INDIAN WELLS, Calif. — At least one Build America Bond issuer has had a subsidy payment reduced because it owed money to the federal government, and this "offset" system is entirely automated, market participants warned here yesterday.

David Cholst, a partner with Chapman and Cutler LLP in Chicago, said one of his governmental issuer clients had its BAB subsidy payment reduced to offset an outstanding penalty stemming from an error made while filing a Form 1099, which is used to report miscellaneous income.

"We had a client that was shorted on their payment by an amount that was a penalty," he said during a panel session at the National Association of Bond Lawyers' Tax and Securities Law Institute, declining to identify the issuer.

Cholst said the amount taken was a "relatively modest amount of money compared to their BAB payment, but they did get it subtracted" from the subsidy payment. "This is actually being enforced," he warned.

Timothy Jones, an attorney with the Internal Revenue Service's associate chief counsel's office who was on the same panel, pointed out that the offset system is entirely automated, meaning neither the IRS nor any other federal officials have the opportunity to consider or weigh in on any offsets.

"Those offsets occur without any input from Treasury and the IRS," he said.

After the panel, Cholst said the reduction was less than 5% of the expected payment, but would not specify the amount or the issuer. He said that though issuer officials were not shocked to see the amount of the payment reduced due to the administrative penalty, they were surprised when the letter they received from the IRS informing them of the reduction said their upcoming payment would be zero due to a technical glitch. However, he said the confusion was quickly rectified with a call to the IRS and the check arrived the next day with the appropriate amount removed.

But the event highlights the fact that issuers may not always receive the full amounts of their expected BAB payments, which could be a problem if the funds are pledged to debt service or needed for some other specific purpose. Bond attorneys said yesterday that while they do not think there have been many such occurrences, it should be considered by any issuers that might owe money to the federal government.

During the panel session, one audience member said some clients — particularly health care issuers that have to deal with Medicare reimbursements— have been reluctant to issue BABs because of the offset issue.

Treasury officials notified market participants last year that since BAB subsidy payments are technically considered tax refunds, they can be reduced to offset any outstanding amounts an issuer owes the federal government. The offset issue has led some issuers to question whether they can reliably count on BAB payments to come in as expected.

IRS officials said yesterday that an IRS automated system checks taxpayer records to see if any money is owed to it before approving a BAB payment. Then before the check is cut, the Financial Management Service, a branch of the Treasury charged with distributing payments for federal agencies, has an automated system that checks the taxpayer information against the records of all other federal agencies.

Cholst said his issuer client received a notice announcing the offset since the IRS caught it, but the notice did not specify the reason. For offsets caught at the FMS level, it is not clear whether issuers would receive any notification whatsoever, or simply find a smaller check in their mailbox. In addition, it is unclear whether state and local government officials involved in issuing BABs would even be aware if they owed the federal government money, especially if the money was related to health care or some other program unrelated to the bonds.

Steve Chamberlin, senior manager of compliance and management at the IRS' office of tax-exempt bonds, was also at the meeting. He said the offset system is part of the federal government's general financial management system, which includes the tax-refund process, and is not something created specifically for BABs. If issuers have a question about why a payment was reduced or what caused an offset, they can contact the IRS, he said.

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