IRS Warns Texas City Agency

WASHINGTON — An Internal Revenue Service agent is warning the Crystal City, Tex., Public Facilities Corp. that $13.9 million of bonds it issued in 2003 to purchase a jail may not be tax-exempt because the agency appears to have exceeded private business-use limits.

The issuer disclosed the warning from IRS agent Cathy Webster in a material event notice posted recently on the Municipal Securities Rulemaking Board's EMMA site.

Specifically, Webster told the corporation on July 28 that she believes a fee arrangement between it and a for-profit company managing the facility, Bobby Ross Group Inc., provides BRG with an equity interest in the facility, which would constitute private business use. In addition, the facility is heavily used by the federal government, which is also considered to be a private user and would violate tax laws pertaining to private business use for tax-exempt bond-financed facilities.

Webster filed a "Notice of Proposed Issue" with the corporation on July 28. The issuer said in its disclosure notice that it plans to dispute the IRS' findings, but at the same time will also "explore the possibility" of reaching a settlement and closing agreement with the agency to protect the tax-exempt status of the bonds.

The bonds were issued to finance the acquisition of the Crystal City Correctional Center and to finance the construction of additional facilities tied to the jail. The issuer acquired the facility from Correctional Properties of Texas Inc., a private company. Bobby Ross Group managed the property for CPOT, which is a related party to it. After purchasing the property, the issuer leased the facility to the city, which in turn entered into a management agreement with BRG to continue overseeing the facility.

The IRS has taken issue with the 15-year management agreement the corporation reached with company. In the notice of proposed issue, which was included in the material event notice, the IRS argued that the arrangement allows the city and BRG to split the net profits from operating the facility, which results in excessive private business use. In addition, the IRS said the way the compensation is structured suggests "an equity interest in the operation of the bond-financed facility."

Tax rules state that private-activity bonds are not tax-exempt if more than 10% of proceeds are for private use and more than 10% of the payments are provided by private parties unless the bonds are used to finance certain qualified facilities.

To support its argument, the IRS pointed out that BRG's management fee is subordinate to debt service, facility operating costs, and several reserve funds. In addition, the fee arrangement provides that the firm only receives its full management fee — $1 million a year — if it earns enough revenue. This means the facility would have to earn $2 million a year to pay the entirety of BRG's management fee.

The IRS contends that BRG's feasibility study was "significantly flawed" in expecting the jail could make that amount of money and failed to account for all the costs the facility would incur. Furthermore, the corporation failed to show that the $1 million management fee was reasonable, and BRG has not provided information to either the issuer or the IRS regarding how much it has been paid the past several years for management work.

The IRS also argued that there is no evidence that the principal purpose of the facility is for use by anyone other than the federal government. It claims 99% of the facility's inmates were from the federal government during the first five years the issuer owned it. "Without the required high level government use of the facility, it would be unable to operate at a profit and would close," Webster told the issuer.

The issuer defended the arrangement by arguing, in part, that making the management fee contingent on revenue generation would incentivize BRG to fill the facility. It also cited two private-letter rulings as support for the arrangement, but Webster dismissed them as "not on point."

Texas-based Jackson Walker LLP was bond counsel on the deal, and Herbert J. Sims & Co. and Municipal Capital Markets Group Inc., were underwriters. Farley P. Katz, a partner with Strasburger & Price LLP, is representing Crystal City and the Crystal City Public Facility Corp. during the audit. He could not be reached for comment.

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