WASHINGTON - The Internal Revenue Service is intensifying its use of an enforcement tool in the tax law to seek penalties against underwriters, issuers, bond counsel, and conduit borrowers that engage in allegedly abusive transactions, but some lawyers are questioning the tax agency's authority to impose some of the fines.
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Traditionally, the IRS' bond enforcement team has used the tax code's Section 6700 only against underwriters, mostly to pressure them into settling over yield-burning violations. But now the tax agency is rapidly expanding its use of this enforcement tool to seek fines also against many other types of transaction participants.
One major area the IRS is focusing on is loan pools, such as those for nonprofit hospitals and multifamily housing properties. The IRS is concerned that many deals were created more to generate big fees for deal participants than to finance legitimate nonprofit or governmental purpose projects. The IRS is using Section 6700 in this area to go after underwriters, issuers, bond lawyers, and also some conduit borrowers who participated in demand surveys, according to Charles Anderson, the IRS' manager of bond field operations.
Another focus is land-based financings where a developer uses tax-exempt bonds to build infrastructure projects such as roads and sewer facilities. The bonds are typically backed by an assessment on the landowners. While this is often a legitimate financing mechanism, it is also relatively open for abuse, Anderson said, because money often "bleeds away" in those types of deals. The IRS is using Section 6700 in this area against underwriters, issuers, and bond lawyers, he said.
Other areas in which the IRS has opened up Section 6700 investigations include yield burning and what officials believe are arbitrage-driven zero-coupon and three-year note deals, he said.
Overall, the IRS is currently using the anti-abuse tool in more than 40 bond audits, according to Mark Scott, the IRS' national bond director. While that represents about 10% of the agency's pending bond audits, the Section 6700 investigations now represent about one-third of his team's time, he said.
Section 6700 allows the IRS to impose monetary penalties on deal participants -- either firms or individuals -- that engage in misrepresentation to violate the tax-law.
The penalties are $1,000 per transaction, or 100% of the gross income derived from the transaction by the participant, whichever is lower. One disagreement between the IRS and some private practitioners revolves around what constitutes a transaction. The IRS' enforcement team argues that each bond denomination, typically $5,000 of a bond issue, represents one transaction. For example, in a $10 million deal, this approach would yield a penalty of the lesser of $2 million or what a participant earned in the deal.
"Our opinion is that each bond denomination is a separate tax shelter when marketed to someone," Anderson said. "That's the way we interpret it."
But Michael Bailey, a bond lawyer with Foley & Lardner who represents clients investigated under Section 6700, disagrees.
"The amount of the penalty could dramatically depend on the IRS' interpretation of Section 6700. There appears to be no sound authority for imposing the penalty based on denomination," he said. "The wording of the tax code indicates that the correct interpretation is that the penalty is $1,000 per sale. Before the IRS takes a position that the penalty applies on a per-denomination basis, it would be prudent to obtain guidance from the Office of Chief Counsel. I have doubts about whether the Office of Chief Counsel would support that position."
The IRS enforcement team so far has not requested guidance relating to the size of the monetary penalty, according to Scott.
But the monetary fine may be the least trouble for a firm or individual sanctioned under Section 6700. In a recent article in the Bond Lawyer, the National Association of Bond Lawyers' quarterly journal, tax controversy lawyer Brad Waterman argues that the stigma associated with Section 6700 could inflict much greater harm. For example, a penalized bond counsel firm could lose lots of clients who do not want to do business with such a firm, he wrote.
Also, a lawyer that has been penalized under Section 6700 could potentially lose the right to practice before the IRS, Waterman wrote.
He reiterated those concerns in a recent interview. "The essence of the 6700 penalty is fraud, and the commission of fraud in the course of one's practice I would think could be grounds for disciplinary action," Waterman said.
Anderson said that if a bond lawyer is assessed monetary penalties under Section 6700, his group probably would then refer that case to the IRS' office of practice, which has the power to bar attorneys from representing clients before the agency. In fact, he said he has referred bond lawyers in the past to that IRS office, but added that those referrals apparently did not lead to any adverse action.
The nature of Section 6700 remains mysterious to some extent. Some people, such as Waterman and Bailey, attach significant weight to the section because in their minds it is intimately connected to fraud.
"It has the tenor of accusing someone of fraud, which may be much more serious than questioning whether an interpretation of complex tax rules is technically correct," Bailey said.
Anderson said he does not see it that way.
"I think fraud is too strong of a word," Anderson said. "If you look at the statute, it talks about misrepresentation or misinformation. It's a penalty for an abusive or very negligent transaction. I never use the words 'fraud' and '6700' in the same sentence, because it really is not a fraud section."
Anderson declined to identify any firms or individuals under investigation. But industry sources say that one underwriting firm that currently is under Section 6700 investigation is George K. Baum & Co. The firm underwrote several of the hospital loan pool deals currently under audit, such as the $330 million of bonds issued by Florida's Orange County Health Facilities Authority in 2000. In that case, none of the bond proceeds were ever loaned to a hospital.
Bob Dalton, vice chairman at George K. Baum, contended in an e-mail yesterday that the firm's transactions were lawful.
"The transactions were structured within the federal tax law and were approved by a number of the most respected bond counsel firms in the country," he wrote in response to a reporter's questions. "There was substantial due diligence as to demand performed under the supervision of bond counsel. There was reasonable expectation to lend out the bond proceeds in each transaction."
"We are not aware of any investigation of George K. Baum & Co. related to these matters," Dalton added.
Aside from that possible investigation, other market participants say the IRS clearly is on the warpath against promoters of what it views as abusive transactions -- and Section 6700 is its new weapon of choice.
While the IRS may not characterize it that way, "clearly it's something we're moving forward on," Anderson said. "It's coming."
