DESCRIPTION OF CHAIRMAN’S MARK OF THE 

"AFFORDABLE EDUCATION ACT OF 2001"

Scheduled for Markup

By the

SENATE COMMITTEE ON FINANCE

on March 13, 2001

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

March 9, 2001

JCX-9-01
i

CONTENTS

Page

INTRODUCTION................................................................................................................ 1

I. MODIFICATIONS TO EDUCATION IRAS................................................................. 2

II. PRIVATE PRE-PAID TUITION PROGRAMS; EXCLUSION FROM

GROSS INCOME OF EDUCATION DISTRIBUTIONS FROM QUALIFIED

TUITION PROGRAMS................................................................................................. 6

III. EXCLUSION FOR EMPLOYER-PROVIDED EDUCATIONAL

ASSISTANCE............................................................................................................... 9

IV. MODIFICATIONS TO STUDENT LOAN INTEREST DEDUCTION......................... 11

V. ELIMINATE TAX ON AWARDS UNDER THE NATIONAL HEALTH 

SERVICE CORPS SCHOLARSHIP PROGRAM AND THE F. EDWARD

HEBERT ARMED FORCES HEALTH PROFESSIONS SCHOLARSHIP

AND FINANCIAL ASSISTANCE PROGRAM............................................................ 12

VI. TAX BENEFITS FOR CERTAIN TYPES OF BONDS FOR EDUCATIONAL

FACILITIES AND ACTIVITIES................................................................................... 13
1

INTRODUCTION

The Senate Committee on Finance has scheduled a markup on March 13, 2001, on a 

proposed Chairman's mark of the "Affordable Education Act of 2001". This document,1

prepared by the staff of the Joint Committee on Taxation, provides a description of the 

Chairman's mark. It contains a description of proposals to (1) modify the rules relating to 

Education IRAs; (2) establish private-prepaid tuition programs and provide an exclusion from 

gross income for certain distributions from qualified tuition programs; (3) expand and extend the 

exclusion for employer-provided educational assistance; (4) modify the student loan interest 

deduction; (5) eliminate tax on certain awards; and (6) modify the tax treatment of certain types 

of bonds for educational facilities and activities.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Description of 

Chairman's Mark of the "Affordable Education Act of 2001" (JCX-9-01), March 9, 2001.
2

I. MODIFICATIONS TO EDUCATION IRAS

Present Law

In general 

Section 530 of the Internal Revenue Code (the “Code”) provides tax-exempt status to 

education individual retirement accounts (“education IRAs”), meaning certain trusts or custodial 

accounts which are created or organized in the United States exclusively for the purpose of 

paying the qualified higher education expenses of a designated beneficiary. Contributions to 

education IRAs may be made only in cash.2 Annual contributions to education IRAs may not 

exceed $500 per beneficiary (except in cases involving certain tax-free rollovers, as described 

below) and may not be made after the designated beneficiary reaches age 18.

Phase-out of contribution limit

The $500 annual contribution limit for education IRAs is generally phased out ratably for 

contributors with modified adjusted gross income (“AGI”) between $95,000 and $110,000. The 

phase-out range for married taxpayers filing a joint return is $150,000 to $160,000 of modified 

AGI. Individuals with modified AGI applicable above the phase-out range are not allowed to 

make contributions to an education IRA established on behalf of any individual.

Treatment of distributions

Earnings on contributions to an education IRA generally are subject to tax when 

withdrawn. However, distributions from an education IRA are excludable from the gross income 

of the beneficiary to the extent that the total distribution does not exceed the “qualified higher 

education expenses” incurred by the beneficiary during the year the distribution is made.

If the qualified higher education expenses of the beneficiary for the year are less than the 

total amount of the distribution (i.e., contributions and earnings combined) from an education 

IRA, then the qualified higher education expenses are deemed to be paid from a pro-rata share of 

both the principal and earnings components of the distribution. Thus, in such a case, only a 

portion of the earnings are excludable (i.e., the portion of the earnings based on the ratio that the 

qualified higher education expenses bear to the total amount of the distribution) and the 

remaining portion of the earnings is includible in the beneficiary’s gross income.

