NEW ORLEANS — Bond lawyers are warning their issuer clients that they are operating at their own peril if they do not spend their bond proceeds in a timely fashion, since Internal Revenue Service agents in audits are raising concerns about proceeds that are spent late or not spent at all.
The unspent proceeds issue is "an area where at least in the Western region of the United States is being heavily policed," said Carol Lew a shareholder at Stradling Yocca Carlson & Rauth in Newport Beach, Calif. The IRS is being really strict about delayed or unspent proceeds, even when the proceeds weren't spent quickly due to the financial crisis, she added.
Lew and others discussed unspent proceeds in at the National Association of Bond Lawyer's Tax and Securities Law Institute here.
Under federal tax law, bonds generally are hedge bonds unless the issuer reasonably expects to spend 85% of the proceeds in three years. For hedge bonds to be tax exempt, the issuer has to reasonably expect to spend proceeds in a manner that meets certain benchmarks, including that 85% of the proceeds be spent within five years of issuance.
The tests are based on reasonable expectations at the time of issuance. But Lew said that the IRS is looking at actual facts to police the hedge-bond rules. Based on what the IRS is doing, bond lawyers should be concerned about whether their clients are actually spending their proceeds in a way that meets those benchmarks.
"We tell all of our clients, make sure you are meeting those actual facts [for] hedge-bond restrictions, the five year," Lew said, "because if you don't, you are really taking a risk, even if it seems to you [that] you are proceeding in a very prudent, responsible way in a bad situation."
One audience member during the first session suggested that bond transcripts include information about the basis for the issuer's reasonable expectations that the bond proceeds will be spent promptly.
However, David Walton, a panelist and a shareholder at Jones Hall in San Francisco, said that it's unrealistic to require the offering documents to include a signed construction contract. "That's just not how the world works," he said.
James Polfer, head of the tax-exempt bond branch in the IRS chief counsel's office, pointed out that his office has released private-letter rulings in which it evaluates requests for extensions to spend the proceeds of certain tax-credit bonds, some of which have to be spent within three years.
In those rulings, the IRS engages in a similar process where "we see what was expected, what kind of evidence they used to expect it, what went awry [and] their representations to proceed with due diligence," he said. Lawyers can see chief counsel's responses to the requests and see the extent to which it calls into questions issuers' reasonable expectations.
Polfer asked if lawyers are seeing a difference in the process chief counsel has used and the process agents in audits are using. Walton replied, "yes."
Walton said the auditing situation is not uniform, but Lew said she thinks there is coordination how the IRS treats certain factual situations in audits. The consistency is good so that there is not randomness, she added.
On other panels at the conference, top officials in the IRS tax-exempt bond office discussed how the office is dealing with limited budgetary resources. TEB director Rebecca Harrigal said the office has seen a significant drop in resources that may not be stopped or reversed anytime soon.
TEB currently has 76 employees, 49 of whom are in field operations. Because of budget issues, the office can't replace people it loses due to attrition. Two employees in the compliance and program management division have been moved to field operations to help with audits, said Bob Griffo, acting senior manager for field operations. A number of TEB employees are in temporary positions, and Griffo said he's not sure how long that will last.
Agents are likely doing focused, rather than full, examinations under the market segment program due to the budget situation, Griffo said.
Harrigal said that in response to limited resources, she wants to streamline as much as possible. For example, the IRS recently put out a streamlined voluntary closing agreement program for issuers of bonds benefiting nonprofits that had their 501(c)(3) statuses prospectively reinstated after they had been automatically revoked due to failure to file information returns for three consecutive years.
Harrigal said this standardized VCAP program is valuable for the issuers and borrowers and also for the precedent that she's hoping to set with it. She said that she hopes to release more of the "fill-in-the-blank" settlement programs soon.
TEB is continuing to work on revising the Internal Revenue Manual that provides instructions to its employees. Griffo said that the office hopes to include in the revisions new streamlined resolution standards that were announced in September 2013 and are currently being applied.
Griffo said he does not know when the revisions would be published.
TEB prefers for tax-law violations to be resolved. Griffo said that the office starts looking at identifying the bondholders who would be affected by a ruling that a bond issue is taxable when it appears the ruling will go to go to the appeals office.
He said that he is seeing more issuers bringing up the statute of limitations on taxing bond interest in negotiations for closing agreements.
Generally, if the IRS thinks a bondholder needs to pay tax on bond interest in a certain year, the service needs to take action within three years of when the taxpayer filed his or her return for that year. Right now, the IRS can generally only go after interest paid in 2011 and later, and 2011 will no longer be an open taxable year after April 15.
Tax controversy Brad Waterman said some examinations seem to be more contentious than they were years ago. "It's not really statute-of-limitations driven. I know TEB thinks in many cases it is, but it really isn't," he said.
Richard Chirls, a partner at Orrick, Herington and Sutcliffe in New York, said he's recently had several examples of audits where the bonds had been retired a while ago and the IRS agent has said that the audit had to continue.
Griffo said that this year, the IRS is doing data-driven, market-segment examinations and is trying to determine overall rates of compliance with tax laws. Not going through with the audits may impact the validity of the IRS' results, he said. TEB needs to find a way to address the issue concerning long-retired bond issues and the market-segment program, Griffo conceded.
