WASHINGTON – The District of Columbia plans to redeem its James F. Oyster Elementary School pilot revenue bonds following the Internal Revenue Service’s determination that they are taxable, possibly as a start toward resolving the tax dispute with the IRS.

But Mark Scott, former head of the IRS tax-exempt bond office who now has his own private practice representing whistleblowers, said the IRS should not let the district, bond counsel or developer escape penalties even after the redemption, which is planned for Sept. 29, because the transaction was abusive.

Mark Scott, former director of the IRS Tax-Exempt Bond Office who is now in private practice representing whistleblowers.

“I’m glad to see the bonds pulled off the market because they never should have been issued in the first place,” Scott said on Friday.

District officials declined to comment and their tax controversy lawyer, Ed Oswald, with Orrick Herrington and Sutcliffe, couldn't be reached for comment.

The $11 million of PILOTs revenue bonds were issued by the district in 1999 as part of a public-private partnership to build a new elementary school. The district touted the P3 at that time as successful and one that could be replicated.

Most of the bond proceeds were used by the developer, LCOR, to finance the demolishment of an old school and to design and construct a new school within two years. The school was completed and is now operating.

The bonds were to be entirely repaid by payments-in-lieu of taxes (PILOTs) to be made by the developer. The school was built on .79 of an acre.

As part of the transaction, the district transferred to LCOR about .88 of an acre next to the school on which the developer constructed a 210-unit luxury apartment complex with an estimated value of $23 million in 1999.

The district had no financial interest in the apartment complex but exempted the developer from paying property taxes on it in return for making PILOTs for debt service on the bonds.

In essence, Scott says, the district made an indirect loan to the developer of between $3.2 million and $3.76 million and then allowed the developer to pay for it with the PILOTs, based on a tax-exempt rate.

Scott claims that under anti-abuse rules, the IRS commissioner should reallocate or recategorize the $3.2 million to $3.76 million as a loan to the developer for the land for the apartment complex.

He says the P3 transaction falls squarely within the first example cited in the federal tax regulations’ anti-abuse rules regarding private activity bonds.

Under federal tax laws, bonds are PABs if more than the lesser of 5% or $5 million of the bond proceeds are used directly or indirectly to make or finance loans to private parties. PABs are not tax-exempt unless they finance projects that fall into one of several specific categories, none of which include apartment buildings unless the contain at least 30% of affordable units for low-income residents.

Scott is also adamant that, because the transaction was abusive from the beginning, bond counsel should be penalized under Section 6700 of the Internal Revenue Code, which allows the IRS to penalize transaction participants other than the issuer for abuses. IRS has not used this authority in the tax-exempt bond area in recent years.

Scott also said there should be a tax adjustment for the developer so that it can’t fully deduct its payments. “You should not be deducting the principal amount of the loan,” he said.

The IRS sent the district a "Proposed Adverse Determination" that the bonds were taxable in January. In March, the district appealed the finding to the IRS Office of Appeals.

On Thursday, the district posted a notice of redemption on the Municipal Securities Rulemaking Board’s EMMA system stating it would redeem the bonds on Sept. 29.

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