The earnings portion of a distribution from an education IRA that is includible in income 

is also subject to an additional 10-percent tax. The 10-percent additional tax does not apply if a 

distribution is made on account of the death or disability of the designated beneficiary, or if 

made on account of a scholarship received by the designated beneficiary.

 

2

 Special estate and gift tax rules apply to contributions made to and distributions made 

from education IRAs.
3

The additional 10-percent tax also does not apply to the distribution of any contribution 

to an education IRA made during the taxable year if such distribution is made on or before the 

date that a return is required to be filed (including extensions of time) by the beneficiary for the 

taxable year during which the contribution was made (or, if the beneficiary is not required to file 

such a return, April 15th of the year following the taxable year during which the contribution 

was made).

Present law allows tax-free transfers or rollovers of account balances from one education 

IRA benefiting one beneficiary to another education IRA benefiting another beneficiary (as well 

as redesignations of the named beneficiary), provided that the new beneficiary is a member of 

the family of the old beneficiary. 

Any balance remaining in an education IRA is deemed to be distributed within 30 days 

after the date that the beneficiary reaches age 30 (or, if earlier, within 30 days of the date that the 

beneficiary dies).

Qualified higher education expenses

The term “qualified higher education expenses” includes tuition, fees, books, supplies, 

and equipment required for the enrollment or attendance of the designated beneficiary at an 

eligible education institution, regardless of whether the beneficiary is enrolled at an eligible 

educational institution on a full-time, half-time, or less than half-time basis. Moreover, the term 

qualified higher education expenses includes certain room and board expenses for any period 

during which the beneficiary is at least a half-time student. Qualified higher education expenses 

include expenses with respect to undergraduate or graduate-level courses. In addition, qualified 

higher education expenses include amounts paid or incurred to purchase tuition credits (or to 

make contributions to an account) under a qualified State tuition program, as defined in section 

529, for the benefit of the beneficiary of the education IRA.

Qualified higher education expenses generally include only out-of-pocket expenses. 

Such qualified higher education expenses do not include expenses covered by educational 

assistance for the benefit of the beneficiary that is excludable from gross income. Thus, total 

qualified higher education expenses are reduced by scholarship or fellowship grants excludable 

from gross income under present-law section 117, as well as any other tax-free educational

benefits, such as employer-provided educational assistance that is excludable from the 

employee’s gross income under section 127.

Present law also provides that, if any qualified higher education expenses are taken into 

account in determining the amount of the exclusion for a distribution from an education IRA, 

then no deduction (e.g., for trade or business expenses), exclusion (e.g., for interest on education 

savings bonds) or credit is allowed with respect to such expenses.

Eligible educational institutions are defined by reference to section 481 of the Higher 

Education Act of 1965. Such institutions generally are accredited post-secondary educational 

institutions offering credit toward a bachelor's degree, an associate's degree, a graduate-level or 

professional degree, or another recognized post-secondary credential. Certain proprietary 
4

institutions and post-secondary vocational institutions also are eligible institutions. The 

institution must be eligible to participate in Department of Education student aid programs.

Time for making contributions

Contributions to an education IRA for a taxable year are taken into account for the 

taxable year in which they are made.

Coordination with HOPE and Lifetime Learning credits

If an exclusion from gross income is allowed for distributions from an education IRA 

with respect to an individual, then neither the HOPE nor Lifetime Learning credit may be 

claimed in the same taxable year with respect to the same individual. However, an individual 

may elect to waive the exclusion with respect to distributions from an education IRA. If such a 

waiver is made, then the HOPE or Lifetime Learning credit may be claimed with respect to the 

individual for the taxable year.

Coordination with qualified tuition programs

An excise tax is imposed if a contribution is made by any person to an education IRA 

during any taxable year in which any contributions are made by anyone to a qualified State 

tuition program on behalf of the same beneficiary. 

