WASHINGTON — The Internal Revenue Service chief counsel’s office has issued guidance that sides with a conduit issuer in Montana and a retirement home operator in a four-year old dispute over whether some of the authority’s bonds are taxable.
Many municipal market participants are breathing a sigh of relief over the guidance, which was issued in the form of a Jan. 19 technical advice memorandum not made public until earlier this month.
The TAM does not identify the bonds or the authority. But market participants said it centers around $14.15 million of variable-rate demand revenue bonds that were issued in 2002 by the Montana Facility Finance Authority for Missions United Inc., a nonprofit organization that used the proceeds to expand the Mission Ridge continuing-care retirement community in Billings.
The TAM paves the way for the IRS to end the dispute by sending a letter to the authority in the future that closes an audit without any change to the tax-exempt status of the bonds, they said.
The issue in the case is whether thousands of dollars of refundable entrance fees that Mission Ridge collected from new residents were “replacement proceeds” that had to be invested at a yield below the bond yield.
Under Treasury Department rules, for entrance fees or any other monies to be considered replacement proceeds there has to be nexus between the money and the bonds. In addition, the bondholders have to have a reasonable assurance that the monies will be available if the borrower experiences financial trouble.
The IRS began auditing the bonds in 2007, and at that time there was no indication of any tax problems with the bonds, according to disclosure notices the authority filed with nationally recognized municipal securities information repositories.
In January 2009, an IRS agent issued a “notice of proposed issue” that preliminarily determined the bonds were arbitrage bonds and therefore taxable because the entrance fees were replacement proceeds and had not been invested on a yield-restricted basis.
“That caused us all quite a bit of alarm because we thought the rules were being changed,” said Tom Vander Molen, a lawyer at Dorsey & Whitney LLP in Minneapolis. Most lawyers would not have taken that position, he said.
The authority strongly disagreed with the IRS, protested its preliminary determination that the bonds were taxable, and asked the IRS chief counsel’s office to weigh in on the case.
The office concluded in the TAM that the entrance fees were not replacement proceeds. It said that even though there was a nexus between the fees and the bonds because the fees were pledged with other revenues to pay debt service if the borrower ran into financial difficulties, there was no reasonable assurance the fees would be available for that purpose.
The borrower commingled all of the revenues in its accounts and was not limited in its ability to spend the money, the chief counsel’s office wrote in the TAM. At the end of the year, the borrower’s investment balance was equal to only about half the entrance fee revenues it had collected, it said.
“It is reasonable to conclude that, in the absence of action by [the] trustee, the monies could and would be dissipated to cover operating shortfalls and to finance other items prior to any payment to bondholders,” the chief counsel’s office said in the TAM.
“There is no reasonable assurance that the entrance fees will be available to pay debt service on the bonds in the event the borrower encounters financial difficulties,” it said. “Therefore, the entrance fees are not properly characterized as replacement proceeds.”
“The significance of the TAM, apart from the effect on the particular bond issue involved, is that it reaffirms the earlier common understanding of the replacement proceeds test,” Vander Molen said. “This has implications beyond entrance fees and retirement facilities to many types of direct and indirect pledge arrangements in other settings.”
“I think [the TAM] applies broadly to any analysis of pledged funds in terms of determining whether reasonable assurance is there,” said Lauren Mack, a lawyer at Sonnenschein Nath & Rosenthal in San Francisco. “I don’t think it’s just limited to entrance fees.”
However, Mack noted that the IRS took into account the fact that there were no financial covenants that required the borrower to maintain a certain level of assets. That raises the question of whether the agency would find there was reasonable assurance that entrance fees or money would be available to pay debt service, if there were covenants in the bond documents requiring them to be kept on hand, she said.
“The TAM appears to have done an accurate job of relating existing law and ruling precedent to a particular fact pattern,” said David Caprera, a lawyer at Kutak Rock in Denver. “The ruling was clearly favorable to this borrower, but the result depended upon their cash balances and expenditure history. The ruling does not stand for the proposition that all entrance fees are okay.”
“As a practitioner,” Caprera added, “I was pleased to see that the IRS was taking advantage of the expertise available in the chief counsel’s office and hope that we see more TAMs in the future. These are difficult legal issues and the IRS needs to get their best people involved.”
Bradley Waterman, the tax controversy attorney representing the authority and borrower, declined to comment.
