A private activity bond is a government-issued bond whose proceeds will be used by an entity other than a governmental unit. Municipal bond interest income is generally exempt from regular federal income taxes; however, private activity bonds have different rules.
Under IRC Section 141(a), a government-issued bond will be a private activity bond if the bond issue meets:
- The private business tests of IRC Section 141(b), which is the private use test and the private security and payment test, or
- The private loan financing test of IRC Section 141(c).
A private activity bond is either a qualified private activity bond or a nonqualified private activity bond.
Interest income from a “nonqualified” private activity bond is taxable for regular federal tax purposes, so the municipal bond interest exemption does not apply.
Interest income from a “qualified” private activity bond is still tax-exempt, even though nongovernmental entities use the proceeds. Interest from a qualified private activity bond does require an alternative minimum tax (AMT) adjustment for the preference item. Visit our channel for a video tutorial on AMT adjustments for qualified private activity bond interest income on Form 6251 (Alternative Minimum Tax for Individuals).
The state or local authority issuing the bond must notify the IRS by filing Form 8038 (Information Return for Tax-Exempt Private Activity Bond Issues).
Example of a Nonqualified Private Activity Bond
A Florida county (“County B) wants to encourage a for-profit manufacturing company to build a new warehouse and hire local employees. County B issues $10,000,000 of revenue bonds and uses all the proceeds to extend a loan to Company A to construct their warehouse. Company A will repay the principal and interest from its profits.
The transaction meets the private loan financing test of Section 141(c)(1). The transaction does not meet the “qualified small issue bond” exception or any other exception, so it is a nonqualified private activity bond. The interest income paid will be includable in the bondholder’s federal gross income.
Example of a Qualified Private Activity Bond
A Florida county (“County D) needs a new hospital. It wants to partner with a Section 501(c)(3) nonprofit hospital organization (“Nonprofit A”) that operates in five states. County D issues $50,000,000 of revenue bonds and uses all the proceeds to extend a loan to the nonprofit organization to build and operate the hospital.
The transaction is a qualified 501(c)(3) bond and a tax-exempt qualified private activity bond issue. The interest income paid to the bondholders is excluded from regular federal gross income; however, the bondholders must still account for the AMT preference item.
Investors can find more information about tax-exempt bonds issued for 501(c)(3) charitable organizations in IRS Publication 4077.