Description of Proposal

Annual contribution limit

The proposal would increase the annual education IRA contribution limit from $500 to 

$2,000. Thus, under the proposal, aggregate contributions that may be made by all contributors 

to one (or more) education IRAs established on behalf of any particular beneficiary would be 

limited to $2,000 for each year.

Special needs beneficiaries

The proposal would provide that the rule prohibiting contributions to an education IRA 

after the beneficiary attains 18 would not apply in the case of a special needs beneficiary (as 

defined by Treasury Department regulations). In addition, a deemed distribution of any balance 

in an education IRA would not occur when a special needs beneficiary reaches age 30. 

Contributions by persons other than individuals

The proposal would clarify that corporations and other entities (including tax-exempt 

organizations) are permitted to make contributions to education IRAs, regardless of the income 

of the corporation or entity during the year of the contribution.

Contributions permitted until April 15

Under the proposal, individual contributors to education IRAs would be deemed to have 
5

made a contribution on the last day of the preceding taxable year if the contribution is made on 

account of such taxable year and is made not later than the time prescribed by law for filing the 

individual’s Federal income tax return for such taxable year (not including extensions). Thus, 

individual contributors generally would be allowed to make contributions for a year until April 

15 of the following year.

Coordination with HOPE and Lifetime Learning credits

The proposal would allow a taxpayer to claim a HOPE credit or Lifetime Learning credit 

for a taxable year and to exclude from gross income amounts distributed (both the contributions 

and the earnings portions) from an education IRA on behalf of the same student as long as the 

distribution is not used for the same educational expenses for which a credit was claimed. 

Coordination with qualified tuition programs

The proposal would repeal the excise tax on contributions made by any person to an 

education IRA on behalf of a beneficiary during any taxable year in which any contributions are 

made by anyone to a qualified State tuition program on behalf of the same beneficiary.

Redesignation of education IRAs as education savings accounts

The proposal would rename “education IRAs” as “education savings accounts.”

Effective Date

 The provisions modifying education IRAs would be effective for taxable years beginning 

after December 31, 2001. 
6

II. PRIVATE PRE-PAID TUITION PROGRAMS; 

EXCLUSION FROM GROSS INCOME OF EDUCATION DISTRIBUTIONS 

FROM QUALIFIED TUITION PROGRAMS 

Present Law

Section 529 of the Code provides tax-exempt status to "qualified State tuition programs," 

meaning certain programs established and maintained by a State (or agency or instrumentality 

thereof) under which persons may (1) purchase tuition credits or certificates on behalf of a 

designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher 

education expenses of the beneficiary, or (2) make contributions to an account that is established 

for the purpose of meeting qualified higher education expenses of the designated beneficiary of 

the account (a “savings account plan”). The term "qualified higher education expenses" 

generally has the same meaning as does the term for purposes of education IRAs (as described 

above) and, thus, includes expenses for tuition, fees, books, supplies, and equipment required for 

the enrollment or attendance at an eligible educational institution,3 as well as certain room and 

board expenses for any period during which the student is at least a half-time student.

No amount is included in the gross income of a contributor to, or a beneficiary of, a 

qualified State tuition program with respect to any distribution from, or earnings under, such 

program, except that (1) amounts distributed or educational benefits provided to a beneficiary are 

included in the beneficiary's gross income (unless excludable under another Code section) to the

extent such amounts or the value of the educational benefits exceed contributions made on behalf 

of the beneficiary, and (2) amounts distributed to a contributor (e.g., when a parent receives a 

refund) are included in the contributor's gross income to the extent such amounts exceed 

contributions made on behalf of the beneficiary.4

A qualified State tuition program is required to provide that purchases or contributions 

only be made in cash.5 Contributors and beneficiaries are not allowed to direct the investment 

of contributions to the program (or earnings thereon). The program is required to maintain a 

separate accounting for each designated beneficiary. A specified individual must be designated 

as the beneficiary at the commencement of participation in a qualified State tuition program (i.e., 

when contributions are first made to purchase an interest in such a program), unless interests in 

such a program are purchased by a State or local government or a tax-exempt charity described 

in section 501(c)(3) as part of a scholarship program operated by such government or charity 

under which beneficiaries to be named in the future will receive such interests as scholarships. 

