private business use test.⁵ The key conditions:

All payments to the manager must be reasonable compensation for services actually provided, including reimbursement of direct expenses and related overhead.
No element of the manager’s compensation can depend on the facility’s net profits, or on both revenues and expenses for any period. Performance incentives tied to quality or productivity are allowed; incentives tied to profitability are not.
The contract cannot shift the burden of the facility’s operating losses onto the manager.
The term, including renewal options, cannot exceed the lesser of 30 years or 80% of the weighted average economic life of the managed property.
The governmental or qualified user must retain significant control, including approval of annual budgets and capital expenditures.

Revenue Procedure 2017-13 applies to any management contract entered into on or after January 17, 2017, and issuers may apply it retroactively to older contracts.⁶ Contracts outside the safe harbor are not automatically violations, but they require a facts-and-circumstances analysis most issuers would rather avoid.

Research and Output Contracts

Research agreements create private business use when a nongovernmental sponsor retains exclusive rights to intellectual property developed in a bond-financed laboratory. If the government or university keeps ownership of the research results and the sponsor gets only a non-exclusive license, the arrangement is far less likely to be treated as private use. The decisive question is whether the sponsor walks away with proprietary benefits the public does not share.

Output contracts, where a private utility purchases electricity, gas, or similar output from a bond-financed facility, are private business use when the purchaser has a contractual right to a share of the facility’s capacity. An agreement granting a private power company 20% of a municipal plant’s output means 20% of the facility is serving a private purpose for the length of the contract.

Measurement Runs for the Life of the Bonds

Private business use is measured over the entire term of the bonds or the economic life of the financed property, whichever is shorter. The tests apply to actual facts, not to the issuer’s intentions at closing.³ An issuer who honestly expected fully governmental use on the day of issuance can still face reclassification years later if circumstances change.

The regulations use the term “deliberate action” for any action within the issuer’s control that causes the private use tests to be met. Intent to violate the rules is not required; voluntarily entering into the arrangement is enough.⁷ Signing a 15-year lease with a private tenant is a deliberate action on the date of signing, even if the issuer believed in good faith the lease was fine.

The practical consequence is that every contract touching bond-financed property has to be monitored from issuance through final maturity. A building financed with 30-year bonds requires tracking every tenant, management arrangement, and operational change across the full three decades. The private use percentage is not a one-time closing calculation. It is a rolling obligation that shifts with each new lease or contract renewal.

What Happens When the Tests Are Failed

Failing the private use tests does not automatically make bond interest taxable. It reclassifies the bonds as private activity bonds, and certain categories of private activity bonds still qualify for tax exemption.¹ These “qualified bonds” include exempt facility bonds for airports, docks, mass transit, water and sewage, solid waste, qualified residential rental projects, broadband, and several other categories listed in IRC Section 142;⁸ qualified 501(c)(3) bonds; qualified mortgage and veterans’ mortgage bonds; qualified small issue bonds; qualified student loan bonds; and qualified redevelopment bonds.

Even qualified private activity bonds have to clear further hurdles to keep their exemption, including a state-by-state volume cap under IRC Section 146 and additional requirements under IRC Section 147 covering land acquisition, maturity length, and public approval. A private activity bond that does not fit any qualified category, or that exceeds the volume cap, produces fully taxable interest for every bondholder.

Fixing a Violation

When a deliberate action pushes bonds past the limits, the issuer is not necessarily stuck with taxable bonds. Treasury regulations provide remedial actions that, if taken promptly, preserve tax-exempt status.⁹ Access to these remedies depends on the issuer having reasonably expected, on the date of issuance, that the private use tests would not be met. An issuer who structured bonds in anticipation of excess private use cannot claim them later.

The most direct remedy is retiring the portion of bonds that financed the excess private use. Callable bonds can be redeemed outright. Non-callable bonds have to be defeased through an irrevocable escrow established within 90 days of the deliberate action, funded with enough to cover principal, interest, and any call premium through the earliest call date.¹⁰ The escrow cannot be invested in higher-yielding obligations or in investments where the obligor is a user of the bond proceeds. Defeasance will not satisfy the requirement if the period between the issue date and the first call date exceeds 10½ years,¹¹ which puts a premium on preventing violations in the early years of issues with long non-call periods.

Changing the use of the property is an alternative. Converting the privately used space back to governmental use eliminates the problem. Sale to a governmental unit at fair market value is also acceptable, provided the disposition proceeds are applied to a governmental purpose within two years. Sale to a private party requires that the proceeds be used to redeem or defease the nonqualified portion of the bonds, and the transaction must be arm’s length at fair market value.

When standard remedies are unavailable or cannot fully cure the violation, the IRS offers a Voluntary Closing Agreement Program for tax-exempt bond issuers.¹² The issuer comes forward, discloses the violation, and negotiates 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. Submitting within six months of the deliberate action results in a lower payment than submitting between six and twelve months out, and late discovery costs considerably more.

Tighter Rules for 501(c)(3) Bonds

Qualified 501(c)(3) bonds are a carve-out that lets charitable organizations like hospitals and universities use tax-exempt financing.¹⁴ The central accommodation is that the 501(c)(3) organization itself is treated as a governmental unit for purposes of its exempt activities. A nonprofit hospital using a bond-financed building for patient care is not creating private business use, even though the hospital is technically a nongovernmental entity.

The 10% thresholds are replaced with 5% limits. No more than 5% of net proceeds can be used for private business purposes, and no more than 5% of debt service can be secured by or derived from private payments. All property financed with net proceeds has to be owned by the 501(c)(3) organization or a governmental unit. Issuance costs count against the 5% limit, so the practical room for any private use is even smaller than it appears.

Use by the 501(c)(3) organization itself still counts as private business use if it involves an unrelated trade or business, meaning an activity not substantially related to the exempt purpose. A university gift shop generating unrelated business income under IRC Section 513 that occupies bond-financed space has its square footage counted against the 5% ceiling.¹⁵ Management contracts have to meet the same Revenue Procedure 2017-13 safe harbor conditions that apply to governmental bonds. A contract that fails the safe harbor treats the entire managed facility as being used by the private manager, which can blow through a 5% ceiling almost immediately. Nonprofit hospitals that outsource cafeteria operations, parking management, or specialty medical services to for-profit companies are the most common place this problem shows up.

Compliance Does Not Stop at Closing

The private business use rules impose ongoing obligations for as long as the bonds remain outstanding, often 20 to 30 years. The IRS recommends written post-issuance compliance procedures covering due diligence reviews at regular intervals, a designated responsible official, retention of records substantiating compliance, and procedures to identify and correct problems in time.¹⁶

Forms 8038 and 8038-G now ask whether the issuer has adopted these written procedures, which signals that the IRS treats post-issuance monitoring as a baseline expectation. Every lease, management contract, naming-rights agreement, and operational change touching bond-financed property has to be tracked. A tenant turnover in year 18 of a 30-year bond can create a violation as easily as one in year two, and the issuer who stopped paying attention is the one most likely to miss the 90-day remedial action window.

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