Tax-exempt bond audits.

• Author: Reichert, Mary Gassmann

What are the alternatives available to a municipal bond issuer that receives a "Preliminary Determination of Taxability Letter" from the IRS?

The Internal Revenue Service (IRS) enforcement and compliance function in the tax-exempt bond area has only recently developed and is vastly different from its tax enforcement and compliance activities for taxpayers. Because of these differences, as well as the relatively short time period that has elapsed since the IRS began its bond audit program, many difficult issues confront municipal issuers in connection with an IRS audit.

History of Tax Enforcement Activity

The interest on state and local government obligations has been exempt from federal taxation since the inception of federal internal revenue laws in 1913. The first material restrictions on the exemption for municipal debt were added to the Internal Revenue Code (the Code) by the Revenue and Expenditure Control Act of 1968. Compliance with these and subsequent provisions of the Code by municipal issuers and their bond counsel was primarily based on the honor system. Accordingly, other than compliance with local law, bond counsel's willingness to give an approving opinion that bonds were exempt from federal taxation was the only restriction upon a creditworthy political subdivision's exercise of its borrowing power. Until the early 1990s, the IRS conducted virtually no enforcement activity in the tax-exempt bond area.

The honor system suffered a severe blow from a transaction by a Wall Street underwriter financing several multi-family housing transactions in the United States and Guam in late 1985. Without the knowledge of the issuer and in violation of the explicit terms of the financing documents executed by the issuer, bond proceeds were diverted by the underwriter and others and used to acquire guaranteed investment contracts, the earnings on which were used to pay bondholders. As a result of the diversion, the projects were not constructed. These transactions triggered the interest of the IRS and the Securities and Exchange Commission (SEC) in municipal finance and resulted in tax enforcement and compliance initiatives by both agencies.

Compliance Program

In June 1993, the IRS first announced its Tax-Exempt Bond Compliance Program which involved consolidating enforcement activities relating to tax-exempt bonds under the jurisdiction of the Assistant Commissioner, Employee Plans and Exempt Organizations. The government's stated goal was "to achieve a significant increase in the level of audit coverage, and to respond promptly to abusive transactions." In addition to announcing new training for IRS agents and its lawyers on tax-exempt bond issues, the announcement put municipal market participants on notice that the government was concerned about certain types of financings: advance refunding transactions which employed open-market purchases of U.S. Treasury obligations, backloaded debt services payment transactions, and financings which had a potential for private-business use of the financed facilities. Consistent with the announcement, in the past four years, the IRS has focused its enforcement efforts on "yield burning," window refundings (backloaded debt service deals), and hospital bonds, portions of the proceeds of which were allegedly used to provide a private benefit to physicians.

The Tax-Exempt Bond Compliance Program designed two programs to ensure compliance with federal law. The Targeted Program was to respond to audits targeted by media referral or "snitch" letters sent to the IRS regarding closed transactions. Snitch letters historically have been provided by disgruntled employees of the issuer or law firms and underwriters who were not selected for the financing. The Random Program was designed to measure issuer compliance, through statistical samplings of the Information Return, Form 8038.

By the end of 1994, the Targeted Program involved more than 300 bond issue "referrals," about half of which were actually audited. The Random Program was not initiated until October 1996 despite plans to begin over a year earlier. To date, the Random Program has conducted only approximately 100 audits and has focused solely on small-issue industrial development bonds. The level of tax compliance found in those cases has not been formally published. The IRS's top municipal enforcement official has indicated that most of those audits will be completed in the spring of 1998 with results forthcoming soon thereafter.

Audit Procedures

Announcement of the Guidelines. In the summer of 1995 the IRS issued proposed audit guidelines designed to increase its enforcement activities related to tax-exempt bonds. The guidelines set forth general procedures to be observed by the IRS auditors in the examination of municipal finance transactions and apply to any financing arrangement of states and their political subdivisions involving the issuance of debt obligations, whether styled as notes, bonds, installment sales, lease-financing arrangements, or otherwise.

Under the guidelines, the Assistant Commissioner of the Exempt Organizations Division of the IRS is responsible for municipal tax enforcement initiatives. Although those responsibilities include setting the policies and procedures for the audit program, the district directors of the four key districts (midstates, northeast, southeast, and western regions) are empowered to negotiate closing agreements with issuers in coordination with the national office of the IRS and to institute special sampling and nationwide information gathering programs regarding cases to be...