WASHINGTON — The Internal Revenue Service’s new requirements for tax-exempt organizations to provide it with detailed information about their outstanding bonds represents a “sea change” and an expansion of the agency’s oversight of the tax-exempt bond area, a former Treasury official and other lawyers said.
The IRS issued a final revised Form 990 with a new Schedule K last month that asks tax-exempt organizations for information about their outstanding bonds, including the use of bonds proceeds and whether the proceeds were invested in a guaranteed investment contract, as well as whether the borrowers have entered into any management or service contracts, or research agreements in connection with bond-financed projects that could result in private business use.
The IRS is requiring exempt organizations with more than $100,000 of bonds outstanding to list any bonds issued after 2002 that are still outstanding for the 2008 tax year in forms to be filed in 2009. The agency gave the borrowers a one-year delay in responding to the detailed questions in Schedule K. Those questions must be answered for the 2009 tax year in forms to be filed in 2010. The IRS had said the detailed questions also would only apply to bonds issued after 2002.
However, IRS officials told members of the American Bar Association’s tax-exempt bond committee at a meeting in Las Vegas Friday that the new requirements apply to refundings, which could include underlying bonds issued before 2003.
Ed Oswald, a partner at Orrick, Herrington & Sutcliffe LLP, who was Treasury attorney-adviser for bonds in the late 1990s, said that the IRS action represents a “sea change” because “the IRS is broadening its focus to address whether applicable tax rules are being followed after bonds are issued.”
Historically, he said, the IRS has mostly focused on bonds at the time they were issued — the structure of the bond transaction, the parties involved, and the set of facts that was in place at that time. The agency has touched on post-issuance compliance issues in some respects during the past year or two.
But Schedule K marks the first time the IRS will collect detailed post-issuance compliance information that could provide the foundation for audits in some cases, and encourage borrowers to set up post-issuance compliance procedures and policies.
“There’s somewhat of a paradigm shift and maturation in terms of oversight and review” as the IRS expands its focus to the post-issuance period, Oswald said. The IRS wants to know, “now that the project has been financed and is operating, are the conduit borrowers and issuers following the broad set of rules and living up to their responsibilities as these bonds are outstanding for the next 10, 15, 20 years down the line,” he said.
The IRS and its advisers have clearly been moving in this direction, Oswald and other lawyers said.
Until recently, the agency tried to collect some post-issuance information from tax-exempt entities in Form 990, but its requests were in the instructions for the form and, as a result, were overlooked by many borrowers.
“It was actually a subject of confusion,” said Maxwell “Mike” Solet, a partner at Mintz Levin Cohn Ferris Glovsky and Popeo, PC in Boston. “They wanted information about it, but you had to read the instructions and it wasn’t obvious from the form itself. I think there was fairly widespread ignorance about what was buried in the instructions and I don’t believe the IRS did much of a job in following up on that.”
The IRS also sent a questionnaire to between 200 and 300 tax-exempt charitable organizations last year to gauge their compliance with municipal bond-related tax requirements. The questionnaire asked if the organizations had guidelines in place to ensure their bonds remain in compliance with the tax requirements, which officials are primarily responsible for monitoring such issues, and how copies of records are maintained.
IRS officials told ABA panel members Friday that only about 5% of those that responded to the survey said they did not have post-issuance compliance procedures in place.
The agency is expected to send a similar questionnaire to state and local governmental issuers this year.
In addition, Cliff Gannett, director of the tax exempt bond office, and Steve Chamberlin, the head of TEB’s office of compliance and program management, have talked about the importance of post-issuance compliance in public speeches during the past year or two.
A number of lawyers believe the new Schedule K is designed to obtain information for audits.
“This is an audit tool absolutely and so are the surveys,” said Mark Scott, a partner at Vinson & Elkins LLP and former head of the IRS tax-exempt bond office.
Gannett made clear to ABA panel members last week that the IRS may use information from the new Schedule K’s for audits.
But Solet and Michael Bailey, a partner at Foley & Lardner LLP in Chicago who heads the ABA tax-exempt financing committee and also worked at the IRS in the 1990s, believe the primary goal of Schedule K is to push tax-exempt organizations to develop policies and procedures to ensure compliance with bond-related tax requirements.
“I think it’s partly audit-driven, but I think it’s partly driven by a desire to change post-issuance compliance procedures at the borrower conduct level,” Solet said. “There’s been a growing focus on the existence of procedures to monitor and ensure post-issuance compliance.”
Bailey agreed. “The tone [of the revised schedule] is more focused on encouraging voluntary compliance than on serving as a basis for IRS audits,” he said. “One of the principal objectives of the Service in the Schedule K is to encourage borrowers to have post-issuance compliance and the IRS intends that the detailed reporting requirements will provide incentive for borrowers to be more rigorous in record-keeping and post-issuance compliance monitoring.”
Solet, who chairs an IRS advisory committee that wrote a report on post-issuance compliance last year, said the IRS’ intent is obvious in the one-year delay of the effective date for compliance with Schedule K and the questions asked by it.
The supplemental information sheet published in conjunction with the new Schedule K, states: “The one year delay for most portions of the form will provide organizations an opportunity to put in place the systems needed to compile the information required to complete the schedule.”
Also, Schedule K asks whether the exempt organization maintains adequate records regarding the allocation of proceeds and if it has implemented procedures to ensure post-issuance compliance.”
“I think what you’re seeing is the IRS providing the time for 501(c)(3) borrowers to implement those kinds of procedures so that they are able to avoid answering ‘no’ to those questions,” Solet said.
The IRS plans to issue instructions for filling out the new schedule and agency officials told ABA panel members that the instructions for the requests for bond-related information will probably be issued first.
Solet said the IRS must give issuers some flexibility in responding to Schedule K because the schedule is part of the Form 990 and borrowers who sign the forms are subject to penalties for perjury if they give incorrect information.
“I think that it’s important that the instructions clarify what a conduit borrower is to do when their information is simply not sufficient to allow a simple answer,” he said. “It’s not always clear how to answer these questions, especially because they sometimes involve bond issues that have been outstanding for a long time where prior information and records are inadequate.”
Some market participants contend that the IRS would like to, at some point, require state and local governments to provide post-issuance information in tax returns.
“That’s exactly what they want to do,” Scott said. “They have found away [do require that] through the 990 [for exempt organizations] and clearly they would like to expand that, but I think there are some potential roadblocks that they would have to overcome.”
First of all, there is no comparable form to the 990 for state and local governments, he and other lawyers said. The only post-issuance form for state and local bond issuers is the 8038-T and that only has to be filed if the issuer is rebating arbitrage.
Solet said, “I’m not aware that the IRS has ever considered the question of whether to ask for ongoing filings like the 990 from governmental entities,” adding, “That would raise some much more complicated questions since governmental entities don’t file tax returns.”
But in a June 28 letter to Sen. Charles Grassley, R-Iowa, the top Republican on the Senate Finance Committee, Kevin M. Brown, who was acting IRS commissioner at that time, suggested there might not be major obstacles to requiring such information from state and local issuers.
Brown said that one of two difficulties with establishing “a comprehensive picture of the tax-exempt community” is the “numerous exemptions from filing.”
“Some of these exemptions have their basis in well-established policy with an arguable Constitutional underpinning (e.g. churches do not have to file for exemption or annually),” he continued. “The rationale for other exemptions is less obvious (e.g. the lack of meaningful annual reporting in the tax-exempt bond area).”
Neither Gannett nor Chamberlin could be reached for comment.