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MASBO Annual ConferenceMay 1, 2014IRS Audits on Tax-Exempt Bonds.....Be Prepared!Do’s & Don’ts from the Perspectives ofAttorney, Financial Advisor and School DistrictAttorneyI. 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 tax-favored 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 AdvisorTax-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 PoliciesFormal 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 debtCompetitive bid sale preferred; negotiated bid sales under certain circumstancesOptional prepayment provisions may be includedDerivative transactions are prohibitedPost-Issuance Compliance PoliciesOutlines who is responsible for performing different aspects of post-issuance 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 proceedsArbitrage Compliance reportingTracking potential private use situationsSchool DistrictOur exam:Examination of $93,375,000 GO School Building Bonds, Series 2007A, Issued 2-13-2007Notified on 6-1-12 by IRS Tax Exempt & Government Entities Division, Bismarck, ND (copy of notification included)Response requested within 24 calendar daysPurpose: To determine compliance with tax requirementsForm 4564 – Information Document Request (District 112’s Form 4564 attached)Process used:Reviewed Form 4564 to determine who to request data from (internal & external sources).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) Issues/Considerations:Reimbursement Resolution – limited to reach back 60 days prior to such approval. Board authorization to pre-spend bond proceedsNeed excellent record keeping and accounting of bond proceedsBe 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 issueWhen 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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