It’s not unusual to find a local government that has trouble spending the money it borrows for a project, or that has money left over when the project is done. We’ve written before, for example, about what you can do with proceeds left over on an installment financing.

Slow spending on financing proceeds is becoming a bigger issue, and for some of our clients that’s beginning to implicate tax rules applicable to local government borrowing.

Why it’s becoming a bigger problem –

  • Supply chain issues mean projects can take longer. Even if you have a good construction contract and a good contractor, delays in getting materials mean that proceeds aren’t being spent as quickly as you’d planned.
  • Many local governments are now able to invest their proceeds at a rate above the rate they’re paying on their loans. It wasn’t that long ago that loan rates below 2% were common, and today the daily rate on the NCCMT is well over 5%.

Why this is an issue for the tax rules —

  • For most borrowings, once you have the money on hand beyond three years, you’re technically not allowed to invest the funds at a rate above the bond rate (well the IRS rules talk about a “yield” above the “yield” on the loan, but in most cases the rates and the yield are all but identical). So now if you have old proceeds and you’re investing above the bond rate, all that excess belongs to the feds, no matter why you’re slow in spending, and no matter at what rates you invested for the first three years.

This requirement to pay over “excess earnings” is similar to, but different from, the “rebate” requirement that people often refer to. Most importantly for our discussion, the rebate exception for borrowers that borrow less than $5 million in a calendar year does not exempt you from repaying excess earnings.

So what should you do?

  • Figure out how you’re going to spend your remaining financing proceeds. If you’re building a school and just waiting on materials, you may be stuck waiting. But if your project is done or you have other projects to do, you may be able to find a different route. For example, here’s a flowchart we did that covers spending money left on hand from an installment financing.
  • Talk to your bond counsel and rebate consultant to see what your exposure might be. You want to figure out what you might owe the IRS before you spend all the money on an alternative project, and you want to get your proceeds into investments that match the IRS rules and your need for the funds.

If you have a liability to pay over excess earnings, that’s just getting bigger every day, so it’s something you should pay attention to.

Click here for our disclaimer, click here to learn more about our public finance practice, and click here to send us an email with your question on this topic or anything else.