Tax departments should be prepared for audits of tax-exempt bonds

When asked why he robbed banks, Willie Sutton responded, "Because that's where the money is." A similar spirit has informed the early efforts of the Internal Revenue Service's Tax Exempt Bond (TEB) Group in its choice of which bonds to audit. There appears to be a strong preference for auditing bonds whose proceeds have been lent by the issuer to large corporations ("conduit borrowers"). Tax departments in companies with tax-exempt financing need to be alert to the potential for audits of their bonds and need to take steps to ensure that their companies are prepared to defend those audits. Document retention and fact development is key, and corporations should be mindful that their normal Large and Mid-Size Business Division audit cycles and statutes of limitation do not apply.

Audits of tax-exempt bonds can create substantial financial exposure to companies. For example, if the IRS determines that a $50,000,000 series of bonds with a 5-percent coupon does not qualify as tax-exempt, its opening offer to settle the case without taxing the bondholders would be for the conduit borrower to pay more than $2 million plus interest and redeem the bonds (thereby causing the loss of lower-rate financing). Any amount less than the opening offer would have to be justified by factual hazards of litigation.

Given this potential exposure, taxpayers must be prepared to prove the exempt status of their bonds. For example, in the case of bonds issued to provide industrial sewage facilities, the taxpayer must be able to prove that the subject wastewater meets the biochemical oxygen demand limits set forth in the Treasury Regulations. For taxpayers who have obtained financing through qualified small issue bonds, the taxpayer must be able to prove compliance with the capital expenditure limitations that extend three years after issuance of the bonds. For any exempt facility bond, the taxpayer must be able to prove that there has been no change in the use of the facility to a non-exempt use.

A Brief History of Tax-Exempt Bond Audits

Before the early 1990s, the tax-exempt finance industry was largely self-regulated. The IRS had no organized audit program. Compared with other self-regulated industries, the tax-exempt finance industry performed fairly well. The industry was dominated by a handful of nationally-recognized, leading bond law firms whose tax partners consulted with one another regularly (by conference call) on whether given financing approaches satisfied the Internal Revenue Code requirements (sections 103 and 141-150) for tax exemption. Most issues of tax-exempt bonds were the product of a consensus of these firms, and the IRS did not question their bond opinions.

If a given firm wanted to be more aggressive, or developed a proprietary strategy, it sought a ruling from the IRS Chief Counsel's office rather than consult with the other law firms. If it obtained the ruling, it had at least a 90-day marketing head start to contact potential bond issuers before the redacted ruling was published and other firms began to reverse engineer and market the transaction themselves. In the event a law firm outside this close-knit community issued an opinion on a more aggressive financing without either the support of the other firms or a ruling, an article might appear on the front page of The Bond Buyer (the industry publication), which could lead to either IRS inquiry, a Treasury press release that the bonds might be taxable or, in extreme cases, an actual audit. These problem bonds were very rare.

In the early 1990s, the IRS began examining tax-exempt bonds in connection with exempt organization (EO) audits of hospitals and universities. While the IRS developed some audit expertise in the area of these so-called section 501(c)(3) bonds, that expertise was not applied to the wider world of government obligations and private activity bonds. A 1993 General Accounting Office report criticized the reliance on self-regulation in the tax-exempt finance industry and recommended that the IRS institute a more active audit program.

A significant impediment to any audit program was the fact that the taxpayer subject to audit was the bond-holder, whereas the facts relating to whether tax-exempt bonds qualified for exemption under the Code were in the hands of the governmental issuer or the conduit borrower. This became an even larger problem with the advent of tax-exempt bond mutual funds holding an increasing proportion of tax-exempt bonds in the market. The effect on taxpayer returns became more diffused. Thus, if the IRS wanted to audit a particular bond issue, it had to identify and audit the bondholders who were excluding the tax-exempt interest on their returns and, through those audits, seek third-party information from the issuer and conduit borrower to determine whether the bonds met the requirements for exemption under the Code and regulations.

