The Taxman Cometh (to Issuers of Tax-Exempt Bonds):
The IRS Tax-Exempt Bond Compliance Program
By J. Alexander Meleney, Hopkins & Sutler
(Mr. Meleney is a partner in the Chicago firm of Hopkins & Sutter who has practiced both in the tax and municipal
finance areas. Mr. Meleney has extensive experience both in representing taxpayers before the IRS and serving as
bond counsel.)
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Most municipal corporations and their related
agencies have been blissfully immune to the unpleasant
interrogations which are periodically visited upon most
other entitles by the Internal Revenue Service (IRS).
However, under a new enforcement initiative of the
IRS, many governmental units which have issued tax-exempt bonds may suddenly be faced with a new problem — how to respond to an IRS audit.
In June 1993 the IRS, in Announcement 93-92,1993-24 IRB 66, reported the implementation of its "Tax-
Exempt Bond Compliance Program" (the "Compliance
Program"). In Announcement 95-61, 1995-32 IRB 54,
the IRS issued proposed audit guidelines (the "Audit
Guidelines") for tax-exempt bonds. The above documents as well as other information coming from the
IRS, including a letter to the SEC dated January 10,
1994, indicate that the Compliance Program will include two types of audits, (i) targeted audits aimed at
transactions identified as having potential problems
based on information received from market participants, the press, IRS officials, or other sources, and (ii)
random audits designed to gather statistical samplings
from which the IRS can develop profiles for future
audits of tax-exempt bonds. The Compliance Program
will also include expanded training for IRS agents and
attorneys, development of final audit procedures and
guidelines based on the actual experience of agents who
have audited tax-exempt bonds, enhanced coordination among the IRS and other governmental agencies
(presumably the SEC), increased staffing, and reviewing the processing of the Form 8038 information returns. What seems clear from this activity is that the IRS
intends to take a closer look at the tax-exempt bond
market to insure that issuers (and bond counsel) are
complying with the various technical rules that have
proliferated since 1986. Issuers of such bonds can expect that some of their number will be responding to an
IRS audit.
Governmental issuers may be puzzled by the fact
that they will be responding to IRS audits. After all, if
the bonds are not tax-exempt it is the bondholders who
have a tax liability. Moreover, many financings involving private projects financed with industrial development bonds are "conduit" financings; the private developer rather than the issuer should be responsible for
handling IRS inquiries about these bonds. Although
those are legitimate responses, because of concerns that
auditing bondholders will prematurely disrupt bond
markets before a determination is made that the bonds
are taxable and the inherent problems of identifying
public holders of tax-exempt bonds, the IRS has opted
for a procedure that attempts to resolve the tax status of
the bonds before proceeding against bondholders.
Moreover, as many tax-exempt bonds are not conduit
financings and governmental units are the nominal issuer of virtually all tax-exempt bonds, the Audit Guidelines have designated the issuer as the "taxpayer" that
will be the target for the IRS audit.
Being designated the taxpayer for purposes of the
IRS audit of an issue of tax- exempt bonds does not
mean the issuer is responsible for any taxes ultimately
found to be due (although the issuer or other parties
may make settlement payments to the IRS to avoid
taxation of bondholders as described below). Instead,
as the designated taxpayer the IRS will make requests
for additional information from the issuer and will not
negotiate or even discuss the audit with other parties
unless authorized by the issuer to do so in writing.
Under the Audit Guidelines, the IRS anticipates that
most cases will be resolved without taxing bond-
February 1996 / Illinois Municipal Review / Page 19
holders. If the IRS finds that an issue of bonds has failed
some requirement for tax-exempt status, the IRS in
most cases will seek some payment from the issuer (or
from some other interested party) in lieu of taxing the
bondholders. However, the IRS cannot compel the
payment of such settlements. In cases not involving
violations of the arbitrage rules, the starting point for
calculating the required settlement payment will be the
total tax plus interest that would have been paid by the
bondholders for years not closed by the statute of limitations (potentially a large sum). However, the IRS has
indicated that it will negotiate lower settlements depending on the seriousness of the violations. In the case
of violations of the arbitrage rules, the settlement will
generally be based on the arbitrage profits earned.
Only if a settlement cannot be agreed to at the issuer
level will the IRS seek to tax bondholders. Also, in the
absence of a settlement, the IRS may seek to impose
penalties on the Issuer or others for failing to report
interest payments to bondholders on Form 1099 and
possibly for failure to withhold taxes on such interest
payments, procedures not required for tax-exempt
bonds but required if interest on the bonds is taxable.
Unfortunately, there is no procedure available to
resolve an IRS audit before the IRS has attempted to tax
the bondholders. If settlement discussions do not result
in an agreement with the IRS, the only options are to
capitulate to the IRS position or let the IRS attempt to
tax the bondholders and resolve the matter in court. In
the latter case, the potential imposition of the penalties
discussed above may represent a powerful club in the
hands of the IRS to force issuers to settle cases.
To a large extent, the procedures outlined above
represent a formalization and refinement of the procedures that the IRS has used in the few audits of tax-exempt bonds that it has previously undertaken. The
most recent example of IRS enforcement efforts is
Harbor Bancorp. v. Commissioner of Internal Revenue, 105 T.C. No. 19 (October 16, 1995). In that case,
after failing to settle with the issuer and the conduit
borrower, the IRS assessed taxes against the bondholders and was sustained by the Tax Court. With the
implementation of the IRS's Compliance Program and
its success in the Harbor Bancorp. case, issuers can
expect more enforcement efforts from the IRS and
more court cases.
Although space does not permit a more complete
description of the Compliance Program and its consequences to issuers, following are some important issues
which will have to be addressed by the issuer early in
the audit process:
1. Who Pays? What party pays the expenses of responding to the IRS audit and the amount of any settlement with the IRS? In the case of general obligation
bonds, presumably the issuer pays. Rut what about tax
increment financings? In the case of conduit borrowings, presumably the conduit borrower will pay. But
what happens if the conduit borrower is a thinly capitalized development partnership or is otherwise unable to
pay? Ultimately it may by the issuer's reputation that is
at stake.
2. Attorneys? Although the bond counsel for the
tax-exempt bonds being audited appears to be a logical
choice, if the IRS audit finds problems with bond counsel's analysis they may have a conflict in their continuing representation of the issuer before the IRS. Also,
although bond counsel may be experienced with bond
transactions, they may have no experience in handling
IRS audits which have their own procedures and rules.
3. Disclosure. At some point the existence of an IRS
audit must be disclosed to bondholders. Such disclosure is likely to have a traumatic effect on the market for
publicly traded bonds and the timing and content of
any disclosure must be considered carefully.
In sum, some Illinois issuers of tax-exempt bonds
can expect to hear from the IRS which will expect them
to defend the tax-exempt status of their bonds. Those
unlucky issuers will be faced with a series of unfamiliar
issues, in some cases requiring quick responses. Also,
some issuers facing an IRS audit may find their finances
strained by the cost of defending their bonds and the
cost of any settlement negotiated with the IRS. Although most issuers of tax-exempt bonds can still expect to escape examination by the IRS, no issuer should
be surprised if they suddenly find themselves being
questioned by the taxman. •
Page 20 / Illinois Municipal Review / February 1996
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