State and local governments may issue tax-exempt bonds to finance correctional and detention facilities, prisons, and jails (“Prison Facilities”). Although such bonds are generally issued to finance projects expected to be used by the issuing state or local government, Prison Facilities financed in this manner may also be used by the federal government and its agencies to house and detain federal inmates.
This Issue Snapshot discusses the rules which apply when the federal government and its agencies use Prison Facilities financed by tax exempt bonds, and the circumstances under which such use by the federal government (“Federal Use”) may be considered private business use.
IRC Section and Treasury Regulation
Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)
IRS Private Letter Rulings (CCH) 200718021, 9835032
Private Activity Bonds and Private Business Use
A bond issued by a state or local government may not qualify for tax exempt status if there is excessive private business use of the facilities financed by the issue.
Tax-exemption for bonds issued by state and local governments is governed by Section 103(a), which provides that, except as provided in Section 103(b), gross income does not include interest on any state or local bond. Section 103(b)(1) provides that Section 103(a) shall not apply to any private activity bond that is not a qualified bond (within the meaning of Section 141).
Section 141(a) provides that the term "private activity bond" includes any bond issued as part of an issue that meets the private business use test and private security or payment test.
Section 141(b)(1) provides generally that an issue meets the private business use test if more than 10 percent of the proceeds of the issue are to be used for any private business use. Section 141(b)(6) defines "private business use" as use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit. For this purpose, any activity carried on by a person other than a natural person must be treated as a trade or business, and the use of financed property is treated as the direct use of proceeds.
For a more detailed discussion of the application of the private business tests of Section 141, see the analysis in the issue snapshot “Private Business Use – Management Contracts”.
Federal Use Considered Nongovernmental Use / Regulations Provide Exception
The rules governing tax-exempt bonds do not consider the federal government to be a governmental user for purposes of determining their tax-exempt status. This is stated in Section 150(a)(2), which specifies that a “governmental unit” does not include the United States or any agency or instrumentality thereof. Since the federal government and its agencies are not considered governmental units, Federal Use (such as the housing of detainees) of Prison Facilities financed by tax-exempt bonds may be considered private business use.
However, the regulations provide an exception that allows for circumstances under which Federal Use is not considered private business use. This is set forth in Treas. Reg. Section 1.141-3(d)(3), which provides an exception for arrangements other than arrangements resulting in ownership of financed property by a nongovernmental person.
For Federal Use of Prison Facilities, the relevant exception is set forth in Treas. Reg. Section 1.141-3(d)(3)(i), which applies to arrangements which are not available for use on the same basis by natural persons not engaged in a trade or business. For such use to be eligible for the exception, all three of the following conditions must be met:
- The term of the use, including all renewal options, is not longer than 100 days;
- The arrangement would be treated as general public use, except that it is not available for use on the same basis by natural persons not engaged in a trade or business because generally applicable and uniformly applied rates are not reasonably available to natural persons not engaged in a trade or business; and
- The property is not financed for a principal purpose of providing that property for use by that nongovernmental person.
A relevant example is provided in Treas. Reg. Section 1.141-3(f), example 15, which addresses contracts for Federal Use of Prison Facilities. Contracts to house prisoners are not considered arrangements for general public use because leasing space for prisoners is not available on the same basis by natural persons not engaged in a trade or business. The example describes circumstances under which a contract for Federal Use would qualify for the exception under Treas. Reg. Section 1.141-3(d)(3)(i). In the example, the federal government is charged approximately the same amount as persons that enter into similar agreements, the term of use under the contract is not longer than 100 days, with no right to renew, and the prison was not financed for a principal purpose of housing federal prisoners. Also, the federal prisoners will be housed on a space-available, first-come, first-served basis, and it is reasonably expected that other persons will enter into agreements similar to the federal use agreement. Although the contract is expected to be renewed indefinitely and it is reasonably expected that, during the term of the bonds, more than 10 percent of the prisoners will be federal prisoners, the issue does not meet the private business test because the arrangement satisfies the conditions of the exception.
Another example is described in IRS Private Letter Ruling 200718021, which includes a similar fact pattern with a few different aspects. The ruling describes a contract for Federal Use that does not exceed 100 days, with no right to renew. However, the contract will automatically renew for a period of less than 100 days absent cancellation by either party, and the issuer reasonably expects that it will be renewed for at least five years. Also, the federal government will pay approximately the same per-diem rate that other nongovernmental persons would pay, and the county represents that the prison facility is being constructed to serve the long-term needs of the county, and not for a principal purpose of providing the facility for federal government use. Taking into consideration the automatic renewal feature and the other facts as described, the ruling concludes that the contract will not result in private business use of the bonds within the meaning of Section 141(b). See also Private Letter Ruling 9835032 (federal government has no right to renew the contract to house its prisoners, although it is reasonably expected to renew indefinitely).
Federal Use Arrangements, Management Contracts
A number of federal agencies house prisoners in Prison Facilities which are not owned by the federal government. These include the US Marshall Service (USMS) and Immigration and Customs Enforcement (ICE). Although these agencies sometimes use federal facilities to house detainees, in many instances they are housed in state, local or privately-owned Prison Facilities under contracts with the state or local government, also known as Intergovernmental Agreements (IGA).
In addition to arrangements made for Federal Use, state and local governments may also enter into contracts with private companies to manage the Prison Facilities they own. Management contracts which provide for private companies to manage Prison Facilities financed by tax-exempt bonds may also result in private business use, if the contracts do not comply with applicable rules. For a detailed discussion of the rules which apply to management contracts used in conjunction with Prison Facilities financed by tax-exempt bonds, see the issue snapshot “Private Business Use – Management Contracts”.
Issue Indicators or Audit Tips
In analyzing potential private business use arising from Federal Use of a Prison Facility financed by tax-exempt bonds, compliance with all three of the conditions must be reviewed:
- Purpose of financing: The housing of federal prisoners must not be a primary purpose of the financing.
- Contract, lease or intergovernmental agreement (IGA): The term of any contract for Federal use may not be longer than 100 days, including all renewal options. An automatic renewal feature may be considered, but must be evaluated by taking into account all relevant facts and circumstances.
- Financial arrangements under the contract: for the arrangement to be treated as general public use, even though it is not available for use on the same basis by natural persons not engaged in a trade or business, the costs charged under the contract for Federal Use must be comparable to those charged to any other or local governments which may use the facility, or any other nongovernmental user.