Section 8001 of the IRS Restructuring and Reform Act of 1998 addressed the situation by allowing the IRS to treat the issuer of tax-exempt bonds as the taxpayer for purposes of audit and consideration by Appeals. As initially proposed, the bill would have allowed issuers to be treated as the taxpayer through any litigation on the taxability of the bonds. This approach, however, met opposition from mutual fund companies which feared that if bonds were determined to be taxable by the Tax Court, the mutual funds would be placed in the position of having to become an intermediary between the IRS and their fund investors. Nevertheless, the Conference Committee's report on the 1998 Act provides that "Congress will evaluate judicial remedies in future legislation once the IRS's tax-exempt bond examination program has developed more fully and the Congress is better able to ensure that any such future measure protects all parties in interest to these determinations (i.e., issuers, bondholders, conduit borrowers, and the Federal Government)." In the meantime, while the governmental issuer is the "taxpayer" for purposes of audit and Appeals (a role often assumed as a practical matter by the conduit borrower with agreement of the issuer), bondholders or investors in mutual funds are the taxpayers for purposes of litigation or collection of additional tax by the IRS.

This schizophrenic approach pushes the IRS and issuers/conduit borrowers to resolve any differences on the taxability of the bonds no later than Appeals. From the IRS's perspective, the prospect of auditing and assessing tax on potentially thousands of returns for a small adjustment per return is a nightmare. From the issuer's (or conduit borrower's) perspective, any such effort by the IRS would invite the attention of class-action securities lawyers, with accompanying litigation costs. Both sides avoid this Armageddon scenario by reaching agreements in ways that do not lead to taxation of the bondholders.

The Tax-Exempt Bond Audit Program

The 1998 Act, which also sanctioned a reorganization of the IRS, opened the door to an organized audit program by the IRS of tax-exempt bonds. The IRS's new Tax-Exempt/Government Entities (TE/GE) "silo" provided an appropriate home for the focus on tax-exempt bond audits. Audit activity is contained in TE/GE's TEB Group, with a handful of group managers spread across the country managing a total of approximately 50 agents who perform the audits. When the group started, only a few of these agents (and their managers) had experience with auditing tax-exempt bonds through the EO program. Most entered the program with little or no exposure to tax-exempt financing, and few had any experience in audits of sophisticated transactions involving business taxpayers in the LMSB Division. Most of the agents continue to be drawn from the EO and small-business/self-employed exam functions. While the TEB Group has instituted a substantive education program to train the agents in the IRS's view of requirements for tax-exempt bonds, most of the strategy, direction and sophisticated analysis comes from the leaders of the TEB Group in Washington, D.C.

The leaders of the TEB Group have taken aggressive positions with respect to private activity bonds that finance the projects of large businesses in particular. Since neither the IRS nor the conduit borrowers have an effective recourse to litigation, the TEB Group generally takes a hard line in negotiating a closing agreement with the conduit borrower in lieu of taxing the bondholders. The closing agreements may require substantial payments to the IRS to compensate the government for lost tax revenue on the bonds and that the bonds be redeemed (thereby increasing the conduit borrower's cost of financing). While issuers have recourse to Appeals if the TEB Group concludes that a bond is taxable, Appeals itself is still relatively inexperienced in this area, and there are only four Appeals Officers in the United States who handles bond issues.

Procedure

Audits begin with a notice by the TEB agent to the issuer of the bonds that the IRS is auditing the bonds. The issuer is the governmental agency issuing the bonds, and the conduit borrower may not receive notice of the audit for many months. Governmental agencies are not experienced with IRS audits. Issuers may not be sophisticated about dealing with the IRS, may attempt to comply with initial information document requests (IDRs) and may even meet with the agent before the conduit borrower is aware of the audit. Typically, however, there comes a point when the agent is asking questions about the facility financed by the bonds that the issuer cannot answer or is asking for a tour of the conduit borrower's facility, and the conduit borrower will become aware of the audit.

