Bond recovery payment creates only incidental private benefit

Plain-English summary

A state nonprofit organization financed a project with state-issued bonds, later defaulted, and reorganized in bankruptcy. Replacement bonds issued under the reorganization included a payment based on available project revenue and capped at the unpaid principal and interest on the original bonds. The IRS concluded that this component did not benefit private bondholders more than incidentally because it allowed them to recover no more than the amount originally owed. The payment therefore did not adversely affect the organization's section 115 income exclusion on private-benefit grounds. The IRS did not decide whether the organization otherwise performed an essential governmental function, whether its income accrued to the state, or whether the original bonds were debt for federal tax purposes.

Ruling snapshot

• Question: Does the revenue-based recovery payment to replacement bondholders create impermissible private benefit under section 115?
• Outcome: No, provided the payment does not exceed the amount originally owed on the discharged bonds.
• Key authorities: IRC § 115; Rev. Rul. 90-74

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201606004                                             Third Party Communication: None
Release Date: 2/5/2016                                        Date of Communication: Not Applicable
Index Number: 115.00-00, 115.06-00,
              115.06-02                                       Person To Contact:
                                                              --------------------, ID No. ----------------
----------------------------------------                      Telephone Number:
-----------------------------------------                     --------------------
------------                                                  Refer Reply To:
---------------------------------                             CC:TEGE:EOEG:EO2
                                                              PLR-115901-15
                                                              Date:
                                                              November 3, 2015




Organization          =   ----------------------------------------
State                 =   ----------
Year A                =   ------
Year B                =   ------
Original Bonds        =   -----------------------------------------------------------
Bond 1                =   ----------------
Bond 2                =   ------------------------------
Project               =   ----------------------------------------------------------------
Component             =   ----------------------------------
x%                    =   --------
y%                    =   --------
z%                    =   ------
Date 1                =   --------------------------
Date 2                =   -----------------------
Bond X                =   --------------------
Bond Y                =   --------------------
Bank                  =   ----------------------------------------

Dear ----------------------------------------:

This letter responds to a letter from Organization’s authorized representative dated April
24, 2015, requesting a ruling that the Organization’s payment of the Component of
Bond Y will not adversely affect the status of the income of the Organization as not
included in gross income pursuant to IRC section 115. Organization represents the
facts as follows.

Organization is a State nonprofit corporation. Organization has represented that all of
its income is excludable under IRC section 115(1) in that its income is derived from an
PLR-115901-15                                 2

essential governmental function and all of its income accrues to the State or a political
subdivision of State.

In Year A, State issued tax-exempt Original Bonds consisting of Bond 1 and Bond 2 and
loaned the proceeds to Organization to fund the Project. Under the financing
agreement, Organization made payments of debt service to State equal to the debt
service due on Original Bonds. The payments from Organization to State were used to
make debt service payments to the holders of Original Bonds. In Year B, Organization
defaulted on making its debt service payments under the financing agreement and filed
for bankruptcy.

Pursuant to the plan of reorganization approved by the Bankruptcy Court, Organization
issued Bond X and Bond Y in satisfaction of certain claims against Organization, arising
primarily out of the default on Original Bonds. Bond X and Bond Y were issued to the
holders of Bond 1 on a pro rata basis and Original Bonds were discharged.

Bond Y bears interest at the rate of x% through Date 1 and y% thereafter, plus a
Component payment. The Component is equal to z% of net Project revenue that is
available after the payment of the fixed rate of interest on the Bond X and Bond Y. In
no event will the Component payments exceed the Deficiency Amount. The Deficiency
Amount is defined as the difference between the aggregate scheduled debt service on
Bond 1 accrued through the date Organization filed its voluntary petition for bankruptcy,
less the sum of the payment offered or paid by Bank in its offer for Bond 1 and all
principal and interest previously paid on Bond X and Bond Y. The Component payment
is intended to allow Bond 1 holders of Original Bonds to recover, without any
duplication, principal and interest accrued or the accreted value of capital appreciation.

Law and Analysis

IRC section 115(1) provides that gross income does not include income derived from
any public utility or the exercise of any essential governmental function and accruing to
a state or any political subdivision thereof.

Rev. Rul. 90-74, 1990-2 C.B. 34, holds that the income of an organization formed,
operated, and funded by political subdivisions to pool various risks (e.g., casualty, public
liability, workers’ compensation, and employees’ health) is excludable from gross
income under IRC section 115(1) because the organization is performing an essential
governmental function and the income accrues to the political subdivisions. In reaching
these conclusions, the revenue ruling explains that, other than an incidental benefit to
employees by insuring against the risks, private interests do not participate in or benefit
from the operation of the organization and private interests do not benefit from the
income of the organization.
PLR-115901-15                                  3

Organization used Original Bonds to fund Project. Pursuant to the Bankruptcy Court
Order, Original Bonds were discharged and replaced with Bond X and Bond Y.
Component allows bondholders of Bond Y the potential to recover principal and interest
or the accreted value of capital appreciation amounts of Bond 1 that was discharged by
the Bankruptcy Court. The benefit to the bondholders of Bond Y receiving the
Component payment is no greater than what they would have received as the
bondholders of Bond 1 had the Organization not reorganized under the bankruptcy
laws. Furthermore, based on the facts above, terms of the Component are a means to
ensure that the holders of the Bond Y recover the amounts originally owed under the
Bond 1. The Project revenues are simply the source from which the amounts originally
owed under the Bond 1 will be paid.

Based solely on the facts and representations submitted by Organization, we conclude
that the payment of Component to the holders of Bond Y in an amount no more than
originally owed to the holders of Bond 1 does not benefit private interests more than
incidentally for purposes of determining whether the income of Organization otherwise
satisfies the requirements for the exclusion under IRC section 115(1).

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, no opinion is expressed or implied concerning whether
Organization’s income is derived from the exercise of an essential governmental
function or whether Organization otherwise satisfies the accrual requirement of IRC
section 115(1), such that its income is excludable from gross income under IRC section
115(1).

In addition, no opinion is expressed on whether the Original Bonds are debt obligations
for federal income tax purposes.

This ruling is directed only to the taxpayer requesting it. IRC section 6110(k)(3)
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
PLR-115901-15                               4

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                     Sincerely,

                                     /S/

                                     Andrew F. Megosh, Jr.
                                     Senior Tax Law Specialist
                                     Exempt Organizations
                                     (Tax Exempt & Government Entities)




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