Presentation 2

MASBO Annual Conference
May 1, 2014
IRS Audits on Tax-Exempt Bonds.....Be Prepared!
Do’s & Don’ts from the Perspectives of
Attorney, Financial Advisor and School District
I. Commencement of Examination.
A. Letter from the IRS. A letter from the Internal Revenue Service (IRS) to an issuer
of bonds states that an IRS examination of a specific issue of bonds has commenced. The
letter indicates whether the examination is routine, part of a broader market segment
inquiry or other initiative based on the type of bonds, or if there is a suspected problem
with that particular bond issue.
B. Procedural Posture. While usually it would be the bondholders, as the “taxpayers,”
that ultimately would be held liable to pay the taxes on bonds that do not comply with the
federal tax rules, the IRS initially treats the issuer as the “taxpayer” and attempts to
resolve any problems directly with the issuer. The issuer has a strong interest in
resolving problems in order to avoid the highly unpalatable and adverse consequences of
having the IRS tax the holders of the issuer’s bonds. In the case of direct pay tax credit
bonds (Build America Bonds and Qualified School Construction Bonds), the issuer
effectively is the taxpayer and, accordingly, has direct liability for repaying federal
subsidy payments.
C. Information Document Requests. The examination notice is accompanied by an
initial Information Document Request (IDR) which normally asks for copies of bond
documents, certain records and written answers to various questions. In terms of content,
the IDR may be quite general or very specific. The IRS might ask for a site visit or an
interview. Exercise caution in answering questions whether in writing or orally.
Misinterpretations of seemingly innocuous responses can lead (and have, in fact, led) to
misunderstandings and, in turn, lengthy and expensive IRS review and challenges.
Consider consulting legal counsel before answering questions by phone or in person and,
further, consider running any written answers past counsel. Review of the IDR by
counsel can highlight areas of sensitivity where particular care is needed and, more
importantly, provide strategies for the answers. If the issuer or counsel discovers a tax
problem, it might be advisable to proactively advise the IRS of the problem in order to
obtain a more favorable outcome than if the IRS makes the same discovery on its own.
II. Examination Process.
A. Follow-up requests or inquiries are possible. Follow-up requests or inquiries may
simply reflect an IRS need for further clarification or may indicate that the IRS has
identified areas of concern. The IRS might express specific concerns that issuer needs to
reply to very carefully in order to support its position, or, if problems are discovered, to
deal with them in a way that minimizes adverse consequences.
B. No Change Letters. The issuer’s desired outcome is a “no change letter” from the
IRS stating that the examination has been concluded and that the IRS is not challenging
the tax status of the bonds. Occasionally, a no change letter will contain a warning that
the issuer should be more careful about recordkeeping or something else that was
considered too minor to warrant a penalty at the time.
C. Settlement Proposals. If the IRS has serious concerns about compliance with the
applicable tax requirements for the bonds, it typically offers the issuer an opportunity to
address the concerns or to settle the case. Typically a settlement would require the issuer
to pay a percentage of the taxpayer exposure (the amount of tax the bondholders would
have to pay); sometimes the IRS will require that the bonds be retired. In the case of
direct pay subsidies, the IRS would typically require repayment of a portion of the
subsidies. There are numerous factors the IRS considers in determining what it requires
to settle a case, including issuer cooperation with the IRS, issuer good faith, the
seriousness of the instance of noncompliance, and whether the issuer has written
procedures for post-issuance compliance. If the dispute involves a legal issue, it is
possible to request that the IRS field (examination) function seek formal field service
advice or a technical advice memorandum from IRS lawyers experienced with taxfavored bonds. The issuer is permitted to make its arguments in writing to those lawyers
and, in some circumstances, to discuss the case with them.
D. Notices of Proposed Issue (Forms 5701-TEB). A Notice of Proposed Issue (NOPI)
is a formal document from the IRS that typically contains the assertion of the preliminary
belief (or serious concern) that the bonds are not qualified for tax-exemption or tax
credits. Although technically preliminary, NOPIs normally are not issued lightly, and
require the approval of supervisors of the IRS agent. At this juncture, the issuer is again
offered the opportunity to settle the case or to provide a written explanation of why the
government’s concern is misplaced.
