The relationship between bond issuers and the Internal Revenue Service will fundamentally change in enforcement actions involving direct-pay Build America Bonds authorized by the stimulus package, bond lawyers said this week.

The BAB program allows muni issuers in 2009 and 2010 to offer an unlimited amount of taxable debt and to elect to either receive a cash subsidy from the federal government or have it provide bondholders with a tax credit. Both the payment and tax credit would be equal to 35% of the interest paid on the bonds.

The bond lawyers pointed out that, in audits of traditional tax-exempt debt, bondholders typically are at risk because the interest payments they receive could be declared taxable by the IRS if the bonds violate the tax laws or rules. In some cases, the IRS will enter into closing agreements with the issuers, allowing them to pay the government in return for preserving the tax-exempt status of the bonds. However the payments are often based on the projected loss of tax revenue to the government.

Under the direct-pay option of the BAB program, the bonds are already taxable, and it is the issuers receiving the payments from the Treasury Department rather than the bondholders that are directly at risk in an audit.

The BAB program "changes the administrative relationship between the IRS and state and local governmental issuers, because now the issuer will be effectively in the posture of taxpayers," said Michael Bailey, a partner at Foley & Lardner LLP in Chicago who also chairs the American Bar Association's tax-exempt financing committee and is a member of an IRS advisory committee.

The National Association of Bond Lawyers asked the Treasury in a letter sent last week to clarify in forthcoming guidance that issuers of direct-pay BABs will have the same rights as taxpayers during audits and other enforcement activities, including the ability to take disputes to court or to sue the agency for a refund.

But it is unclear at this point exactly how the IRS will handle enforcement actions in connection with the bonds. Most attorneys suspect the IRS will stop payments when they suspect or find violations, and perhaps even seek a refund.

"They could not only take action to interrupt the payments, they could seek the prior payments back and get them directly from the state or local government," said Bailey.

But it is unclear how far back the agency might reach back for repayment, and to what extent it could go to ensure reimbursement.

"It ... raises some very sensitive issues for the service, because it's one thing to collect against bondholders, it's another thing to ... talk about putting a lien on city hall," Bailey said. "In some respects, it involves sensitive issues of federalism."

Another question is at what point would the IRS stop payments regarding bonds believed to have violated the tax laws. Would it be when the agency initially deems the bonds noncompliant, or once all attempts at appeals have been exhausted, or at some other point?

Traditionally, IRS decisions involving tax-exempt bonds have rarely been litigated in court, in part because bondholders are not interested in costly and lengthy legal battles, and in part because issuers want to resolve audits without involving or upsetting bondholders, attorneys said.

But Thomas Vander Molen, a partner at Dorsey & Whitney LLP in Minneapolis, thinks that the new direct relationship between the IRS and issuers could lead to more litigation. At the same time, he said it also might make the IRS more willing to fight a court challenge.

"I would think that would make it easier for the issuers to bring a direct challenge in court," he said. But it "could cut both ways ... the ability to get to court directly may make it easier in one sense to make a challenge, and in another sense, the IRS may be more inclined to fight a case because they don't have to deal with the bondholders."

Tax controversy attorney Bradley S. Waterman, who has his own firm, agreed that the new relationship could make it easier to litigate IRS decisions, but suggested a change to the law may be needed to clarify that issuers can challenge the agency in courts.

"The issue is whether there is any mechanism under present law pursuant to which an issuer will be able to challenge an adverse IRS position relating to direct-pay BABs in court," he said.

Although John J. Cross 3d, tax legislative counsel for the Treasury's office of tax policy, told attorneys last week the Treasury hopes to release "very preliminary" guidance on direct pay BABs in the next 30 days, he said its main purpose will be to outline how and when issuers would receive payments from the government. The idea will be to provide enough information to issuers so they can begin putting together these types of deals, with more details to come later on, he said at NABL's Tax and Securities Law Institute in Orlando.

IRS officials declined to comment.

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