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