IRS continues to audit taxable qualified school construction bonds

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The sinking fund overfunding audits are part of the 2020 IRS compliance strategy announced a year ago.

The Internal Revenue Service is continuing to audit taxable qualified school construction bonds as evidenced by a recent public notice filed by Idaho’s Canyon County.

Canyon County reports the audit involves $7.7 million in direct pay QSCBs it issued Nov. 23, 2010, with a coupon rate of 5.29% maturing Sept. 15, 2029.

The school district is Middleton District #134, located in a Boise suburb.

Last year, the IRS took no action after a similar audit of another Idaho school district involving QSCBs.

That 2019 audit involved Kimberly School District 414, which issued $1.485 million general obligation bonds under the QSCB program to pay for the renovation of a gymnasium, completion of a sports complex, construction of technology classrooms at Kimberly High School, and various improvements throughout the district.

Telly Meier, field operations manager for the IRS Indian Tribal Governments/Tax-Exempt Bonds section, informed Kimberly of the “no action" decision in a letter dated Oct. 9, 2019.

More recently, in a letter dated Sept. 17, 2020, the IRS notified the Middleton, Idaho, school district of its plans to audit the district’s QSCBs.

Canyon County filed a public notice of the IRS audit Sept. 24 on the EMMA database of the Municipal Securities Rulemaking Board.

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 direct-pay subsidy is part of the Build America Bonds program, which provides a 35% federal subsidy on interest payments. That subsidy, however, is subject to a federal budget sequestration reduction, which varies each year.

Seven BAB audits, involving public agencies in Puerto Rico, also were publicly reported in 2019.

The IRS focus on direct-pay bond subsidies involves a technical area of tax law.

Many of these bonds have a bullet maturity and ended up with yields close to zero when the subsidy is taken into account. Because these so-called bullet bonds have 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.

The sinking fund overfunding audits are part of the 2020 IRS compliance strategy announced a year ago.

Other areas of the 2020 compliance strategy include jail bonds with respect to whether federal government use and management contracts cause excessive private business use; and whether variable-rate bonds comply with the rebate and yield restriction rules under Internal Revenue Code Section 148.

Last month IRS officials told members of the National Association of Bond Lawyers their current audit priorities for tax-exempt bonds also include advanced refunding bonds, with defeasance escrows that were funded with open market securities.

“These exams included determination of new restriction compliant fair market value requirements and identification of any slow growth failures,” Allyson Belsome, program manager of the IRS Office of Tax-Exempt Bonds, told NABL members.

Belsome said the IRS “will soon initiate exams on private activity bonds issued to finance airports, which will include arbitrage compliance determinations, as well as whether the requirements under 142a requiring 95% of the net proceeds to be used for airport purposes were met.”

Another addition made earlier this year, according to Belsome, was comprehensive examinations of Section 144 small issue bonds.

The IRS is expected to soon announce its 2021 compliance strategy for the fiscal year that began Oct. 1.

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Tax audits IRS Tax credit bonds Build America Bonds Washington DC NABL
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