Tax-Exempt Financing for Religious Nonprofits: Lessons on the First Amendment

ABC Prep School is a secular nonprofit organization that owns and operates a K-8 private school. The school has an enrollment of 200 students, modern facilities, a committed faculty, engaged and generous parents and an active, well-connected board of trustees.

ABC Prep School is a secular nonprofit organization that owns and operates a K-8 private school. The school has an enrollment of 200 students, modern facilities, a committed faculty, engaged and generous parents and an active, well-connected board of trustees. The school offers a broad-based curriculum, has after-school programs and athletic teams. XYZ Religious School is a few miles down the road from ABC. It, too, is a nonprofit organization operating a 200-student school. It has a similarly dedicated faculty, board and parents. XYZ produces athletic teams which compete against the rival ABC teams. It offers similar high school preparatory courses.

A notable difference between the two schools, however, is the strong religious component of the XYZ school. Students and faculty at XYZ are selected in part on the basis of their religion, classes begin with a prayer, students are required to take a Bible study class and to attend daily religious services at the on-campus chapel, all members of the board of trustees are leaders of the church with which the school is affiliated, teachers enjoy no protections with regard to academic freedom, and the stated mission of the school includes teaching religion and helping students develop a religious commitment.

ABC and XYZ each has 30 acres of land adjacent to its campus, and each wants to build a high school. The board of trustees of ABC determines that the most attractive financing for the high school is a “tax-exempt bond” transaction. The trustees pass a resolution regarding the financing and move on to other business. At the XYZ meeting down the road, one of the trustees reports that tax-exempt bonds would offer XYZ the lowest interest rate of all financing options. However, XYZ’s lawyer wonders aloud if the school may just be “too religious” to use them because of the First Amendment’s provisions concerning separation of church and state.

At one time, XYZ may have had to use more expensive conventional financing. However, recent decisions of the Supreme Court, as well as other federal and state courts, suggest that XYZ should conduct a thorough examination of the First Amendment issues to determine if they might obtain tax-exempt bonds. This article discusses the benefits of tax-exempt bonds as a financing mechanism and reviews the state of the law regarding the issuance of such bonds for religiously sponsored entities.

What is tax-exempt bond financing?

In an ordinary tax-exempt bond transaction, a local government entity, often a development authority, issues bonds to finance facilities for a private organization. Investors purchase the bonds and the development authority uses the funds either to make a loan to the nonprofit or to acquire facilities for lease to the nonprofit. The nonprofit agrees to make payments in amounts sufficient to pay debt service on the bonds. The primary benefit of tax-exempt bond financing is the lower interest rates paid by the nonprofit borrower. The bonds issued by the authority for the benefit of 501(c)(3) organizations can be qualified to pay tax-exempt interest to the investors, and the lower interest rates are passed on to the nonprofit borrower. Interest on such bonds also generally is exempt from income taxation in the state in which the bonds are issued. With capital facilities financed by low-interest, long-term bonds, nonprofit organizations can direct their fundraising activities into endowment and other projects, as well as into debt reduction. Tax-exempt bond financing for nonprofit organizations without a religious component, such as the ABC Prep School, is well established.

Tax-Exempt Bonds for Religious Organizations

A nonprofit organization qualified under Section 501(c)(3) of the Internal Revenue Code may use tax-exempt bond financing for any capital assets that it acquires and uses for its charitable or educational purposes, provided that the transaction is structured properly.1 However, when considering a bond issue for a school such as the XYZ Religious School, federal constitutional law, as well as state and local law, must be analyzed to determine whether the financing is permissible.

Constitutional Considerations

The U.S. Constitution provides that Congress shall make no law respecting an establishment of religion.2 In its 1971 case Lemon v. Kurtzman,3 the U.S. Supreme Court devised a three-part test for determining whether state aid flowing to a religious institution violated the Establishment Clause: first, the legislation permitting the aid must have a secular purpose; second, the primary effect of the statute cannot be the advancement of religion; and third, the statute may not lead to excessive entanglement between government and religion.4 The Supreme Court has only once directly considered whether bond financing for a religious school was the type of governmental aid which violates the Establishment Clause. In Hunt v. McNair,5 the Supreme Court used the Lemon test to analyze a bond transaction in which a South Carolina public authority issued revenue bonds benefiting a Baptist school. The Court found that the pertinent legislation had a secular purpose, advancing the education of state residents by allowing bonds to be issued for all institutions of higher learning. In looking at the advancement prong of the Lemon test, the Court applied the “pervasively sectarian” test:

