WASHINGTON - A federal court in Tennessee has rejected a law firm's claim that the Internal Revenue Service should be drastically limited in the monetary penalties it can assess under a section of the tax code that allows it to sanction bond lawyers, underwriters, and other transaction participants that engaged in abuse.

The Jan. 27 ruling by Judge Curtis L. Collier of the U.S. District Court for the Eastern District in Chattanooga runs counter to a decision made last year by a federal judge in California, who sided with another law firm in ruling that the IRS could only impose relatively small monetary penalties under Section 6700 of the tax law.

In the Tennessee court, the Chattanooga-based law firm of Grant, Konvalinka & Harrison PC is suing the IRS over $570,870 in Section 6700 penalties the agency has assessed the firm for its role in the remarketing of four zero-coupon bond deals done in the early 1990s to finance the sale of four nursing homes in Georgia.

In these deals, four authorities - the Colquitt County Development Authority, the Richmond County Development Authority, the Savannah Economic Development Authority, and the Washington Wilkes Payroll Development Authority - issued $16.4 million of total bonds, $6.7 million of which were zero-coupon bonds.

The authorities then loaned most of the proceeds to Southern Care Corporation Facility, a Texas-based nonprofit organization, to finance the purchase of the nursing homes from Greenbriar Corp., formerly Medical Resources Corporation of America Inc., a for-profit retirement real estate company based in Dallas.

As part of the transaction, Southern Care sold the $6.7 million of zero-coupon bonds to Greenbriar, which used the proceeds to buy triple-A rated Treasury securities that it placed in escrow to defease the bonds, thereby increasing the market value of the bonds.

Grant Konvalinka assisted in the remarketing of the bonds, which generated a significant profit for insiders, according to bond documents and market participants.

The IRS investigated and concluded the bonds were abusive arbitrage bonds. It also found that Grant Konvalinka provided eight allegedly false opinions that stated the remarketed bonds were tax-exempt after the defeasement, rendering the firm liable for 6700 penalties.

The Justice Department, which is representing the IRS in the case, claims the remarketings could not have occurred without the firm's involvement, so that the firm was complicit in the bad deals, according to court documents.

However, Grant Konvalinka has told the court that this assertion "is based upon a fundamental misunderstanding of the transactions involved and, in particular, the role of [the firm] in the transactions."

It argues that in delivering their opinions, it relied on the opinions of the now-defunct Peterson Dillard Young Self & Asselin, another law firm that served as bond counsel and opined that the original bonds were tax-exempt. That firm disbanded in 1997.

The IRS conducted widespread audits of these and other zero-coupon deals several years ago that ultimately resulted in a $30 million settlement between the agency and UBS PaineWebber Inc., now UBS Securities LLC, and seven unidentified law firms in 2002. UBS acquired J.C. Bradford & Co. in 2000, which underwrote 14 of these deals.

Under the settlement, the IRS agreed not to challenge the tax-exempt status of the bonds in question. However, the agency pursued 6700 probes against transaction participants.

In 2004, Greenbriar agreed to pay the IRS $216,000 in 6700 penalties over its role in the four deals involving Grant Konvalinka.

On Jan. 3, 2005, the IRS demanded $570,870.49 in 6700 penalties from Grant Konvalinka for its role in the four deals. On Feb. 2 of that year, the law firm paid the IRS $85,361 and requested a refund. The IRS denied the refund on April 21, 2005. On Aug. 11, 2006, the law firm paid the IRS an additional $534,680.17, bringing its total penalties and interest to $620,041. It again requested a refund on Feb. 21, 2007 but received no response from the IRS.

Grant Konvalinka sued the IRS on April 19, 2007, demanding a refund of the entire amount it had paid, plus interest and the payment of its legal fees.

Under Section 6700 of the tax code, the IRS can impose monetary penalties - 100% of ill-gotten gains or $1,000 per bond "activity," whichever is less - on municipal bond transaction participants for causing transaction-related tax law violations. However, municipal market participants and the IRS have long disputed what constitutes an "activity" for purposes of calculating 6700 penalties.

The IRS calculated that Grant Konvalinka owed $107.7 million in 6700 penalties for its part in the deals. The agency reached that figure by assessing a $1,000 penalty for the issuance of each bond, which it assumed to be $5,000 par value. However, the IRS is demanding only $570,870.49 from the firm, the gross income it made from the deals.

On Nov. 14, 2008, Grant Konvalinka filed a motion for partial summary judgment with the court seeking to limit the maximum penalty that the IRS could assess against it to $16,000.

The firm claimed that it had engaged in no more than 16 activities for the deals - the eight bond series it remarketed and the eight opinion letters it wrote for those remarketings.

In making its claim, Grant Konvalinka relied on a recent ruling in the case, Hargrove & Costanzo v. United States, which is pending before the U.S. District Court for the Eastern District of California in Sacramento.

In that case, Richard H. Hargrove, a former bond lawyer at now-defunct Hargrove & Costanzo PC, is challenging an IRS order that he pay $1.9 million in 6700 penalties for willfully or recklessly giving tax-exempt bond opinions for 18 fraudulent land-based bond deals.

Hargrove claims the most he is liable for under 6700 is $19,000, a drastically lower amount than the $44.4 million penalty the IRS calculated for Hargrove and the $1.9 million in penalties it is seeking from him. The $1.9 million figure equals the total gross income Hargrove made on the deals.

In that case, Judge Lawrence J. O'Neill ruled that Hargrove owed at most only $36,000 because he only conducted two activities in each of the 18 deals - he participated in the formation of each issuer, and he issued bond opinions declaring the bonds to be tax-exempt.

The federal government is strongly disputing the Hargrove ruling in the Grant Konvalinka case.

"The Hargrove decision ... is totally at odds with the plain language of [Section] 6700," U. S. attorney James R. Dedrick, who is representing the IRS, wrote in a rebuttal to Grant Konvalinka's motion to get the judge to limit the penalties. "Simply put, the Hargrove court got it wrong."

Last Tuesday, Collier agreed with Dedrick, calling the Hargrove ruling "misguided." He denied Grant Konvalinka's motion to set the maximum 6700 penalty at $16,000.

But Collier stopped short of officially endorsing the government's method of calculating the penalty.

"Although the court is not necessarily concluding the government's interpretation of the statute is correct, it does not find plaintiff's interpretation correct," Collier concluded.

Although both the Hargrove and Grant Konvalinka cases have yet to be decided, market participants are keeping a close eye on them to see what the future may hold for Section 6700.

Mary Gassmann Reichert, a partner with Bryan Cave LLP in St. Louis, said the IRS could lose one of the tools it uses to encourage settlements during audits if its 6700 penalties are drastically reduced.

"If the district courts decide that the Hargrove approach is correct, then the 6700 penalty threat will become irrelevant to issuers," she said. "In the past, the service has often opened a 6700 case as a way to urge an issuer to settle .... If Hargrove prevails, that strategy will be very neutralized."

However, bond lawyers have pointed out that the penalty limits established by the California court are only strictly binding to the Hargrove case's specific circumstances, and would not necessarily hold legal precedent elsewhere.

But market participants have said that other individuals facing 6700 penalties could use the California court's decision as a basis for their own argument, as Grant Konvalinka did in its pending case.

"To use the classic phrase, 'the jury's still out,' " Reichert said.

William T. Ramsey, an attorney with Neal & Harwell PLC, who is representing Grant Konvalinka, could not be reached for comment.

Bradley S. Waterman, a tax attorney based here who represented Greenbriar before the IRS, declined to comment.

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