IRS audit of Idaho school district shows national scope of compliance plan

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An Internal Revenue Service compliance initiative begun in Puerto Rico earlier this year has spread nationwide as evidenced by a recent audit of tax credit bonds issued by a school district in Idaho.

The IRS also is focusing on audits of jail bonds and variable rate bonds as part of a 2020 compliance strategy announced Oct. 16.

The Idaho audit involved $1.485 million general obligation bonds issued with a taxable direct-pay federal subsidy under the Qualified School Construction Bonds program.

A total of $22 billion in QSCBs were authorized for 2009 and 2010 as part of the American Recovery and Reinvestment Act of 2009 to stimulate economic growth.

The school district was notified of the audit in August.

“We decided to close the examination with no action,” Telly Meier, field operations manager for the IRS Indian Tribal Governments/Tax Exempt Bonds section, told the district in a letter dated Oct. 9.

“The bonds will keep their tax advantaged status as Direct Pay Tax Credit Bonds,” Meier wrote. “Issuers of direct pay bonds receive a refundable credit payment equal to a percentage of the interest payable on the bonds on each interest payment as provided in Section 54A, and Section 6431 of the Internal Revenue Code.”

The IRS, as it typically does, reserved the right to conduct another audit of the same bonds in the future.

“If we conduct another examination of the Bonds in the future, any change we make from that examination can affect all open years of the Bonds,” the letter said.

Kimberly School District 414, which is located in the southern end of the state near the intersection of the Nevada and Utah state lines, used the money to pay for renovation of a gymnasium, completion of a sports complex, construction of technology classrooms at Kimberly High School and various improvements throughout the district.

The Kimberly audit came on the heels of eight other IRS audits involving public agencies in Puerto Rico that were initiated earlier this year.

Seven of those audits involve Build America Bonds, which are another kind of federally subsidized taxable bonds that also were authorized under the 2009 federal economic stimulus legislation.

Six of those audits have focused on the Form 8038-CP that the issuers filed with the IRS, according to Kristen Franceschi, a partner at the law firm of DLA Piper who is representing the Puerto Rico agencies in all of the audits.

Those six appear to involve the interest payments that the IRS is focusing on.

“Even though direct-pay bonds are no longer authorized to be issued, there are still direct-pay bonds out there that have been issued and we continue to follow up and monitor the compliance of those interest payments as well as the administration of those bond issuances,” TEGE Commissioner Tamera Ripperda told tax reporters in a conference call Oct. 16. “That’s why direct-pay bonds are still a part of our compliance plan because many have maturity dates going out many years.”

The seventh IRS audit in Puerto Rico is examining the underlying BABs, according to Franceschi.

The eighth Puerto Rico audit involves an advance refunding.

“It is not surprising to me that the IRS would audit BABs and other direct pay bonds, since the money is coming directly out of the Treasury’s coffers,” Franchesci said in an email Friday.

BABs receive a 35% federal subsidy on their interest payments, although that subsidy is subject to a federal budget sequestration reduction which varies each year. In the current 2019 federal fiscal year the cut is 6.2% of the 35% subsidy. That shaves 2.17 percentage points off the subsidy, reducing it to 32.83%.

Richard Moore, president of the National Association of Bond Lawyers and a tax partner at the San Francisco headquarters of Orrick, said the IRS focus on direct-pay bond subsidies involves “a real hyper-technical area.”

Many of these bonds ended up with yields close to zero when the subsidy is taken into account, he said.

Because many of them are so-called bullet bonds with one date of maturity, issuers need to stockpile the final payments into a sinking fund which is subject to special federal rules including an allowable arbitrage yield.

Sinking fund overfunding audits, according to the IRS, determine whether an overfunding causes the bonds to be arbitrage bonds, which negatively impacts their qualification as tax credit bonds.

“Who knows how many issuers stayed on top of that and made sure to comply,” Moore said. “I suspect that a high percent of the deals that had that structure will be audited.”

Moore described the list of compliance priorities for 2020 as “somewhat short,” but “realistic in terms of what they can look at in any given year.”

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Tax audits Taxable bonds Build America Bonds IRS Washington DC Idaho