At this stage, it is critical that the tax department of the conduit borrower and the conduit borrower's representatives assume control of the audit. Issuers typically have no experience in dealing with either the IRS or the substantive issues under the Code that may arise. In fact, issuers are usually happy to turn the audit over to the conduit borrower once the conduit borrower expresses a willingness to pay any costs of representation. The issuer remains the "taxpayer" for purposes of the audit, however, so the borrower's tax department will need to obtain Form 8821 (Tax Information Authorization) from the issuer in order to deal directly with the IRS and will similarly need the issuer to sign Form 2848 (Power of Attorney and Declaration of Representative) if outside counsel is brought in. The conduit borrower should also keep securities counsel abreast of the progress of the audit so that decisions of securities disclosure requirements can be made on an informed basis.

The tax department should defend the bond audit with the same professionalism, diligence, and attention as its LMSB audits. In addition to answering the direct questions posed by the agent, the tax department should consider what factual proof is needed to demonstrate that the bonds are tax-exempt and begin developing that proof. The tax department of most conduit borrowers may not have been heavily involved in the initial bond offering, which is typically a company treasury function. (The financings are usually promoted by underwriters and bond law firms that provide the structure, tax analysis, and bond opinion as part of their services.)

Moreover, for bonds issued before 2000, it is not likely that the company's treasury department, the underwriters, or the bond law firms considered the possibility of needing to be prepared for an IRS audit. Normal practice prior to that time would not have been to develop documentation beyond the transactional documents for the financing. The bond opinion is issued on the basis of a set of assumptions and representations provided by the bond counsel and signed by corporate officers (typically known as the "Tax Certificate"), so that any factual development that is done at the time of the issuance would be limited to any due diligence performed by the company to support the Tax Certificate. Without an awareness of the possibility of an audit, however, this due diligence material may not be retained.

The audit will seek to determine whether the bonds satisfy the requirements of the Code. At the start of the audit, there is no particular tax period in issue. The IRS can and does audit bonds that were issued many years prior to the start of the audit: bonds issued up to 10 years before audit are not uncommon, but bonds issued more than 15 years before audit would be rare. If there comes a point where taxability becomes a possibility, the statute of limitations for the bondholders controls. Thus, any IRS settlement would be calculated based on the three most recently filed return years. The document retention issues for conduit borrowers, however, can extend back well beyond the three-year limitation period.

Face-to-face contact with the agent is typically limited to the IRS-required tour of the bond-financed facility. The TEB Group manager may or may not accompany the agent at this juncture, and may or may not be involved with the conduit borrower during the information gathering stage of the audit. IDRs are usually transmitted by mail or fax, and telephone contact is sporadic. Because the agents are relatively inexperienced with both the tax-exempt bond law and large businesses, it may be necessary to negotiate the content of IDRs in order to keep them in a range of reasonableness and relevance. If after working through a series of IDRs the agent and the agent's manager conclude that the bonds satisfy the Code requirements for tax exemption, the agent will issue a "no change" letter, and the audit is ended. By its terms, the "no change" letter holds open the possibility of a later audit of the same bonds. As a practical matter, this would only happen if circumstances change after the audit is concluded (such as a change in use of the facility). The IRS will not come back to reconsider facts occurring prior to the audit.

If the agent believes that the bonds do not satisfy all of the requirements for tax exemption, the IRS will send the issuer a "preliminary adverse determination," setting forth the agent's understanding of the facts and law. This performs the function of a Form 5701 (Notice of Proposed Adjustment) delivered during an LMSB audit. It allows the agent to clarify misunderstandings of fact or law prior before deciding whether to seek technical advice or to send the taxpayer to Appeals. The preliminary adverse determination offers the issuer three opportunities: a conference with the agent's TEB Group manager; taxpayer--initiated technical advice; or assistance from the Office of the Taxpayer Advocate. Because access to technical advice is also available later in the process and the Taxpayer Advocate's Office is unlikely to be effective for sophisticated taxpayers, the conference with the TEB Group manager is generally the path of choice. This permits the conduit borrower to clear up any misunderstandings held by the agent, educate the more experienced manager about the bonds and the facility, and make additional submissions that set forth the conduit borrower's position. If the conference does not produce agreement, the conduit borrower can request technical advice.

