Good news for sectarian educational institutions issuing tax-exempt bonds.

The Sixth Circuit Court of Appeals has held that the issuance of tax-exempt bonds to a sectarian university does not violate the First Amendment as the bonds were part of a neutral program to benefit education and conferred only an indirect benefit on the university. The court held that the nature of the institution is irrelevant and that the conduit financing advanced a governmental interest without creating the impression that the government was endorsing religion.

Introduction

Since the inception of a federal income tax in 1913, the federal government has continuously provided an exemption for interest on bonds issued "by or on behalf of' states and localities (12). While initially capitalizing on this exemption via the issuance of general obligation bonds, over time, state and local governments issued revenue bonds to finance private business activities to promote economic growth (9). Congress exempted from the federal income tax interest on industrial revenue bonds connected to projects which benefited a local economy. Typically, industrial revenue bonds are issued by a governmental authority, however, the authority does not actually, directly borrow the funds or become liable for repayment of the funds (21).

In a case of first impression, the Sixth Circuit Court of Appeals recently addressed the constitutionality of the issuance of tax-exempt bonds by the Industrial Development Board ("Board") of the Metropolitan Government of Nashville ("Metro") to David Lipscomb University ("Lipscomb"), which was ruled a "pervasively sectarian" educational institution (6). Specifically, the court addressed the issue of whether tax-exempt bond financing to a "pervasively sectarian" educational institution constituted a form of direct state aid with the primary effect of advancing religion, and thus, violating the Establishment Clause of the U.S. Constitution (2). Ultimately, the court answered the question with a resounding--No!

Steele presents an interesting blend of analysis of federal tax law and constitutional law. In this day and age, issues of separation of church and state have been in the forefront of constitutional issues before the Supreme Court (20). While it remains to be seen whether Steele will reach the Supreme Court, it certainly has established a foundation with its well-reasoned opinion for other circuit courts to follow its reasoning. This may have a positive impact on local economies as it will foster the issuance of industrial revenue bonds to all sectarian educational institutions, thus stimulating construction projects and investment throughout the United States. Tax practitioners, businesspersons, underwriters, developers, state and local governments, investors in tax-exempt bonds, and sectarian educational institutions all should be aware of Steele. However, before analyzing Steele, a general overview of the relevant statutory scheme of the Internal Revenue Code of 1986 ("Code"), as amended, governing the typ e of bonds issued in Steele is necessary (13).

Statutory Overview: Tax-Exempt Qualified Private Activity Bonds

Pursuant to Code [section]103(a), "gross income does not include interest on any State or local bond." However, Code [section]103(b) (1) provides that Code [section]103(a) shall not apply to "any private activity bond which is not a qualified bond (within the meaning of Section 141)." A private activity bond is defined, in relevant part, in Code [section]141 (a) (2) as any bond issued as part of an issue "which meets the private loan financing test of subsection (c)." Code (ss)141(c)(1) provides that the "private loan financing test" is met "if the amount of the proceeds of the issue which are to be used (directly or indirectly) to make or finance loans...to persons other than governmental units exceeds the lesser of (A) 5 percent of such proceeds, or (B) $5,000,000."

The private activity bonds must also be qualified under Code (ss)141(e) for the interest on the bonds to be tax-exempt. Under Code (ss)141, there are three standards that the bond must satisfy. First, per Code (ss)141(e)(1), the bond must fall within an enumerated category. Code (ss)141(e)(1)(G) enumerates a "qualified 501(c)(3) bond" as a qualified private activity bond. Code (ss)145(a) defines a "qualified 501(c)(3) bond" as a private activity bond if "all property which is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization...." Second, Code (ss)141(e)(2) provides that the bond issue must meet the volume cap requirements of Code (ss)146. Third, Code (ss)141(e)(3) provides that the bond issue must meet "the applicable requirements of each subsection of Section 147." Code (ss)147(f)(2)(A) provides, inter alia, under the public approval requirement for private activity bonds, that the bond must be approved by both the governmental unit which issued the bond and each gov ernmental unit having jurisdiction over the area in which any facility receiving financing through the bond proceeds is located. Congress enacted the public notice and approval requirements to assist in eliminating inappropriate uses of tax-exempt financing and to restore the benefits of it for traditional governmental purposes (11). Accordingly, a bond which satisfies the requirements of Code (ss)141(e) and Code (ss)147 will constitute a "qualified private activity" and the interest thereon will be exempt from federal income tax under Code (ss)103(a).

Steele v. Industrial Development Board of the Metropolitan Government Nashville

The facts in Steele are not overly complex. David Lipscomb University, a private, not-for-profit religious corporation affiliated with the Churches of Christ is a liberal arts university located in Nashville, Tennessee. In the early 1990s, it had an enrollment of approximately 2,500 students. Lipscomb's primary mission has been to integrate Christian faith and practice with the pursuit of academic excellence.

In the early 1990s, Lipscomb undertook a major development project to expand and renovate its campus to facilitate an increase in student enrollment to 3,000. Lipscomb applied for a $15 million, low-interest loan from the Board to fund a new library; convert the old library into administrative offices; construct an intramural building and field, tennis courts and baseball stadium; expand the Swang Business Center; make parking, landscaping and walkway improvements; and acquire computer and fiber optic equipment.

The Board is a public corporation created under the authority of Tennessee statutory law (14). Metro approved the creation of the Board by resolution under Tennessee law (16). Under state law, the Board has the authority to issue tax-exempt revenue bonds for public works projects, including "any nonprofit educational institution in any manner related to or in furtherance of the educational purposes of such institution... (15)." The statute further provides that after the approval and sale of the tax-exempt bonds the bonds do not constitute an indebtedness of either the Board or Metro (17). Also, neither the Board nor Metro can be held liable to pay any portion of the principal or interest on the bonds (17). Further, no state or local government tax revenues are to be spent due to the issuance of the bonds.

The Board provides conduit financing services to a myriad of nonreligious and religious nonprofit organizations. There never was a claim that the Board ever favored or disfavored any religion. In fact, the Board arranged tax-exempt financing for, among others, sectarian and nonsectarian educational institutions, the Jewish Community Center, the YMCA, Nashville Public Radio, and the Easter Seal Society.

The Board approved Lipscomb's request for the loan at a public meeting on April 10, 1990. After another public bearing on May 30, 1990, the Board formally approved the issuance of $15 million in tax-exempt industrial development bonds to finance the loan. On May 31, 1990, Nashville Mayor Bill Boner approved the issuance of the bonds, thus certifying they served a public purpose.

The bonds were sold to private investors and the proceeds were loaned to Lipscomb. The loan agreement stipulated that Lipscomb was not to use any bond-financed facilities for sectarian instruction or as a place of religious worship. Also, Lipscomb was obligated to pay all sums due on the bonds.

Sovran Bank, as trustees for the bondholders, was assigned the loan documents. It provided the principal security for the loan documents via an irrevocable letter of credit for Lipscomb's account to Sovran Bank as trustee for the bondholders. Lipscomb and the Board also entered into a promissory note and loan agreement to provide additional security. Accordingly, even though there was no direct transfer of money from the Board to Lipscomb, the money did flow to Lipscomb in the form of a loan from the Board, which is an instrumentality of Metro. Ultimately, Lipscomb saved about 30 percent of the cost of its development project due to the low-interest loan and was able to increase its enrollment to about 3,000. Furthermore, the tax revenues collected by the government were reduced as the bonds were tax-exempt.