Aid normally may be thought to have a primary effect of advancing religion when it flows to an institution in which religion is so pervasive that a substantial portion of its functions are subsumed in the religious mission or when it funds a specifically religious activity in an otherwise substantially secular setting.6

The Court considered factors such as religious qualifications of teachers and students, mandatory observance of religious services and academic freedom, ultimately concluding that the school was not pervasively sectarian. Accordingly, the Court did not disturb the bonds, which had already been issued.

Some observers believe that the “pervasively sectarian” test has been eroded by later Supreme Court decisions.7 The test, however, has never been formally overruled by a majority of the Court. In the past three years, the Sixth Circuit has heard two cases involving the issuance of tax-exempt bonds for religious schools. In the first, Johnson v. Economic Development Corp.,8 the Court found that the school in that case was sectarian, but not pervasively sectarian, and allowed the financing to go forward.

In the Sixth Circuit’s later case, Steele v. Industrial Development Board,9 the Court decided that even though the school in question was a pervasively sectarian institution, the indirect nature of the aid washed away any constitutional problem. A Tennessee Industrial Development Board had issued bonds to assist the David Lipscomb University in a major redevelopment of its campus. Taxpayers asserted that the bonds violated the Establishment Clause of the Constitution. The lower court sided with the taxpayers, finding that the University was pervasively sectarian and that the aid flowing to it was not permissible. The Sixth Circuit reversed on appeal. The Court noted that the vitality of the “pervasively sectarian” test was questionable in light of recent Supreme Court cases.10 Most significantly, the Court managed an end run around the “pervasively sectarian” test. Even if the University was pervasively sectarian, the Court determined that the aid provided by tax-exempt bonds was of a limited sort “analogous to an indirect financial benefit conferred by a religiously neutral tax or charitable deduction.”11 As is usual in such bond issues, the Industrial Development Board did not provide any tax funds and the University, not the Board, was responsible for payments on the bonds. Funds for the transaction came from independent investors. The transaction did not suggest that the State endorsed the University. Rather, the Industrial Development Bond was a mere conduit which assisted in general economic development by issuing bonds on a neutral basis for the benefit of religious and nonreligious entities alike. As the Court put it, “the Board no more endorsed Lipscomb University than it did Wal-Mart in issuing industrial revenue bonds.”12

The Supreme Court declined to review the case on appeal. While it is tempting to consider this a tacit endorsement of the Sixth Circuit’s opinion, there remains some continuing constitutional uncertainty with the application of the “pervasively sectarian” test to tax-exempt bond issues. To date, no other circuit court of appeals has had occasion to rule on a tax-exempt
bond case.

State and Local Law Considerations

State constitutions may impose additional restrictions on tax-exempt bonds issued for religious entities, above and beyond the federal constitutional limits. Such provisions must be carefully reviewed. For example, the Constitution of the State of Georgia has a provision entitled “Separation of Church and State” which reads:

No money shall ever be taken from the public treasury, directly or indirectly, in aid of any church, sect, cult, or religious denomination or of any sectarian institution.13

Because no public funds are involved in the ordinary bond transaction, this provision should not be interpreted to impose additional limitations on bonds issued for religious schools in Georgia. While the exemption from Georgia state income tax on such bonds does lead to less tax revenue for the public treasury, no funds flow from the treasury to the borrower.

The so-called “enabling legislation” of a bond issuer may also limit the types of projects for which the entity may issue bonds. Most often, these laws are designed to encourage development neutrally, without regard to the nature of the beneficiary. In some instances, a nonprofit entity may be able to select from two or more bond issuers, and their enabling legislation should be reviewed to choose the most appropriate issuer.

