The Internal Revenue Service and a Little Rock issuer are fighting over whether the IRS can declare bonds taxable after previously signing a closing agreement to settle a tax dispute over them.

In a closing agreement, an issuer typically settles tax-law violations by agreeing to pay the IRS money or take remedial action, such as redeeming its bonds, in return for the agency’s permitting them to remain tax-exempt.

The fight escalated last week after the IRS notified the Little Rock Residential Housing and Public Facilities Board that it wants to tax some of the interest earnings from $3 million of tax-exempt enterprise zone revenue bonds the board issued in June 2004.

The board disclosed on Friday that it received a March 8 letter stating the IRS “found that the bonds violate one or more of the requirements” for tax-exempt status. The action comes after the IRS entered into a closing agreement with the board to settle a tax dispute over the bonds on April 25, 2008.

The dispute centers around bonds the board issued on June 30, 2004. The board lent the proceeds to HLR LLC, a limited liability company in Arkansas, which used the proceeds to help finance the acquisition and renovation of a 263-bed Hilton hotel three miles west of Little Rock’s business district. The hotel project was completed and is currently operating.

Roughly three years after the bonds were issued, the IRS determined the board failed to comply with a tax-law requirement for enterprise zone bonds that at least 35% of the employees of the bond-financed facility— the hotel in this case — be residents of an empowerment zone or enterprise community, which are ­distressed areas. According to the IRS, while the bonds initially qualified as ­enterprise zone bonds, they failed to meet the 35% employee requirement after ­issuance.

The IRS admits that the borrower, 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.

On April 25, 2008, the board and the IRS entered into a closing agreement under which the issuer and borrower agreed to make a payment to the IRS and redeem all of its outstanding bonds by Aug. 1, 2008. The payment was made, but on Jan. 10 of this year, the issuer reported to the IRS that it was unable to redeem the bonds. The borrower reported that it was still unable to meet the 35% requirement.

On Jan. 11, the IRS opened another audit of the bonds and that led to the agency’s determination last week that the bonds were taxable.

According to the IRS, the issuer contends that the closing agreement settled the tax dispute and does not permit the agency to take any further enforcement action pertaining to the bonds, even if the issuer failed to meet the terms of the agreement. The issuer claims the bonds must remain tax-exempt.

The closing agreement 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 a material fact.” The issuer notes it has not committed any fraud or malfeasance and has not misstated any material facts.

But the IRS claims it can tax bondholders’ interest earnings from the bonds for violations arising after the effective date of the closing agreement.

“The conduit borrower failed to meet the continuing annual requirements of an enterprise zone business for all periods subsequent to Aug. 1, 2008,” the IRS said. “Accordingly, the bonds are not qualified enterprise zone facility bonds for the period subsequent to the period covered under the 2008 closing agreement.”

The IRS contends the interest paid on the bonds after Aug. 1, 2008, is taxable.

Brad Waterman, counsel for HLR, said Friday: “This case is far less complicated than it appears. HLR remains ­committed to a resolution that is both fair and ­realistic.”

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