The Issue Spot: Governmental Bonds: Private Benefit Limitations

Governmental Bonds: Private Benefit Limitations Current tax law distinguishes between bonds that finance property and activities that primarily support state and local governments and the general public ( “governmental bonds”) and bonds that are issued predominantly for private purposes (“private activity bond”). In the mid-20th Century, the federal government began to scrutinize the use of tax-exempt bonds by state and local governments to finance private projects that did not serve a traditional public purpose. While certain categories of tax- exempt “qualified private activity bonds” can be used to finance various specific projects (e.g., affordable housing) despite significant private benefit, interest on private activity bonds that purport to be governmental bonds generally is taxable. Thus, an issuer of governmental bonds must guard against running afoul of the limits placed on private benefit. This Issue Spot focuses on the private use limitations placed on governmental bonds. These limitations are separated generally into what are known as the “private business test” and the “private loan financing test.” If either the private business test or the private loan financing test is met, interest on the bonds will be taxable. As a result, issuers of governmental bonds must understand these tests to avoid an unintended (and potentially costly!) mistake.

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