A transfer of credits (or other amounts) from one account benefiting one designated 

beneficiary to another account benefiting a different beneficiary is considered a distribution (as is 

a change in the designated beneficiary of an interest in a qualified State tuition program), unless 

 

3

 An “eligible education institution” is defined the same for purposes of education IRAs 

(described in Part I, above) and qualified State tuition programs.

4

 Distributions from qualified State tuition programs are treated as representing a prorata share of the contributions and earnings in the account.

5

 Special estate and gift tax rules apply to contributions made to and distributions made 

from qualified State tuition programs.
7

the beneficiaries are members of the same family. For this purpose, the term "member of the 

family" means: (1) the spouse of the beneficiary; (2) a son or daughter of the beneficiary or a 

descendent of either; (3) a stepson or stepdaughter of the beneficiary; (4) a brother, sister, 

stepbrother or stepsister of the beneficiary; (5) the father or mother of the beneficiary or an 

ancestor of either; (6) a stepfather or stepmother of the beneficiary; (7) a son or daughter of a 

brother or sister of the beneficiary; (8) a brother or sister of the father or mother of the 

beneficiary; (9) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or 

sister-in-law of the beneficiary; or (10) the spouse of any person described in (2)-(9). 

Earnings on an account may be refunded to a contributor or beneficiary, but the State or 

instrumentality must impose a more than de minimis monetary penalty unless the refund is (1) 

used for qualified higher education expenses of the beneficiary, (2) made on account of the death 

or disability of the beneficiary, or (3) made on account of a scholarship received by the 

beneficiary to the extent the amount refunded does not exceed the amount of the scholarship 

used for higher education expenses.

To the extent that a distribution from a qualified State tuition program is used to pay for 

qualified tuition and related expenses (as defined in sec. 25A(f)(1)), the beneficiary (or another 

taxpayer claiming the beneficiary as a dependent) may claim the HOPE credit or Lifetime 

Learning credit with respect to such tuition and related expenses (assuming that the other 

requirements for claiming the HOPE credit or Lifetime Learning credit are satisfied and the 

modified AGI phaseout for those credits does not apply).

Description of Proposal

Qualified tuition program

The proposal would expand the definition of “qualified tuition program” to include 

certain prepaid tuition programs established and maintained by one or more eligible educational 

institutions (which may be private institutions) that satisfy the requirements under section 529 

(other than the present-law State sponsorship rule). In the case of a qualified tuition program 

maintained by one or more private eligible educational institutions, persons would be able to 

purchase tuition credits or certificates on behalf of a designated beneficiary (as set forth in sec. 

529(b)(1)(A)(i)), but would not be able to make contributions to a savings account plan (as 

described in section 529(b)(1)(A)(ii)).

Exclusion from gross income

Under the proposal, an exclusion from gross income would be provided for distributions 

made in taxable years beginning after December 31, 2001, from qualified State tuition programs 

to the extent that the distribution is used to pay for qualified higher education expenses. This 

exclusion from gross income is extended to distributions from qualified tuition programs 

established and maintained by an entity other than a State or agency or instrumentality thereof, 

for distributions made in taxable years after December 31, 2003.

Coordination with HOPE and Lifetime Learning credits

The proposal would allow a taxpayer to claim a HOPE credit or Lifetime Learning credit 
8

for a taxable year and to exclude from gross income amounts distributed (both the principal and 

the earnings portions) from a qualified tuition program on behalf of the same student as long as 

the distribution is not used for the same expenses for which a credit was claimed.

Rollovers for benefit of same beneficiary

The proposal would provide that a transfer of credits (or other amounts) from one 

qualified tuition program for the benefit of a designated beneficiary to another qualified tuition 

program for the benefit of the same beneficiary would not be considered a distribution for a 

maximum of three such transfers.

