A case pending in a federal court in California could severely limit the Internal Revenue Service's ability to financially penalize bond lawyers and other transaction participants responsible for abuses in municipal bond deals done before 2004. But market participants are still unsure of what the final fallout from the case will be or how it might change IRS practices.

In the 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 penalties under Section 6700 of the tax code for willfully or recklessly giving tax-exempt bond opinions for 18 fraudulent land-based bond deals.

The IRS assessed the penalties in January 2005. Hargrove appealed them and the case has been pending before the U.S. District Court for the Eastern District of California in Sacramento for three years.

The deals, which were done between 1995 and 2000, were underwritten by now-defunct underwriter Pacific Genesis Group Inc., which was essentially driven out of business by federal and state regulators.

The IRS charged in a 200-page Section 6700 assessment report dated Jan. 10, 2005, that the attorney helped promote the tax-exempt financings to "unsophisticated" cities and towns but did not disclose that the deals failed to satisfy the private-activity restrictions of Section 141 of the tax code because they were used for private rather than public purposes.

The IRS also found the deals created excessive fees for participants and that several of the issuers were not qualified under state law to issue tax-exempt bonds in the first place.

Hargrove, 71, however, argued that the 6700 penalty was "invalid, unlawful, erroneous, unauthorized, and void," and that the IRS' method of calculating how large the penalty should be overreaches the intention of the law defining that section of the tax code.

While the case has not yet gone to trial to determine if Hargrove should be penalized, the court has already ruled that he, at most, would owe only up to $36,000 under Section 6700.

That ruling, which was handed down on Sept. 4, is the latest volley in the ongoing controversy over how far the federal government can go in imposing 6700 penalties.

Section 6700 of the tax code was created by Congress in 1982 to give the Internal Revenue Service a more effective tool to go after transaction participants who encourage abusive tax shelters. Lawmakers revised the section in 1989 to clarify that it applied to participants of tax-exempt bond transactions.

The section states that the penalty for a violation is the lesser of $1,000 for each "activity" the offending party has undertaken, or 100% of the gross income earned by the offender on the transaction.

In Hargrove's case, the $1.9 million figure is the entire amount he made on the transaction and it is thought to be the largest Section 6700 penalty ever imposed by the IRS on someone in a muni transaction. The $1,000 per activity penalty - the IRS defines an "activity" as the issuance of a single bond, which is assumed to be a par value of $5,000 - would yield a total penalty of $44.4 million.

However, the Justice Department, which is representing the IRS in the case, calculates the penalty by multiplying it times the total number of bondholders. Because 4,143 investors purchased bonds from the deals, Justice calculated a penalty of $4.1 million. Either way, the gross amount made on the deals is less than what Hargrove made from them.

Hargrove filed a lawsuit against the U.S. to challenge the assessment on Jan. 12, 2006. Before that, he responded to the IRS' request for payment of $1.9 million by sending the agency a check for $19,000, which he claimed was "the maximum amount" the IRS could have been assessed, allocating $1,000 per fraudulent deal.

In a ruling that sided more with Hargrove than the IRS or Justice, Judge Lawrence J. O'Neill ruled that Hargrove conducted two activities in each deal: he participated in the formation of each issuer, and he issued each bond opinion declaring the bonds to be tax-exempt. As a result, the maximum penalty assessed under Section 6700 would be $36,000, O'Neill reasoned.

O'Neill claimed the language of Section 6700 prevents the IRS from levying penalties multiple times for a single overall deal. "Congress' inclusion of the object of the sale, in 'an entity,' restricts the scope of the sale to 'per entity,' not multiple transactions per entity," he said in the ruling.

Bond attorneys and other market participants may be pleased to see a court reduce the amount of penalties the IRS can levy on Section 6700 violations, but many remain skeptical as to how large an impact this ruling could have going forward.

Some attorneys said the ruling lowers penalties so much that it removes much of the deterrent factor of Section 6700 and may ignore what lawmakers intended for that section of the tax law.

"What sting does a monetary penalty have if, no matter how much the loss because of your misbehavior, you're only going to get hit for two grand?" asked one bond attorney who did not want to be identified. "That can't be what Congress intended."

Additionally, the ruling would only apply to older deals. Section 6700 was modified in 2004, and now defines the penalty as simply half of what a transaction participant made in the deal or deals in question. Under the new section, Hargrove would have been subject to $972,000 in penalties. But for deals completed prior to 2004, such as those in the Hargrove case, the older definition still applies.

Furthermore, O'Neill still may find Hargrove not liable for any 6700 penalties, rendering the previous decision limiting the penalties mostly moot.

Even if O'Neill rules against Hargrove, bond attorneys said this week that the penalty limits established by the California court are only strictly binding to this specific case and its circumstances, and would not hold any legal precedent elsewhere. That means the IRS would not be compelled to change its policy on computing 6700 penalties by the ruling.

Also, the Hargrove ruling is from a single court. If the IRS is challenged on another similar 6700 penalty, it could make the same case in another court and a judge could rule in its favor.

However, market participants have said that other individuals facing 6700 penalties could use the California court's decision as a basis for their own argument.

Section 6700 penalties are believed to be rarely levied on participants of tax-exempt bond deals. The exact amounts are not known because neither the IRS nor the parties involved are required to disclose the penalties. Bond attorneys said that it is more often the case that 6700 penalties are used as a bargaining tool in negotiations to settle tax law charges bond audits. In such settlements, issuers usually make a payment to the IRS, and in exchange, the service agrees not to declare the interest earnings from the bonds taxable.

In the past, 6700 was viewed as an important tool in the IRS arsenal because it allowed them to target specific players they believed to have caused or promoted abuses in bond deals.

Even if 6700 penalties are drastically reduced in the future, transaction participants, especially bond attorneys, should still be leery of the negative side effects of the penalty beyond the financial impact, according to Bradley S. Waterman, a Washington-based tax controversy attorney.

In a 2002 article in the Bond Lawyer, a quarterly journal of the National Association of Bond Lawyers, Waterman wrote that while 6700 penalties can sometimes be "relatively modest ... the collateral damage arising from a section 7600 investigation and from the assessment of a penalty can easily dwarf the financial exposure."

In other words, the stigma that comes with a 6700 penalty can sometimes be as damaging, if not more so, than a monetary penalty, according to Waterman.

"The assessment of a section 6700 penalty can sound the death knell for the penalized firm from the standpoint of retaining existing clients and attracting new business," he wrote.

In addition, besides 6700, bond attorneys are still subject to the IRS' Circular 230 regulations, which govern the practice of tax lawyers that come before the IRS. Although just targeted at attorneys, Circular 230 provides the agency with several ways to discipline attorneys, including suspending or fining them.

The trial in the Hargrove case is expected to begin on Nov. 10, having been pushed back from May 13.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.