We would like to lend money to a small village in Illinois, and we do not have experience with governmental lending. We think we would structure this as a loan with a ten-year term and periodic installment payments secured by future tax revenue. How can we confirm that the loan payments will be exempt from federal income tax? Do we need documentation from the village, or something in their meeting minutes?

We recommend consulting with your bank’s accountants to confirm the tax-exempt status of this local government loan. We have collected some relevant resources below which may be helpful.

The Illinois Municipal Code authorizes villages to borrow money from banks, subject to the village’s debt limits and provided that the loan is payable within ten years. The indebtedness must be authorized in an ordinance passed by the village president and trustees and evidenced by a promissory note (or similar debt instrument) executed by the village president. The payments must be a “lawful direct general obligation of the municipality payable from the general funds of the municipality and such other sources of payment as are otherwise lawfully available.”

As to the exemption of interest income from federal income tax, we again recommend consulting with your bank’s accountants. The IRS has issued general guidance on tax-exempt government bonds, a term that it uses to refer to notes and other financing arrangements entered into by state and local governments. As explained in the “Tax-Exempt Governmental Bonds” publication linked to below, tax-exempt bonds must meet the private activity bond tests and other requirements in order to qualify for a tax exemption. The application of these tests and requirements is relatively complex and requires a full understanding of the loan, which is why we recommend consulting with accounting professionals to confirm the tax-exempt status of any loan to a village or other governmental entity.

For resources related to our guidance, please see:

Illinois Municipal Code, 65 ILCS 5/8-1-3.1 (“The corporate authorities may also borrow money from any bank or other financial institution provided such money shall be repaid within 10 years from the time the money is borrowed. The mayor or president of the municipality, as the case may be, shall execute a promissory note or similar debt instrument, but not a bond, to evidence the indebtedness incurred by the borrowing. The obligation to make the payments due under the promissory note or other debt instrument shall be a lawful direct general obligation of the municipality payable from the general funds of the municipality and such other sources of payment as are otherwise lawfully available. The promissory note or other debt instrument shall be authorized by an ordinance passed by the corporate authorities and shall be valid whether or not an appropriation with respect to that ordinance is included in any annual or supplemental appropriation adopted by the corporate authorities. The indebtedness incurred under this Section, when aggregated with the existing indebtedness of the municipality, may not exceed the debt limitation provided in Section 8-5-1 of this Code. . . .”)

Illinois Municipal Code, 65 ILCS 5/1-1-2 (“(1) ‘Municipal’ or ‘municipality’ means a city, village, or incorporated town in the State of Illinois . . . .”)

Illinois Municipal Code, 65 ILCS 5/1-1-2 (“(2) ‘Corporate authorities’ means (a) the mayor and alderpersons or similar body when the reference is to cities, (b) the president and trustees or similar body when the reference is to villages or incorporated towns, and (c) the council when the reference is to municipalities under the commission form of municipal government.”)

Illinois Municipal Code, 65 ILCS 5/1-1-2 (“(8) Wherever the words ‘city council’, ‘alderpersons’, ‘commissioners’, or ‘mayor’ occur, the provisions containing these words shall apply to the board of trustees, trustees, and president, respectively, of villages and incorporated towns and councilmen in cities, so far as those provisions are applicable to them.”)

IRS, Publication 4079, Tax-Exempt Governmental Bonds (“State and local governments receive direct and indirect tax benefits under the IRC that lower borrowing costs on their valid debt obligations. Because interest paid to bondholders on these obligations is not includable in their gross income for federal income tax purposes, bondholders are willing to accept a lower interest rate than they would accept if the interest was taxable. These benefits apply to many different types of municipal debt financing arrangements including bonds, notes, loans, lease purchase contracts, lines of credit and commercial paper (collectively referred to as ‘bonds’ in this publication).
To receive these benefits, issuers must ensure that the requirements under the IRC are met, generally for as long as the bonds remain outstanding. These requirements include, but are not limited to, information filing and other requirements related to issuance, the proper and timely use of bond-financed property, and limitations on how bond proceeds (funds derived from the sale of bonds) may be invested. This publication describes these rules as they relate to governmental bonds.”)
IRS, Publication 4079, Tax-Exempt Governmental Bonds (“Testing for Governmental Bonds: The Private Activity Bond Tests. IRC Section 141 sets forth tests to determine if a bond is a private activity bond. These tests identify arrangements that actually, or are reasonably expected to, transfer benefits of tax- exempt financing to a nongovernmental person. . . . A state or local bond will be a private activity bond if, as of the issue date of the bonds or at any time while the bonds are outstanding, the bond issue exceeds the limits set forth in either:

the private business tests of Section 141(b), which consist of the private use test and the private security and payment test, and certain special private business rules (see Special Private Business Test Rules and Special Rules for Certain Utility Financings, below), or

the private loan financing test of Section 141(c).”)