IRS closes jail bond audit with no change to tax-exempt status

The Internal Revenue Service has closed the audit of $29.5 million in tax-exempt refunding bonds for an Arizona law enforcement center without changing their tax-advantaged status, according to a notice published Friday.

The audit closure, which was official as of Sept. 8, reversed a preliminary determination made by the IRS in March, that 2017 tax-exempt refunding bonds for the Santa Cruz County Jail District detention center in Nogales, Arizona, should be treated as retroactively taxable.

At that time, the IRS said in a letter that the bonds met the private business use and private payment tests contained in Sections 141(b)(1) and 141(b)(2) of the Internal Revenue Code stemming from the portion of the facility that is under contract to house federal prisoners.

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Under those Code provisions, a bond issue meets the private business use test if more than 10% of the proceeds of the issue will be used for any private business use. For bond purposes, the Federal government — which through various law enforcement agencies often contracts with local jails to house federal prisoners — is considered to be a private entity.

In a March 23 response to the preliminary determination, the Santa Cruz County Jail District said that it strongly disagreed with the IRS’s position and that it had engaged legal counsel to represent it in further proceedings.

For jail bonds to retain their tax-exempt status, no more than 10% of the payments for debt service can come from private parties. Private activity bonds are tax exempt only if they fall into specified categories — none of which include jails or correctional facilities.

In analyzing whether an issue exceeds private use thresholds, the IRS also considers the length of the contract associated with the Federal use of the facility and the nature of the costs charged under the contract compared to those charged to nongovernmental users of the facility.

Notably, prison facilities financed by tax-exempt bonds have been an IRS focus for the last few years — jail bonds were among top tax compliance and enforcement priorities for the IRS in the 2020 fiscal year. So this Arizona case was just one in a line of recent IRS audits involving issuers of tax-exempt jail bonds.

While a number of those audits closed with no change to tax-exempt bond status, issuers in other cases involving detention centers and prisons have undergone similar IRS examinations and subsequently agreed to convert the tax status of the bonds.

For example, in two separate cases in 2017, the IRS closed audits of bonds that were used to finance the development of jail facilities after the issuers converted the bonds from tax-exempt to taxable status.

One settlement with an Otero County New Mexico Jail Project involved $62.3 million in revenue bonds sold in 2007. The other settlement was with the Baker County Correctional Development in Florida involving $36.3 million in outstanding first mortgage revenue bonds sold in 2008.

Counsel for the Santa Cruz County Jail district in Arizona did not immediately respond to request for comment on the audit closure.