WASHINGTON — The Internal Revenue Service has determined in an audit that general obligation bonds issued in 2007 and 2009 by the Sierra Kings Health Care District in California are private-activity bonds and not tax-exempt governmental bonds.

In an event notice recently filed with the Municipal Securities Rulemaking Board's EMMA system, the district, which is operating under a confirmed Chapter 9 plan of adjustment, said it will be working with the law firm of Chapman and Cutler LLP in an effort to maintain the bonds' tax-exempt status.

It also said, however, that it "can make no assurance as to the ultimate outcome of the [IRS'] examination or the impact of such outcome on the tax-exempt status of the interest on the bonds."

An IRS agent concluded the bonds were PABs in the sixth information document request during the audit, according to the event notice. The conclusion is based on the IRS' assertion that the bonds met the private business use and private payment tests.

Under federal tax law, bonds are PABs if more than 10% of the proceeds are used for private business use and more than 10% of the debt service is secured by or paid for by private users. PABs are taxable unless they fall into certain qualified categories.

The event notice did not explain why the IRS believes the bonds met those tests, and a Chapman and Cutler lawyer who's working on the case said he could not comment on the reasoning.

The IRS agent told the district to contact him or her if it wants to settle the matter in a closing agreement. If the district disagrees with the IRS' findings, it should explain why in writing, the agent said. Unless the IRS changes its position, it will follow with a notice of proposed issue concluding that the bonds are PABs.

The issuer is a health care district located in Fresno County, Calif. At the time the bonds under examination were issued, the district operated a hospital, a birthing center and rural health clinics.

But in October 2009, the district filed for Chapter 9 bankruptcy, after discovering management had spent about $1.7 million of bond funds on operating rather than capital expenses and had misspent other funds. In November 2011, Adventist Health, a faith-based nonprofit, took over the hospital, birth center and clinics.

Bonds that finance projects for 501(c)(3) organizations, including nonprofit hospitals, can be tax-exempt PABs. However, the percentage of non-501(c)(3) and nongovernmental use of the net proceeds can't be greater than 5% under the private business use and private payment tests.

The district's Chapter 9 plan of adjustment became effective in 2012. Its GO bonds were protected from the bankruptcy process.

The district issued $16 million of the 2007 bonds and $4 million of the 2009 bonds.

A portion of the 2007 bond proceeds were used to make upgrades to health facilities to meet more stringent earthquake and handicap accessibility standards; construct an expansion of the birthing center; and complete an expansion, renovation and equipping of the emergency department, radiology department, a new rural health clinic and a lobby. A portion of 2009 bonds proceeds were to be used to buy equipment; make improvements to the hospital's heating, ventilation and air conditioning system; replace the hospital's roof; and make improvements to the hospital's parking lot, according to bond documents.

Stone & Youngberg LLC was underwriter of the 2007 bonds, and Piper Jaffray and Southwest Securities were underwriters of the 2009 bonds. Quint & Thimmig LLP was bond counsel on both deals.

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