Member of family

The proposal would provide that, for purposes of tax-free rollovers and changes of 

designated beneficiaries, a “member of the family” includes first cousins of the original 

beneficiary.

Effective Date

The provision would be effective for taxable years beginning after December 31, 2001, 

except that the exclusion from gross income for certain distributions from a qualified tuition 

program established and maintained by an entity other than a State (or agency or instrumentality 

thereof) would be effective for taxable years beginning after December 31, 2003. 
9

III. EXCLUSION FOR EMPLOYER-PROVIDED EDUCATIONAL ASSISTANCE

Present Law

Educational expenses paid by an employer for its employees are generally deductible by 

the employer.

Employer-paid educational expenses are excludable from the gross income and wages of 

an employee if provided under a section 127 educational assistance plan or if the expenses 

qualify as a working condition fringe benefit under section 132. Section 127 provides an 

exclusion of $5,250 annually for employer-provided educational assistance. The exclusion does 

not apply to graduate courses beginning after June 30, 1996. The exclusion for employerprovided educational assistance for undergraduate courses expires with respect to courses 

beginning after December 31, 2001.

In order for the exclusion to apply, certain requirements must be satisfied. The 

educational assistance must be provided pursuant to a separate written plan of the employer. The 

educational assistance program must not discriminate in favor of highly compensated employees. 

In addition, not more than five percent of the amounts paid or incurred by the employer during 

the year for educational assistance under a qualified educational assistance plan can be provided 

for the class of individuals consisting of more than 5-percent owners of the employer (and their 

spouses and dependents).

Educational expenses that do not qualify for the section 127 exclusion may be excludable 

from income as a working condition fringe benefit.6 In general, education qualifies as a working 

condition fringe benefit if the employee could have deducted the education expenses under 

section 162 if the employee paid for the education. In general, education expenses are deductible 

by an individual under section 162 if the education (1) maintains or improves a skill required in a 

trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of 

the taxpayer's employer, applicable law or regulations imposed as a condition of continued 

employment. However, education expenses are generally not deductible if they relate to certain 

minimum educational requirements or to education or training that enables a taxpayer to begin 

working in a new trade or business.7

Description of Proposal

The proposal would extend the exclusion for employer-provided educational assistance to 

graduate education, and would make the exclusion (as applied to both undergraduate and 

graduate education) permanent.

 

6

 These rules also apply in the event that section 127 expires.

7

 In the case of an employee, education expenses (if not reimbursed by the employer) 

may be claimed as an itemized deduction only if such expenses, along with other miscellaneous 

expenses, exceed two percent of the taxpayer’s AGI. An individual’s total deductions may also 

be reduced by the overall limitation of itemized deductions under section 68. These limitations 

do not apply in determining whether an item is excludable from income as a working condition 

fringe benefit.
10

Effective Date

The provision would be effective with respect to courses beginning after December 31, 

2001.
11

IV. MODIFICATIONS TO STUDENT LOAN INTEREST DEDUCTION 

Present Law

Certain individuals may claim an above-the-time deduction for interest paid on qualified 

education loans, subject to a maximum annual deduction limit. The deduction is allowed only 

with respect to interest paid on a qualified education loan during the first 60 months in which 

interest payments are required. Required payments of interest generally do not include voluntary 

payments, such as interest payments made during a period of loan forbearance. Months during 

which interest payments are not required because the qualified education loan is in deferral or 

forbearance do not count against the 60-month period. No deduction is allowed to an individual 

if that individual is claimed as a dependent on another taxpayer's return for the taxable year.

A qualified education loan generally is defined as any indebtedness incurred solely to pay 

for certain costs of attendance (including room and board) of a student (who may be the 

taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness 

was incurred) who is enrolled in a degree program on at least a half-time basis at (1) an 

accredited post-secondary educational institution defined by reference to section 481 of the 

Higher Education Act of 1965, or (2) an institution conducting an internship or residency 

program leading to a degree or certificate from an institution of higher education, a hospital, or a 

health care facility conducting postgraduate training.

