CDFA Spotlight: Two Percent Cost of Issuance Limit By Stan Provus

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This article reviews the process for calculating the two percent cost of issuance limitation.

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This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

Internal Revenue Code (IRC) section 147(g)(1) provides that a private activity bond shall not be a qualified bond if the issuance costs financed by the issue exceed two percent of the proceeds of the issue (Not the face amount of the issue). The 2% limit works in tandem with the “95% percent” test. This test provides that at least 95% of net proceeds of certain qualified private activity bonds must be used for the exempt purposes; e.g. construction costs, etc. The 2% cost of issuance limitation must be financed only from the so-called five percent “bad money” portion of the issue. The 2% cost of issuance limitation is counted as part of the 5% “bad money” limit.

The 5% “bad money” limit and 2% cost of issuance limitations are calculated differently. The 5% “bad money” limit is applied to net bond proceeds (sale proceeds minus deposit to a reserve fund), while the 2% limit is applied to sale proceeds.

Example

ABC Industrial Development Authority issues $1,000,000 bonds for XYZ Corporation, who will own and operate a manufacturing facility. This is a fixed-rate qualified small issue bond, hence the need for a reserve fund. Use of proceeds includes:

$1,000,000 Sale Proceeds

($100,000) Deposit to Reserve Fund

$900,000 Net Proceeds

$900,000 x .95= $855,000 is the amount required to be used for exempt purposes
$855,000

$45,000 The 5% “bad money” limit ($900,000 x .05)

($20,000) 2 percent permitted for cost of issuance (1,000,000 x .02)

$25,000 Portion of the “bad money” allowance remaining to be used for non-issuance, nonexempt purposes.

In this example, if more than $20,000 was used to pay cost of issuance costs, the bonds would not be qualified private activity bonds. Similarly, if more than $45,000 (which must include the $20,000 for cost of issuance) was spent for non-issuance/nonexempt purposes, the bonds would not be qualified private activity bonds. It should be noted that the cost of qualified guarantees such as bond insurance or initial letter of credit fees may be financed from the 5% “bad money” portion—in this example up to $25,000 is available for such purposes. In cases where costs exceed these limitations, the excess is often financed with equity contributions or a taxable tail.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.