One of the first jail bond deals the Internal Revenue Service ever audited, a Texas transaction that that appears to have prompted IRS reviews for dozens of similar deals, may be headed for settlement.

Bond counsel Jackson Walker LLP, based in Houston, has tentatively agreed to pay $400,000 to settle a tax dispute between Crystal City Public Facility Corp. in Texas and the Internal Revenue Service over $13.94 million of revenue bonds issued to finance prison facilities. The bonds were issued in 2003, but have been under scrutiny by the IRS since 2010 and in default since last year when the U.S. Marshal withdrew inmates because misconduct and security problems, forcing the facilities to close in May 2012 for repairs and improvements.

The proposed settlement, which would preserve the tax-exempt status of the bonds through Jan. 2, 2013, and remove the basis for pending litigation between transaction participants and bondholders, was disclosed in an event notice filed by U.S. Bank, NA, the trustee for the bonds, on the Municipal Securities Rulemaking Board’s EMMA system.

The bank said it intends to accept the terms of the settlement, unless two thirds of the bondholders direct it to take other action. Under the indenture, at least 66.67% of the holders of the outstanding bonds can direct the trustee to take certain actions. The bank is asking bondholders who want to communicate with it about the settlement to do so no later than Sept 3.

Sources familiar with these transactions said the IRS began auditing the Crystal City bonds in 2010 and believed it was so egregious that it should start audits of dozens of other jail bond deals. Most of those audits are still ongoing.

In this case, the bonds were issued to finance the acquisition of the Crystal City Correctional Center and the construction facilities tied to it. The issuer acquired the prison facilities, located about 90 miles from San Antonio and 47 miles from the Mexican border, and 90 miles from the federal court in Del Rio, Tex., from Correctional Properties of Texas, Inc., a private company.  The issuer then leased the facility to the city, which in turn entered into a management contact with Bobby Ross Group Inc., another private company.

The IRS sent the issuer a proposed adverse tax determination notice in June 2011 that concluded the bonds were taxable because of violations of the laws and rules governing private activity bonds.

Bonds are PABs if more than 10% of the proceeds are used by private parties and more than 10% of the debt service is paid by private parties. PABs are only tax-exempt if they fall within certain “qualified” categories and correctional facilities are not in any of those tax-exempt categories.

The IRS’ concerns were two-fold, according to bond-related documents. First the IRS took issue with the management contract the city had with BRG, under which the net profits were split between the two. The IRS argued this compensation structure suggested “an equity interest in the operation of the bond-financed facility,” creating a private use and payments problem.

In addition, the IRS claimed the prison had too many federal inmates. Federal inmates are considered private, not public, parties under the tax law. The IRS contended that the economics of the prison would not work without substantial federal, and therefore private, use and payments. The federal government tends to pay more for incarceration of its inmates that state or local governments.

W. James Jonas, an attorney in San Antonio who is representing the issuer, declined to comment on the tentative settlement.

But U.S. Bank’s event notice says that, since May 29, 2012, the prison facilities have been operated by Emerald Correctional Management LLC, indicating a new management contract has been put in place. As of end of March 2013, there were only 22 inmates in the correctional facilities.

The U.S. Immigration and Customs Enforcement, under a contract with Emerald that was to have expired April 13 of this year that ICE wants to extend through Sept, 30, has agreed to incarcerate 50 federal inmates per day up to a total of 300. The prison holds a total of over 500 inmates, sources said.

Normally that would cause a problem, but since the bonds are in default, bondholders have not been receiving any tax-exempt interest that the IRS could declare taxable. Also the bond documents permit the issuer to redeem the bonds at a premium of 102% at any time this year.

Sources familiar with these transactions say the IRS typically is willing to settle the tax violations if the issuer redeems the bonds and a penalty is paid. One source speculated the Crystal City Public Facility Corp. may be considering selling taxable bonds to redeem the tax-exempt bonds that remain outstanding.

In event notices filed in late 2012 and earlier this year, U.S. Bank noted that the issuer and the city had filed a lawsuit in the 293rd judicial district of Zavala County, Tex. against various transaction participants alleging “deficiencies related to the issuance of the bonds” which led the IRS’ finding that the bonds were taxable. The issuer and city also sued BRG, alleging breach of the management agreement and misconduct.

In its most recent event notice, the trustee bank said that while it, “believes that this settlement is in the interests of all bondholders because it eliminates retroactive liability to the IRS, bondholders should be aware that this settlement may be deemed to extinguish individual bondholder claims against bond counsel or other participants in the financing relating to the bonds, the indenture, the project and the IRS determination.”

Herbert J. Sims & Co., Inc. and Municipal Capital Markets Group, Inc. underwrote the bonds. Jackson Walker LLP in Houston was bond counsel as well as legal counsel on certain matters for the issuer and the city. Sutin, Thayer & Browne, PC was underwriter’s counsel.

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