The Benefits of Investing in Qualified Zone Academy Bonds

The Benefits of Investing in Qualified Zone Academy Bonds

By Ann W. Seelmeyer, CPA

Federal legislation has extended the ability of school districts across the country to offer qualified zone academy bonds (QZABs). Author Ann Seelmeyer explains how the bonds, which provide both funding to improve school districts and tax credits for investors, could benefit financial institutions.

QZABs were created by the Taxpayer Relief Act of 1997. The QZAB program was originally scheduled to expire at the end of 2001, but subsequent legislation has given school districts until Dec. 31, 2008, to issue the QZABs that the federal government allocated in 2006 and until Dec. 31, 2009, to issue the bonds allocated in 2007.

Financial institutions that purchase the bonds obtain a federal tax credit against regular income tax and alternative minimum tax (AMT) liability.

What are QZABs?
State and local educational agencies use QZABs to provide additional resources for improving school facilities and instruction. The QZAB program was designed to help the schools with the greatest need for financial assistance. The bonds are available for sale only to banks, insurance companies, and other corporations actively engaged in the business of lending money.

Investor Benefits
In exchange for its investment, a bank receives a federal tax credit in lieu of cash interest payments. The credit may be claimed against regular income tax and AMT liability. The tax credit allowed to the bondholder is includible in gross income, as if it were an interest payment on the bond.

If the bondholder cannot use the tax credit because the bondholder does not have a federal tax liability, the holder is allowed a deduction for the current tax year, or succeeding tax year if elected, equal to the amount of the unused tax credit. The tax credit passes through to shareholders of S corporations.

The credit is especially valuable for banks that have become liable for AMT. While most tax credits are limited for AMT taxpayers, the QZAB credit is not.

QZABs are also attractive because of their low default risk. The bonds typically are collateralized through an escrow account funded with U.S. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities), or zero-coupon securities, to ensure repayment of the bond when it matures.

Finally, QZABs constitute qualified investments under the Community Reinvestment Act.

The Amount of the Credit
The tax credit is calculated by multiplying the applicable credit rate by the face amount of the bond. The Treasury sets a credit rate each calendar month that allows the bonds to be issued without discount or interest cost to the issuer. During each calendar month, the Internal Revenue Service determines the maximum term permitted for bonds issued in the following calendar month.

The tax credit is allowed on the one-year anniversary of the issuance of the bond and the last day of each successive one-year period thereafter. Only the holder of the QZAB on the credit — or anniversary — date may take the full amount of the tax credit. Thus, if a bondholder sells the QZAB one day before the credit date, it is not entitled to any tax credit for that year. However, the seller of the QZAB may price the bond at a premium due to the foregone credit.

Potential Downsides
An unused QZAB tax credit cannot be carried back to a prior tax year or carried forward to a subsequent tax year. If a bondholder does not incur a federal tax liability (regular or AMT), it loses the tax credit. The bondholder also would not recognize a federal tax benefit for the credit on its financial statements.

Further, QZABs provide limited liquidity. With the bonds only available to banks, insurance companies, and other lenders, bondholders have a narrow secondary market for selling the bonds. An investor in a QZAB should, therefore, expect to hold the bond for its maximum term.

A Win-Win
QZABs benefit both the school district issuers and their investors. By investing in the bonds, banks can help strengthen public education, while potentially reducing their tax liability.

Ann W. Seelmeyer is a senior manager specializing in taxation for financial institutions with Crowe Chizek and Company LLC in Louisville, Ky. She can be reached at 502.420.4443 or aseelmeyer@crowechizek.com.

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Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.