The maximum allowable deduction per tax return is $2,500. The deduction is phased out 

ratably for single taxpayers with modified AGI between $40,000 and $55,000 and for married 

taxpayers filing joint returns with modified AGI between $60,000 and $75,000. The income 

ranges will be indexed for inflation after 2002.

Description of Proposal

The proposal would increase the income phase-out ranges for eligibility for the student 

loan interest deduction to $50,000 to $65,000 for single taxpayers and to $100,000 to $130,000 

for married taxpayers filing joint returns. These income phase-out ranges would be indexed for 

inflation after 2002.

The proposal would repeal both the limit on the number of months during which interest 

paid on a qualified education loan is deductible and the restriction that voluntary payments of 

interest are not deductible.

Effective Date

The proposal would be effective for interest paid on qualified education loans after 

December 31, 2001.
12

V. ELIMINATE TAX ON AWARDS UNDER THE 

NATIONAL HEALTH SERVICE CORPS SCHOLARSHIP PROGRAM

 AND THE F. EDWARD HEBERT ARMED FORCES HEALTH

 PROFESSIONS SCHOLARSHIP AND FINANCIAL ASSISTANCE PROGRAM 

Present Law

Section 117 excludes from gross income amounts received as a qualified scholarship by

an individual who is a candidate for a degree and used for tuition and fees required for the 

enrollment or attendance (or for fees, books, supplies, and equipment required for courses of 

instruction) at a primary, secondary, or post-secondary educational institution. The tax-free 

treatment provided by section 117 does not extend to scholarship amounts covering regular 

living expenses, such as room and board. In addition to the exclusion for qualified scholarships, 

section 117 provides an exclusion from gross income for qualified tuition reductions for certain 

education provided to employees (and their spouses and dependents) of certain educational 

organizations.

The exclusion for qualified scholarships and qualified tuition reductions does not apply to 

any amount received by a student that represents payment for teaching, research, or other 

services by the student required as a condition for receiving the scholarship or tuition reduction.

The National Health Service Corps Scholarship Program (the “NHSC Scholarship 

Program”) and the F. Edward Hebert Armed Forces Health Professions Scholarship and 

Financial Assistance Program (the “Armed Forces Scholarship Program”) provide education 

awards to participants on condition that the participants provide certain services. In the case of 

the NHSC Program, the recipient of the scholarship is obligated to provide medical services in a 

geographic area (or to an underserved population group or designated facility) identified by the 

Public Health Service as having a shortage of health care professionals. In the case of the Armed 

Forces Scholarship Program, the recipient of the scholarship is obligated to serve a certain 

number of years in the military at an armed forces medical facility. Because the recipients are 

required to perform services in exchange for the education awards, the awards used to pay higher 

education expenses are taxable income to the recipient.

Description of Proposal

 The proposal would provide that amounts received by an individual under the NHSC 

Scholarship Program or the Armed Forces Scholarship Program are eligible for tax-free 

treatment as qualified scholarships under section 117, without regard to any service obligation by 

the recipient. As with other qualified scholarships under section 117, the tax-free treatment 

would not apply to amounts received by students for regular living expenses, including room and 

board.

Effective Date

The proposal would be effective for education awards received after December 31, 2001.
13

VI. TAX BENEFITS FOR CERTAIN TYPES OF BONDS FOR EDUCATIONAL 

FACILITIES AND ACTIVITIES

Present Law

Tax-exempt bonds

In general

Interest on debt8 incurred by States or local governments is excluded from income if the 

proceeds of the borrowing are used to carry out governmental functions of those entities or the 

debt is repaid with governmental funds (Code sec. 103).9 Like other activities carried out or 

paid for by States and local governments, the construction, renovation, and operation of public 

schools is an activity eligible for financing with the proceeds of tax-exempt bonds.

Interest on bonds that nominally are issued by States or local governments, but the 

proceeds of which are used (directly or indirectly) by a private person and payment of which is 

derived from funds of such a private person is taxable unless the purpose of the borrowing is 

approved specifically in the Code or in a non-Code provision of a revenue Act. These bonds are 

called “private activity bonds.” 10 The term "private person" includes the Federal Government 

and all other individuals and entities other than States or local governments. 

