WASHINGTON — The Internal Revenue Service has declared as taxable interest earnings from tax-exempt bonds issued by an authority in Little Rock, Ark., but that may be the least of the bondholders’ concerns because the bonds are in default and they may not receive any more interest payments.

In addition, the IRS’ tax dispute and two settlements with issuer Arkansas Residential Housing and Public Facilities Board and borrower HLR, LLC, may have caused the Service’s tax-exempt bond office to direct field agents not to enter into closing agreements involving bond redemptions until after the bonds are redeemed, sources said.

The $3 million of Series A tax-exempt enterprise zone revenue bonds were issued by the Arkansas Residential Housing and Public Facilities Board in 2004. The bond proceeds were given to HLR to help finance the acquisition, renovation and equipping of a 263-bed Hilton Hotel three miles west of the Little Rock business district, near a medical complex.

The hotel has been operating, but has been renamed the Clarion Hotel Medical Center, according to its website.

The IRS’ tax dispute and resulting settlements with HLR and the board were detailed in a material event notice that HLR filed with the Municipal Securities Rulemaking Board’s EMMA system on Feb. 8.

The IRS started auditing the bonds in 2006 and found that HLR failed to comply with the tax law requirement for enterprise zone bonds that at least 35% of the employees of the bond-financed facility be residents of an empowerment or enterprise community, specially designated distressed areas.

The IRS admitted that HLR had reasonable expectations that it would be able to hire 35% of its workforce from an enterprise zone and that it made a good faith effort to do so. Nevertheless, it did not meet the requirement.

The Service entered into a closing agreement with the issuer and borrower to preserve the tax-exempt status of the bonds on April 25, 2008. Under the settlement, HLR agreed to make a payment to the IRS and to redeem the bonds by Aug. 1, 2008. The payment covered taxes on interest paid up to the date of redemption.

But the bonds were never redeemed, in part because of the financial crisis.

The IRS opened another audit of the bonds on Jan. 11, 2011, warning the bonds may no longer be tax-exempt.

Roughly six months later, the IRS’ tax-exempt bond office issued a proposed adverse determination that the bonds were taxable because HLR failed to meet the 35% requirement and failed to redeem the bonds.

The board protested the adverse determination and asked the IRS’ Office of Appeals to review it.

HLR and the board claimed the first closing agreement settled the tax dispute and that the IRS had no right to take further enforcement action pertaining to the bonds. They pointed to language in the 2008 closing agreement that states, in part, “the matters determined hereunder shall be final and conclusive, except that ... the matter it relates to may be reopened in the event of fraud, malfeasance, or misrepresentation of material fact.”

The borrower and the board claimed they did not commit fraud or malfeasance and did not misstate any material facts, however it appears they failed to convince the Office of Appeals to abandon the audit and its findings.

In May 2012, the IRS, HLR and board entered into another closing agreement, under which HLR made a payment to the Service covering taxes on interest payments made through the end of 2011. All three parties agreed that interest payments made before Jan. 1, 2012 would remain tax-exempt and that interest paid on the bonds after that would be taxable.

But HLR and the issuer were still uncertain, despite the closing agreement, that interest payments made after the start of this year should legally be taxable and they urged bondholders to consult with their lawyers.

They said in the Feb. 8 event notice: “Each bondholder who receives interest on the bonds on or after Jan. 1, 2012 should consult with his/her/its tax advisor and/or legal counsel regarding whether such interest is excludible from gross income under the 2008 closing agreement, notwithstanding the recitation in the 2012 closing agreement to the contrary.”

The notice listed Bradley S. Waterman as HLR’s special tax counsel and he declined to comment.

But bondholders may not have to worry about being taxed on their interest payments. They may not receive any more interest payments because the bonds are in default and one of the owners of HLR has filed for personal bankruptcy, according to documents filed with EMMA, the Arkansas Secretary of State, and the federal bankruptcy court in Arkansas.

The trustee for the bonds, Bank of the Ozarks, filed a Notice of Default on the bonds with EMMA in March of last year. The notice was accompanied by a Jan. 23 letter from a law firm stating that HLR was unable to make a $226,525 payment, due Dec. 1, 2011, to Liberty Bank of Arkansas, which had provided a loan to HLR for the project. The letter said if the default was not cured in 30 days, the bank would initiate foreclosure proceedings.

Bank of the Ozarks then disclosed over EMMA last October that it had drawn on a letter of credit held within the debt service reserve funds for the bonds.

Bruce Burrow, a Jonesboro, Ark. developer who recently filed for bankruptcy is listed as the registered agent for HLR in documents filed with the Arkansas Secretary of State.  Burrow petitioned for Chapter 11 bankruptcy reorganization last July, stating he had between 50 and 99 creditors, liabilities of between $50 million and $100 million, and assets of between only $10 million to $50 million. Liberty Bank of Arkansas was among the list of major creditors, showing a loan of about $24 million for the Hilton, now Clarion, hotel.

Martin Belz, the chairman and president of The Peabody Group, also is linked to HLR, sources said.

That group has three Peabody Hotels — the ones with the ducks that walk through the lobbies —  in Memphis, Tenn., Orlando, Fla., and Little Rock, Ark.  However, Little Rock officials have been working with Memphis-based Fairwood Capital to transition the Peabody into a Marriott, according to local news reports.

Meanwhile, the audits may have spurred the IRS, on Aug. 5, 2011, to add new guidance on closing agreements in its Internal Revenue Manual for field agents. The new guidance, in IRM Section, states that if a closing agreement involves a bond redemption, the agreement cannot be finalized under after the bonds are redeemed. If the bonds cannot be immediately redeemed because of a future call date, an irrevocable defeasance escrow must be established to provide for the payment of the bonds to that call date. The issuer must provide IRS officials with written notice of the establishment of the escrow, before the agreement is executed, the IRS said.

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