E. Proposed Adverse Determinations. If the reply to a NOPI does not convince the
IRS that its preliminary determination was wrong, the IRS typically again offers the
possibility of settling the case. If a settlement does not appear to be likely, the IRS issues
a Proposed Adverse Determination (PAD). Technically, the issuer’s written reply to the
PAD takes the form of a request (often called a “protest”) for an appeal to the
independent IRS Office of Appeals, together with a detailed description of the facts and
law supporting the issuer’s position. The issuer has a right to such an appeal. It still is
possible to settle with the IRS before the protest is submitted. The protest is reviewed by
senior officials at the IRS, and almost always is forwarded to the Appeals Office. On rare
occasions the IRS will revise its PAD and give the issuer another chance to submit a
protest. Once, the IRS decided to concede the case. The IRS may notify bondholders of
its position.
III. IRS Appeals.
The mission of the IRS Office of Appeals is to resolve cases, if possible, without
litigation. The issuer is given the opportunity to discuss its case with an experienced
Appeals Officer. Appeals can decide that the IRS’s position is without merit or is not
worth pursuing, but it is much more common for Appeals to reach a settlement with
issuers. Appeals does take into consideration the “hazards of litigation” and costs to the
IRS of collecting tax from bondholders.
IV. Final Determination.
If Appeals does not concede, and no settlement agreement is reached, Appeals returns the
case to Examinations, which is then free to issue a final determination that the bonds are
taxable (or not eligible for the tax credit). In the case of tax exempt bonds, the IRS would
notify the trustee that it should report interest to the bondholders as taxable, and the IRS
would proceed to contact bondholders to collect the tax. The issuer would have no right
to a judicial review. In the case of direct pay tax credit bonds, the IRS would notify the
issuer of the amount it owes the IRS. The issuer would have an opportunity for judicial
review under these circumstances.
Financial Advisor
Tax-exempt compliance starts with the initial determination to issue Bonds for a project and the
development of a plan of finance. Among other considerations, the use of the proceeds
determines whether a Bond can be issued as a tax-exempt instrument and whether it will stay
tax-exempt. Post-issuance compliance, including the investment of proceeds and secondary
market disclosure, are other considerations.
Policies can help a District make sure its debt is issued with the correct tax status and maintain
that status.
Debt Management Policies
o Formal debt management policies can help a District maximize their
financial resources and facilitate the issuance of debt for their funding
needs. Topics can include:
 Use of tax-exempt and taxable debt
 Competitive bid sale preferred; negotiated bid sales under certain
 Optional prepayment provisions may be included
Derivative transactions are prohibited
Post-Issuance Compliance Policies
o Outlines who is responsible for performing different aspects of postissuance compliance. Generally speaking, in addition to responding to
direct IRS inquiries, you need to determine not less than every five years
if you need to make a payment to the IRS. Use of proceeds and facilities
demand ongoing review. For issues that are 0 - 5 years old, you may want
to do an interim review to determine if you are likely to have a payment
liability and if you used the proceeds as you initially intended to use them.
Post-issuance compliance duties can include:
 Record keeping, including accounting for proceeds
 Arbitrage Compliance reporting
 Tracking potential private use situations
School District
Our exam:
 Examination of $93,375,000 GO School Building Bonds, Series 2007A, Issued 2-132007
 Notified on 6-1-12 by IRS Tax Exempt & Government Entities Division, Bismarck, ND
(copy of notification included)
 Response requested within 24 calendar days
 Purpose: To determine compliance with tax requirements
 Form 4564 – Information Document Request (District 112’s Form 4564 attached)
Process used:
 Reviewed Form 4564 to determine who to request data from (internal & external
 Sent requests to Financial Advisor, Investment Advisor and conference call with attorney
for data needed.
 Requested extension from IRS due to issues with recovering internal data (two software
conversions during spending of bond proceeds)
 Reimbursement Resolution – limited to reach back 60 days prior to such approval. Board
authorization to pre-spend bond proceeds
 Need excellent record keeping and accounting of bond proceeds
 Be sure to use proceeds for only the intended purpose (per official statement)
 Set up a separate UFARS Fund if you have multiple bond issues (cross walk to Fund 06)
 Interest earnings – attribute to appropriate bond issue
 When drawing out funds, draw out exact amount of expenditures (easier to trace)
 Be aware of how much for-profit organizations are renting school district space (hockey
arena example). Affects private use with tax exempt bonds
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