Private activities eligible for financing with tax-exempt private activity bonds

Present law includes several exceptions permitting States or local governments to act as 

conduits providing tax-exempt financing for private activities. Both capital expenditures and 

limited working capital expenditures of charitable organizations described in section 501(c)(3) of 

the Code -- including elementary, secondary, and post-secondary schools -- may be financed 

with tax-exempt private activity bonds ("qualified 501(c)(3) bonds").

States or local governments may issue tax-exempt “exempt-facility bonds” to finance 

property for certain private businesses. Business facilities eligible for this financing include 

transportation (airports, ports, local mass commuting, and high speed intercity rail facilities); 

privately owned and/or privately operated public works facilities (sewage, solid waste disposal, 

local district heating or cooling, and hazardous waste disposal facilities); privately-owned and/or 

operated low-income rental housing; and certain private facilities for the local furnishing of 

electricity or gas. A further provision allows tax-exempt financing for "environmental 

enhancements of hydro-electric generating facilities." Tax-exempt financing also is authorized 

for capital expenditures for small manufacturing facilities and land and equipment for first-time 

farmers ("qualified small-issue bonds"), local redevelopment activities ("qualified redevelopment 

bonds"), and eligible empowerment zone and enterprise community businesses.

 

8

 Hereinafter referred to as “State or local government bonds.”

9

 Interest on this debt is included in calculating the “adjusted current earnings” 

preference of the corporate alternative minimum tax.

10 Interest on private activity bonds (other than qualified 501(c)(3) bonds) is a preference 

item in calculating the alternative minimum tax. 
14

Tax-exempt private activity bonds also may be issued to finance limited non-business 

purposes: certain student loans and mortgage loans for owner-occupied housing (“qualified 

mortgage bonds” and “qualified veterans’ mortgage bonds”).

Private activity tax-exempt bonds may not be issued to finance schools for private, forprofit businesses.

In most cases, the aggregate volume of private activity tax-exempt bonds is restricted by 

annual aggregate volume limits imposed on bonds issued by issuers within each State. These 

annual volume limits are equal to $62.50 per resident of the State, or $187.5 million if greater. 

The volume limits are scheduled to increase to the greater of $75 per resident of the State or 

$225 million in calendar year 2002. After 2002, the volume limits will be indexed annually for 

inflation.

Arbitrage restrictions on tax-exempt bonds

The Federal income tax does not apply to the income of States and local governments 

that is derived from the exercise of an essential governmental function. To prevent these taxexempt entities from issuing more Federally subsidized tax-exempt bonds than is necessary for 

the activity being financed or from issuing such bonds earlier than needed for the purpose of the 

borrowing, the Code includes arbitrage restrictions limiting the ability to profit from investment 

of tax-exempt bond proceeds. In general, arbitrage profits may be earned only during specified 

periods (e.g., defined “temporary periods” before funds are needed for the purpose of the 

borrowing) or on specified types of investments (e.g., “reasonably required reserve or 

replacement funds”). Subject to limited exceptions, profits that are earned during these periods 

or on such investments must be rebated to the Federal Government.

Present law includes three exceptions to the arbitrage rebate requirements applicable to 

education-related bonds. First, issuers of all types of tax-exempt bonds are not required to rebate 

arbitrage profits if all of the proceeds of the bonds are spent for the purpose of the borrowing 

within six months after issuance.11 Second, in the case of bonds to finance certain construction 

activities, including school construction and renovation, the six-month period is extended to 24 

months. Arbitrage profits earned on construction proceeds are not required to be rebated if all 

such proceeds (other than certain retainage amounts) are spent by the end of the 24-month period 

and prescribed intermediate spending percentages are satisfied.12 Issuers qualifying for this 

“construction bond” exception may elect to be subject to a fixed penalty payment regime in lieu 

of rebate if they fail to satisfy the spending requirements.

