n-02-10.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Qualified 501(c)(3) Bonds

Notice 2002-10

PURPOSE
This notice clarifies the application of §§ 145(a)(2) and 514 of the Internal
Revenue Code to the investment of gross proceeds of qualified 501(c)(3) bonds
described in § 145.
BACKGROUND
Section 103(a) provides that, with certain exceptions, gross income does not
include interest on any state or local bond. One type of bond that is eligible for the
exclusion under § 103(a) is a qualified 501(c)(3) bond described in § 145 that satisfies
certain requirements, including the requirements contained in § 148.
In general, a qualified 501(c)(3) bond is a bond at least 95 percent of the net
proceeds of which are to be used by no person other than an organization described in
§ 501(c)(3) (a “501(c)(3) organization”) or a governmental unit. However, under §
145(a)(2), a bond is not a qualified 501(c)(3) bond if more than 5 percent of the net
proceeds of the issue of which it is a part are to be used by a 501(c)(3) organization in
an unrelated trade or business under § 513(a).
With certain exceptions, § 148 and the regulations thereunder prohibit the use of
gross proceeds of an issue of qualified 501(c)(3) bonds to acquire investment property
(as defined in § 148(b)) that produces a yield that materially exceeds the yield on the

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issue. Section 1.148-1(b) of the Income Tax Regulations defines “gross proceeds” to
include, among other things, amounts received from the sale of the issue, amounts
received from investing proceeds of the issue, and certain other amounts with a nexus
to the issue.
Section 501(a) exempts 501(c)(3) organizations from federal income taxation.
However, notwithstanding this general exemption, § 511(a) imposes a tax on the
unrelated business taxable income, as defined in § 512, of 501(c)(3) organizations,
including certain income from debt-financed property, as defined in § 514.

DISCUSSION
Questions have arisen regarding the application of §§ 145(a)(2) and 514 to the
investment of gross proceeds of qualified 501(c)(3) bonds in a manner that complies
with the requirements of § 148. This notice clarifies that the use of gross proceeds of
an issue of qualified 501(c)(3) bonds to acquire investments (as defined in § 1.148-1) in
a manner that complies with § 148 does not constitute an unrelated trade or business
for purposes of § 145(a)(2) and does not result in income from debt-financed property
under § 514. This notice does not affect the determination of whether the use of
property financed with expenditures of proceeds of bonds constitutes an unrelated trade
or business for purposes of § 145(a)(2) or results in unrelated business taxable income
under § 512.
DRAFTING INFORMATION
The principal authors of this notice are Charles P. Barrett of the Tax Exempt and
Government Entities Division, Exempt Organizations, and Sunita Lough of the Tax
Exempt and Government Entities Division, Tax Exempt Bonds. For further information
regarding this notice, please contact Mr. Barrett at (202) 283-8944 (not a toll-free
number) or Ms. Lough at (202) 283-9774 (not a toll-free call).