New IRS muni audit process draws mixed views from lawyers

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CHICAGO – Internal Revenue Service staffing for tax-exempt bond examinations has shrunk dramatically, leading the agency to streamline its audit process in ways that some lawyers applaud and others don’t like.

Speaking on a panel at the National Association of Bond Lawyers’ Bond Attorneys’ Workshop here, Allyson D. Belsome, field officer manager for tax-exempt bonds (TEB) at the IRS, said her group currently has 26 agents, three group managers, two support staff and no technical adviser.

Cautioning that she was speaking personally and not for the IRS, she noted that that is far less than in 2009 when the TEB Office had 60 agents, six managers, five support staff, and technical adviser.

The number of agents conducting exams will shrink further to 19 by June of 2018 because of expected retirements and no plans to hire anyone to fill those positions, Belsome said. That means the group will be less than a third of its former size.

Belsome did not talk about the reason for the funding and resource cuts. But overall IRS staffing has been cut significantly over the last six years because of funding reductions by the Republican-controlled Congress. Republicans grew angry after accusing the IRS of trying to target and take away the tax-exempt status of conservative groups and have repeatedly called for the resignation of IRS Commissioner John Koskinen.

Some NABL members at the meeting were upset that IRS agents have no specific technical support person advising them on audits of tax-exempt bonds.

“This is a complex area and to not have good technical support for the field agents, it’s going to lead to very inconsistent results” in examinations, said Chaz Cardall, a partner at Orrick, Herrington & Sutcliffe in San Francisco.

In May, the tax-exempt bond office was combined with the office of Indian tribal governments to form a new ITG/TEB office within the Tax Exempt & Government Entities Division (TEGE). The new ITG/TEB office within TEGE is managed by Christie Jacobs, who previously managed ITG. As a result, there is no standalone TEB Office any more. Jacobs has no previous muni experience.

Belsome said the IRS had a choice of either conducting fewer examinations because of the reductions in staff or moving to a different examination process.

“Although our staffing has been reduced, our audit coverage has not,” Belsome told The Bond Buyer in an interview.

The TEB Office used to decide what examinations it wanted to conduct and what the scope of those examinations would be. Now a Compliance Planning and Classification Office (CP&C) that operates across the board for all areas of TEGE does that. The tax-exempt bond folks have some input to help fine-tune what’s under consideration, Belsome said.

CP&C is selecting new examinations as part of a compliance strategies and data driven review of certain types of bonds rather than by random selection.

IRS regulations require that first contact with a taxpayer must be by letter because of concerns the agency has about identity theft. IRS agents also are using only one format for their initial contact letters to issuers instead of the four formats it formerly used, said Belsome, whose field office is located in nearby suburb of Downers Grove, Ill.

Recently TEGE released its compliance strategies for fiscal 2018. It included compliance with: arbitrage requirements for tax-advantaged bonds with guaranteed investment contracts and qualified hedges and investments beyond the permitted thee-year temporary period; the rehabilitation requirement for private activity bonds used for acquisition financings; remedial actions taken when bond-financed facilities have an excessive amount of private use; and deep discount bonds and PABs that have excessive weighted average maturities.

“That’s looking at bonds where we think there’s a potential for an issuer there,” said Belsome. “We will identify returns where there’s information reported … that is an indicator of potential noncompliance.”

By returns she’s means the 8038 and 8038-G forms that issuers file when they issue governmental or private activity bonds containing information about those bond issues. Belsome stressed that it’s very important that those returns be filled out correctly.

“It’s going to be a driver of how that examination is going to be conducted largely,” she said, adding, “It sets the tone for the examiner” and the scope of the exam.

Most of these audit topics are focused on a specific, limited issue, she said, but some like the one on deep discount bonds, are focused on structure. The IRS agent wants to know, “Is that market-driven or something else,” asked Belsome, adding, is it part of an arbitrage play?

There are also data-driven exam topics that focus on information in the bond forms plus other information like that on an issuer’s website or Form 990s and schedule Ks filled out by nonprofits.

Belsome stressed that it is extremely important for an issuer or its lawyer to communicate with IRS examiners as soon as possible after the issuer receives a letter informing of it of an audit but before the issuer responds to an information document request (IDR). She said IRS examiners don’t want to waste their time doing an audit if there is no problem with compliance or if they find, for example, that when planning to audit refunding bonds the bonds to be refunded were already audited. At that point they will decide not to do the audit.

Earlier this year, Sunita Lough, Commissioner of the TEGE division, told lawyers at a NABL meeting that an issuer would receive a letter informing it about an examination and then the issuer and/or its lawyer would call the IRS agent to talk about the bonds and potential issues and that would determine what documents the agent requests in the IDR.

But some tax controversy lawyers said that the whole idea of a lot of communication is completely counter to their experience. They also said there are inconsistencies between what IRS officials are saying, what the Internal Revenue Manual says for agents, and what is happening in practice by IRS agents.

Cardall said that in one of his audits, he or the issuer reached out to the IRS agent about 20 times and never heard back except for one return call at midnight. They then reached out to the IRS agent’s manager and were told there is not supposed to be any interaction between the issuer and agent and that all communication should be in writing.

But Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth in Newport News, Calif., said, "It's wonderful" that the IRS is trying to target its audits and wants agents to communicate earlier with issuers. She said she has been in two audits where the agents were happy to talk to her.

Another change is that, in the past, an IRS agent would send an IDR to an issuer and then, after some discussions, send a more targeted IDR to the issuer that drilled down on the tax issues in dispute.

Belsome said issuers are no longer going to get “adverse IDRs.” That means the first document that the issuer gets from the IRS showing the agency has found tax problems is Form 5701, a Notice of Proposed Issue that suggests there is noncompliance and that the bonds may be taxable.

“At that point, they’ve kind of dug in their heels,” said Cardall referring to the IRS agent.

This also raises disclosure issues for issuers and their lawyers. Some issuers and their disclosure counsel believe they must disclose over the Municipal Securities Rulemaking Board’s EMMA system that the issuer has received a Notice 5701 from the IRS. They didn’t have that view when the issuer got an IDR from the IRS.

To the surprise and dismay of some lawyers in the audience, Belsome said that once an issuer sends documents to an IRS agent in response to an IDR, that agent can no longer decide not to examine the bonds. She called it a “taxpayer fairness” issue. She said if issuers send in documents they expect the IRS to decide if there’s a tax issue to ensure the IRS won’t come back later and ask for the same documents and start the whole process all over again.

This means issuers should get lawyers involved right away whenever they receive a letter and an IDR from the IRS, NABL members said. The lawyer may be able to convince the agent that there is no tax issue with the bonds, or that the agent is barking up the wrong tree.

“You need to have a lawyer on that call” with the IRS, Cardall said.

“Having counsel is very important,” said Lew.

Belsome also said that in some cases if issuers redeem bonds, that will resolve IRS concerns about tax problems.

The IRS "should be applauded" for using their resources more efficiently and for showing deference to issuers," Lew said.

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