IRS audits jail bonds for Nogales, Ariz. detention center

The Internal Revenue Service has made a preliminary determination that 2017 tax-exempt refunding bonds for an Arizona county jail and law enforcement center should be treated as retroactively taxable.

The IRS said in a March 10 letter the $29.5 million in jail refunding bonds issued in 2017 by Santa Cruz County meet the private business use and private payments test because part of the facility is under contract to house federal prisoners.

This case is the latest in a string of IRS audits over the last four years in which issuers of tax-exempt jail bonds have agreed to reissue the bonds as taxable because they ran afoul of the federal tax law limit on private use.

Bloomberg News

In this new case, the Santa Cruz County Jail District said in its public filing that it “strongly disagrees with the Service’s position and has engaged legal counsel to represent it in further proceedings with the Service.”

“This is a preliminary determination, not a proposed adverse determination or a final determination,” the jail district said.

The county said it made the public disclosure “solely to comply with the continuing disclosure undertaking” required by the bond documents.

The Tony Estrada Law Enforcement Center adjoining the Santa Cruz County Courthouse is a 100,000-square-foot facility in Nogales that began housing prisoners in March 2011. Nogales is located along the southern border of Arizona adjacent to its much larger Mexican sister city of Nogales, Sonora.

The public notice of the IRS audit was posted Tuesday on the EMMA database of the Municipal Securities Rulemaking Board.

Jail bonds have been targeted by the IRS for audits because federal government use of locally built facilities or management contracts with localities can cause excessive private business use.

Jail bonds were one of the IRS’s three enforcement priorities for 2019-20.

The Santa Cruz Jail District’s investment banker Michael Vasquez of Piper Sandler in Phoenix said in an email Thursday he had no comment on the case, a day after requesting an additional 24 hours to prepare a statement.

Vasquez said in a short phone conversation Wednesday that the number of federal prisoners has varied over time and that’s part of the reasons why the jail district is challenging the IRS preliminary determination.

Vasquez and Manuel Ruiz, chairman of the Santa Cruz Board of Commissioners, declined to reveal how many of the beds at the facility are currently under federal contract.

A story published by the Arizona Daily Star in February 2011 a month before the facility opened said county officials had signed a contract in August 2010 with the U.S. Marshal’s Service for 170 beds at the 372-bed facility.

The county's intergovernmental agreement with the U.S. Marshals Service for Arizona reserved the beds for low-level offenders, namely immigration-law violators, the story said.

That was about 46% of the available beds at the time of the opening.

The 2011 newspaper story reported that the county's administrative services director said the county expected to make about $300,000 a year from the federal government for housing inmates.

The jail facility also has been financed from a half percentage point dedicated sales tax approved by local voters in November 2005.

Unlike state and local governments which are categorized as governments, the federal government is considered to be a private party under the federal tax code.

That means that prisons or detention facilities that are used for federal prisoners or detainees are considered to be under private use.

The tax code classifies a bond as a private activity bond if more than 10% of the proceeds are used for private use and more than 10% of debt service payments are from private parties or secured by private parties.

PABs are tax exempt only if they fall into one of several categories, none of which include jails or correctional facilities.

Other detention centers and prisons operating near the U.S.-Mexico border have undergone similar IRS audits the last couple of years in which issuers have agreed to convert their bonds from tax-exempt to taxable.

Two cases in 2017 involved the Otero County, New Mexico Jail Project, and the Baker Correctional Development Corp. in Florida.

The Otero County settlement involved $62.3 million in revenue bonds sold in 2007.

The Baker County Correctional Development settlements involved $36.3 million in outstanding first mortgage revenue bonds that were part of the $45 million sold in 2008.

Another case in 2018 involved the Kinney County Public Facility Corp. in Texas which issued the $9.23 million in project revenue bonds to finance the acquisition and construction of the warehouse-style building with 384 beds for adults. That detention center is just outside the county seat of Brackettville which, in turn, is about 45 miles from Del Rio, a Texas border community along the Rio Grande River.

At the time of the IRS audit, the Kinney County detention center was used by the U.S. Marshals Service to house prisoners, according to the website of the Geo Group Inc., the for-profit prison company that has a contract with Kinney County to operate the facility.

In December 2019 the IRS closed an audit of jail bonds issued by a regional authority in southwest Virginia without taking any action on their tax-exempt status.

The audit included a $24.6 million series of 2018 federally taxable refunding bonds issued by the Western Virginia Regional Jail Authority as well as series 2015 and 2016 refunding bonds.

In November 2020, El Paso County, Texas reported an IRS preliminary determination that certificates of obligation issued by the county in 2012 were taxable retroactively to the date of issuance. The 2012 official statement said the proceeds were to be spent on a lengthy list of various capital projects, including construction and improvements to the county’s Eastside Jail Annex as well as courthouse annexes in the northwest and eastern sections of the county. The proceeds also were used for design and construction of the Tornillo-Guadalupe Land Port of Entry bridge connecting with Mexico and the related road and other facilities including land acquisition.