After any conference and submission, the IRS has three choices: It can issue a "no change" letter; it can request technical advice if it believes that the issues presented have not been previously addressed by the National Office; or it can issue a "proposed adverse determination," which performs the function of a 30-day letter. The proposed adverse determination again contains the agent's statement of facts and conclusions of law and gives the issuer three choices: contact the agent to begin negotiations on a closing agreement (including a payment and redemption of the bonds to avoid assertion of tax liability against the bondholders); protest the proposed adverse determination to Appeals; or seek assistance from the Office of the Taxpayer Advocate. The decision between a closing agreement with the TEB Group and going to Appeals is one of strategy and will depend on the posture of the case and the relative merits. In general, however, like any significant LMSB examination issues, taxpayers can expect a more knowledgeable evaluation of the matter in Appeals. Taxpayers should also reconsider the potential for requesting technical advice at this point.

Should the conduit borrower be unable to reach an agreement with Appeals, the IRS would issue an "adverse determination" that the bonds are taxable, allowing the IRS to pursue bondholders for the tax. Because of the attendant difficulties for the IRS, the issuers, and conduit borrowers, this does not happen. From January through September 2002, the IRS entered into more than 60 closing agreements with issuers without taxing any investors of bonds that were under audit. It is likely that the IRS issued at least 100 "no change" letters in that period.

Preparation

The difficulties presented to tax departments by this system are considerable. The department may not be aware of or involved in the financings at the beginning. Audits may commence and information may be transmitted to the IRS without notice to the company. Audits arise outside the normal LMSB cycles of the statute of limitations. The agents are relatively inexperienced in dealing with sophisticated financing structures or with large businesses.

Tax departments need to gain control of information and document retention as early as possible. Before substantial time passes an evaluation should be made of whether the factual development is sufficient to withstand the scrutiny of an audit and whether additional information should be gathered. While all financings sold to the company will purport to be "vanilla," the tax department (if not involved in the initial evaluation of the financing) should at least make a preliminary evaluation whether there are "close calls" that might attract the attention of the IRS. Moreover, if tax-exempt financings are being done or will be done in the future, the tax department should become involved in preparing the bonds for audit at the time of the transaction.

While it is probably not worthwhile to disturb or confuse issuers by suggesting (prior to any hint of an audit) that they contact the company immediately if an audit is commenced, once the company is aware of an audit, the tax department should take charge and treat the audit with the same level of attention as any serious issue in a

LMSB audit. The company's knowledge of the issue needs to get ahead of the agent's knowledge and stay there.

The tax department should also obtain as much information as possible from bond counsel concerning its analysis of the qualification for exemption at the time the bonds were issued. Bond opinions issued at closing are very conclusory and contain no analysis. The thorough analysis is contained in a file memorandum retained by the bond firm and considered proprietary by the firm. The memorandum may not have been prepared in connection with the taxpayer's bonds (especially where the bonds were part of a series of "cookie-cutter" deals), but it will provide the analytical basis for the factual representations made by the company in the Tax Certificate. Even if bond counsel, who may have malpractice concerns of its own arising out of the audit, will not provide the memorandum, the taxpayer should insist on an oral presentation of the bond counsel's analysis as soon as possible after the audit commences.

Conclusion

Audits of tax-exempt bonds are still at an early stage in their development. They are, however, a permanent part of the IRS's arsenal in attempting to regulate tax-exempt financing, and the new regulators are acting aggressively. The IRS is extracting millions of dollars from issuers, conduit borrowers, bond counsel and underwriters in the course of these audits, and it is important that companies be prepared for the potential audit of their tax-exempt bonds.

GEORGE A. HANI and ROBERT E. LILES, II are Members of Miller & Chevalier Chartered. Their practices encompass a broad range of federal tax controversy work, including representation of conduit borrowers, issuers, and underwriters in tax-exempt bond audits and appeals. Mr. Hani was an Honors Attorney in the Treasury Department's Honors Program, and Mr. Liles has been a speaker at numerous TEI conferences and chapter meetings.

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