 

11 In the case of governmental bonds (including bonds to finance public schools), the sixmonth expenditure exception is treated as satisfied if at least 95 percent of the proceeds is spent 

within six months and the remaining five percent is spent within 12 months after the bonds are 

issued.

12 Retainage amounts are limited to no more than five percent of the bond proceeds, and 

these amounts must be spent for the purpose of the borrowing no later than 36 months after the 

bonds are issued. 
15

Third, governmental bonds issued by “small” governments are not subject to the rebate 

requirement. Small governments are defined as general purpose governmental units that issue no 

more than $5 million of tax-exempt governmental bonds in a calendar year. The $5 million limit 

is increased to $10 million if at least $5 million of the bonds are used to finance public schools.13

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments are given 

the authority to issue “qualified zone academy bonds.” Under present law, a total of $400 

million of qualified zone academy bonds may be issued in each of 1998 through 2001. The $400 

million aggregate bond authority is allocated each year to the States according to their respective 

populations of individuals below the poverty line. Each State, in turn, allocates the credit to 

qualified zone academies within such State. A State may carry over any unused allocation for up 

to two years (three years for authority arising before 2000).

Certain financial institutions (i.e., banks, insurance companies, and corporations actively 

engaged in the business of lending money) that hold qualified zone academy bonds are entitled 

to a nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of 

the bond. An eligible financial institution holding a qualified zone academy bond on the credit 

allowance date (i.e., each one-year anniversary of the issuance of the bond) is entitled to a credit. 

The credit amount is includible in gross income (as if it were a taxable interest payment on the 

bond), and the credit may be claimed against regular income tax and alternative minimum tax 

liability.

The Treasury Department sets the credit rate daily at a rate estimated to allow issuance of 

qualified zone academy bonds without discount and without interest cost to the issuer. The 

maximum term of the bonds also is determined by the Treasury Department, so that the present 

value of the obligation to repay the bond is 50 percent of the face value of the bond. Present 

value is determined using as a discount rate the average annual interest rate of tax-exempt 

obligations with a term of 10 years or more issued during the month.

“Qualified zone academy bonds” are defined as bonds issued by a State or local 

government, provided that: (1) at least 95 percent of the proceeds is used for the purpose of 

renovating, providing equipment to, developing course materials for use at, or training teachers 

and other school personnel in a “qualified zone academy” and (2) private entities have promised 

to contribute to the qualified zone academy certain equipment, technical assistance or training, 

employee services, or other property or services with a value equal to at least 10 percent of the 

bond proceeds.

A school is a “qualified zone academy” if (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

 

13 The Small Business Job Protection Act of 1996 permitted issuance of the additional $5 

million in public school bonds by small governments. Previously, small governments were 

defined as governments that issued no more than $5 million of governmental bonds without 

regard to the purpose of the financing.
16

graduation and employment rates, and (3) either (a) the school is located in a designated 

empowerment zone or a designated enterprise community, or (b) it is reasonably expected that at 

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act.

Description of Proposal

Increase amount of governmental bonds that may be issued by governments qualifying for 

the “small governmental unit” arbitrage rebate exception

The additional amount of governmental bonds for public schools that small governmental 

units may issue without being subject to the arbitrage rebate requirement would be increased 

from $5 million to $10 million. Thus, these governmental units could issue up to $15 million of 

governmental bonds in a calendar year provided that at least $10 million of the bonds were used 

for public schools.

Allow issuance of tax-exempt bonds for privately owned public school facilities

The private activities for which tax-exempt bonds may be issued would be expanded to 

include elementary and secondary public school facilities which are owned by private, for-profit 

corporations pursuant to public-private partnership agreements with a State or local educational 

agency. The school facilities for which these bonds are issued would be required to be operated 

by a public educational agency as part of a system of public schools. Issuance of these bonds 

would be subject to an annual per-State volume limit equal to the greater of $10 per resident ($5 

million, if greater) in lieu of the present-law State private activity bond volume limits.

Effective Date

The provisions would be effective for bonds issued after December 31, 2001.