What is a Private Activity Bond?

In the United States, one way that city and state governments can entice private companies to establish local businesses is by offering to finance some of the company’s activities. This financing is extended through a private activity bond, or PAB. United States tax law authorizes state and local governments to extend private activity bonds provided a certain set of requirements are met. The bonds are offered for sale to private investors, usually with a high interest rate that is, in most cases, exempt from federal taxes.

Starting up a business, expanding a business, or relocating a company is generally a very expensive proposition. Nonetheless, having a big company in a community is usually a good thing for the local economy. Corporate presences create jobs, improve the stream of business, and can attract other businesses and consumers to the area. Municipal governments have the authority raise money, in the form of bond sales, for businesses in order to make their localities more attractive. This money is raised through the sale of a private activity bond.

The Tax Reform Act of 1986, Public Law 99-514, authorizes states and municipalities to issue private activity bonds so long as one of three conditions, or “tests,” is met. First is the private business use test. To clear this hurdle, at least 10% of the proceeds of the bond must be used for private business use. Second is the private security or payment test, which requires that payments made on the principal or on the interest of at least 10% of the proceeds be secured by property that is for a private business use. The private loan financing test comes third, which requires that the majority of the bond’s proceeds be spent by private, i.e. non-governmental, entities.

Beyond the three tests, each state and city is free to set out specific conditions under which it will establish a private activity bond. Some municipalities require businesses to be of a certain size to qualify for a bond, for instance. Others set rules for how long a company must remain in the area after the repayment of the bond. Issuing governments rarely insure the bonds, and hardly ever promise repayment should the financed company fail to repay. The bonds are risky for investors, but the payout is often worth it.

Private investors often choose to purchase private activity bonds because the interest rates are generally much higher than other municipal or government bonds. That interest is structured to be tax-free, but much of whether that freedom will be realized depends on the owner’s circumstances. Since the passage of the Tax Reform Act, most categories of private activity bond are subject to the alternative minimum tax. The alternative minimum tax applies to taxpayers who can claim so many deductions that they owe virtually no taxes at all. If a taxpayer falls into this category, the interest he earns on any private activity bond will be taxed.