Role of Bond Counsel

In a tax-exempt bond transaction, nationally recognized bond counsel should be retained. Bond counsel is charged with analyzing local and state law as well as federal tax and constitutional law in order to give a legal opinion that the bonds have been properly authorized and issued and that the interest on the bonds is tax-exempt. Because of the specter of the “pervasively sectarian” test, bond counsel will ordinarily want to find out as much as possible about the workings of a religious school seeking bond financing. The heart of the “pervasively sectarian” test is the idea that secular and religious functions of a school are so intertwined that they cannot be separated. For many religious schools, this is not the case. A school may have a largely secular educational governance structure and curriculum, yet have an attached chapel or other religious building on campus. Or a school may have designated classrooms where religious instruction is conducted. In such cases, bond counsel may be able to allocate the proceeds of the tax-exempt bonds to the secular structures and classrooms, while the religious space, for example a chapel, is funded out of gifts, the school’s own funds, taxable bonds or other conventional financing. Funding only the secular assets provides an additional layer of protection against any Establishment Clause challenge.

However, for many religious schools, like the XYZ Religious School, the line between secular and religious is not so easily drawn. After the Steele case, even pervasively religious schools within the footprint of the Sixth Circuit (Tennessee, Michigan, Ohio and Kentucky) should be able to obtain tax-exempt financing, provided there is no state or local barrier. In other states, some bond counsel may conclude that financing pervasively religious schools is permissible based on the recent encouraging rulings coming out of the courts. Others may take the position that Hunt is still good law, conduct the traditional “pervasively sectarian” inquiry and err on the side of caution until the constitutional waters clear up.

Legal Challenges

Bonds issued for religious borrowers are at times scrutinized by First Amendment groups and may be more likely to be challenged in court. If so, the significant cost savings of tax-exempt financing can be diminished or wiped away altogether, even if the case is ultimately resolved favorably. A challenge may come before or after bonds are issued, and the remedies requested in a lawsuit may vary. A suit coming prior to the issuance of bonds will likely seek to enjoin their issuance. A suit filed after the fact may seek to have the bonds invalidated. In the Steele case, the plaintiffs sought, and the district court granted, a permanent injunction against the Industrial Development Board enjoining the Board from issuing any additional bonds on behalf of any other “pervasively sectarian” institution.14

Careful Analysis Still Required

Religiously sponsored organizations resembling the XYZ Religious School should not automatically assume that they cannot finance capital improvements through tax-exempt bonds. Competent bond counsel can analyze relevant state and constitutional issues. The Supreme Court missed an opportunity to provide needed clarity in the tax-exempt bond field by declining to hear the Steele case on appeal. However, the current Supreme Court, and other state and federal courts, appear to be taking a more nuanced and permissive view of the Establishment Clause in state aid cases generally, and if Steele becomes the rule, religion would largely cease to be an issue in the tax-exempt bond setting. Until the Court steps in, however, XYZ Religious School and its kin should not be shut out of the market altogether, but must tread more carefully than their peers down the road at ABC Prep School.


  1. See James P. Monacell, Overview of Bond Financing for 501(c)(3) Nonprofit Organizations, on the SGR Web site,

  2. U.S. Const. amend. I (“Congress shall make no law respecting the establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of people peaceably to assemble, and to petition the government for a redress of grievances.”). 

  3. Lemon v. Kurtzman, 403 U.S. 602 (1971). 

  4. Id. at 612-13. 

  5. Hunt v. McNair, 413 U.S. 734 (1973). 

  6. Id. at 743 (citations omitted). 

  7. See, e.g., Trent Collier, Revenue Bonds and Religious Education: The Constitutionality of Conduit Financing Involving Pervasively Sectarian Institutions, 100 Mich. L. Rev. 1108, 1121-29 (2002) (discussing later Supreme Court cases which suggest that “the pervasively sectarian analysis may be out of step with the Court’s current understanding of the Establishment Clause” and citing other commentators in agreement); Stuart J. Lark, New Opportunities and Continuing Challenges in Securing Tax-Exempt Financing, Taxation of Exempts, September/October 2003, at 87 (arguing that recent cases remove the “pervasively sectarian” barrier to bond financing for religious schools). 

  8. Johnson v. Econ. Dev. Corp., 241 F.3d 501(6th Cir. 2001). 

  9. Steele v. Indus. Dev. Bd., 301 F.3d 401 (6th Cir. 2002). 

  10. Id. at 408. 

  11. Id. at 413. 

  12. Id. at 416. 

  13. Ga. Const. art. 1, § 2, para. 7. 

  14. Steele v. Indus. Dev. Bd., 117 F. Supp. 2d 693, 735 (D. Tenn. 2000). 

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