Lawyer: IRS Agents Concerned About Unspent Bond Proceeds

WASHINGTON — Internal Revenue Service agents have been raising concerns during audits about tax-exempt bond proceeds that were unspent or weren't spent in a timely manner, Orrick, Herrington & Sutcliffe tax partner Richard Chirls said Wednesday.

For example, if a seven-year-old bond issue still has a significant amount of unspent proceeds, or its proceeds were all spent but it took a while, "that's a red flag for the IRS," he said. "They're going to wonder whether the bonds were properly sized or whether they were issued earlier than is necessary."

Chirls and fellow Orrick tax partner Larry Sobel spoke during a webinar on IRS audits. The event was sponsored by Orrick and hosted by The Bond Buyer. More than 400 people listened to the webinar, and the sign-up list included issuers and borrowers, investment bankers, financial advisors, bond lawyers and about 10 IRS employees, Chirls said.

The issue of unspent or delayed spending of proceeds is coming up frequently in audits because many municipalities delayed and canceled projects due to the 2008 economic downturn. But IRS agents aren't buying the argument that deals were originally sized reasonably and that changed circumstances caused the projects to be delayed or canceled, Chirls said.

"This is a hot point where issuers and their counsel and the IRS are bumping heads, and it's a pretty touchy area," he said.

Rebecca Harrigal, the director of the IRS' tax-exempt bond office, said several months ago that TEB had completed slightly more than 1,000 audits in fiscal 2013 and found actual or potential noncompliance in about 47% of the examinations.

Most audits are random, but some are targeted. Market participants can often tell if an audit is targeted based on the language the IRS uses in its letter informing the issuer of the audit, Sobel said.

Bonds are commonly audited about five years after issuance because at that point, the first arbitrage rebate payment has been due and most of the projects being financed with the bonds have been completed and have operated for some time. However, a targeted audit may occur sooner after the bonds are issued because IRS agents may have developed an interest in the bonds after reading news articles or public records, Chirls said.

At the beginning of an audit, the IRS will send an issuer an information document request, and the questions on this form will give the issuer a sense of what the agency is examining. In audits of some types of bonds, such as advance refunding bonds and Build America Bonds, the IRS has been asking in detail about how the issue price of the bonds was established, Chirls said.

Sobel said issuers should bring on tax counsel during an audit. He's found it important for issuers and counsel to closely examine their deals and post-issuance events when an audit first starts, so that counsel can anticipate the IRS' concerns.

The two lawyers discussed when IRS audits need to be disclosed on the Municipal Securities Rulemaking Board's EMMA system.

In deciding if an audit should be disclosed, Chirls said, issuers have to look at whether the circumstances result in material information. Under Securities and Exchange Commission rule 15c2-12, an adverse tax opinion or an event affecting the tax-exempt status of a security must be disclosed, even if the dollar amount of the tax-law violation is small.

If an audit is not disclosed during its early stages, issuers and their lawyers should monitor the audit during its course in case the circumstance change and disclosure becomes necessary, Chirls said.

Sobel said that whether an audit is random or targeted plays a role in whether he decides disclosure is needed.

Generally, he doesn't think it's necessary to disclose an audit at its start if he's reasonably sure the audit is random. If an issue comes up later in the audit, he'll reevaluate whether a disclosure is warranted, he said.

If an audit is targeted, "it's quite important to get that message out," he said. In two cases where he's suspected audits were targeted, he's quoted from the IRS cover letter in the EMMA notice to give market participants a sense of what is taking place.

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