IRS rules could render tax-free bonds taxable
By Linda Bentley | September 30, 2009
‘It is within our control that the IRS gets upset’
CCUSD – Currently, Cave Creek Unified School District taxpayers are repaying $15 million in bonds approved by voters in 2000 for the purpose of building a new high school. The CCUSD Governing Board voted to issue the bonds in September 2006, only because they would have expired and they had little hope voters would approve another bond measure anytime soon.
According to the debt service requirements table, $533,307 in interest alone was paid in fiscal year 2006/2007, $639,969 in 2007/2008 and for 2008/2009 the principal payment was $1.9 million with $639,919 in interest. For the 2009/2010 fiscal year, the interest payment appears to be $563,909.
Taxpayers have been paying over $50,000 per month in interest alone on those bonds.
However, the district isn’t building a new high school and at the time it issued the $15 million in bonds, it was still seeking answers to questions about whether the district was required to use the money to build a new high school or if it could be used to add on to the existing high school or for other improvements.
However, when tax-free bonds are issued, the IRS looks at whether the issuer “reasonably expects” to satisfy three tests: the expenditure test, the time test and the due diligence test as per 26 C.F.R. § 1.148-2(e)(2).
The expenditure test requires the issuer to spend “at least 85 percent” of the bond proceeds on “capital projects” within three years.
The time test requires that the issuer incur “within 6 months of the issue date a substantial binding obligation” to spend “at least 5 percent” of the bond proceeds on “capital projects.”
And last, the due diligence test requires that “completion of the capital projects and the allocation of the funds … to expenditures proceed with due diligence.”
IRS regulations look at whether the issuer reasonably expected to satisfy the three tests “as of the issue date,” not whether it satisfied those requirements later.
Generally, to allay the concerns of investors, issuers retain bond counsel to provide an unqualified legal opinion that the interest on the bonds will be exempt from federal taxation.
According to the National Association of Bond Lawyers (NABL), the purpose of an unqualified bond opinion is to assure investors “there is no reasonable risk of … taxability that the investors should take into account in making an investment decision, except for risks disclosed in the opinion.”
And because investors rely so heavily on unqualified bond opinions, the NABL states bond counsel must “apply a high standard of professional conduct.” In particular, a bond opinion “should be based upon a reasonably sufficient examination of material legal and factual sources and reasonable certainty as to the subjects addressed therein.”
These statutory and regulatory restrictions are designed to “minimize the arbitrage benefits from investing gross proceeds of tax-exempt bonds in higher yielding investments and to remove arbitrage incentives … to issue bonds earlier … than is otherwise reasonably necessary to accomplish the governmental purpose for which the bonds were issued.”
Arbitrage is defined by the Encarta English Dictionary as “the simultaneous buying and selling of the same negotiable financial instruments or commodities in different markets in order to make an immediate profit without risk.”
During an April 2006 governing board meeting, Bryan Lundberg of the investment banking firm Peacock, Hislop, Staley & Given and Attorney Fred Rosenfeld of Gust Rosenfeld, CCUSD’s bond counsel provided the board with information about issuing bonds and requirements the district must meet.
Lundberg said his firm has had experience with bonds left over and stated, “The tax challenges associated with that are extremely expensive.”
Rosenfeld said there were tax penalties if the bond money is not spent within a three-year period.
Associate Superintendent of Finance Kent Frison said he was concerned if the district didn’t build a new high school they would not be able to spend the entire amount.
At the time, the CCUSD Long Range Planning Committee had not yet received parameters from the board.
Rosenfeld stated, “If we decided not to build (a new high school), the SEC will take a very harsh position. To get audited will cost a minimum of a half million dollars.”
He went on to say if the district was unable to spend the money in three years because of an earthquake of some other natural disaster, that was another story, but a change of determination by the board is not sufficient to prevent the fine.
“It is within our control that the IRS gets upset,” said Rosenfeld.
Also, he said the people who received tax exemptions through purchase of the bonds would then have to pay taxes and could sue the district if it did something to cause the bonds to not be expended.
The board was then educated as to the possible penalties due to changing their minds and not expending the full bond component.
Three years have come and gone.
In June 2006, the board authorized the issuance of $11.7 million in bonds to build a second high school, with the bond consultant to determine the amount of the sale, although it had no idea what type of school or where it planned to build the school.
In June 1006, the School Facilities Board authorized $12.2 million to build a 640-student high school.
Although the bonds were issued in September 2006, the district had still not decided on any of the options presented by the Long Term Planning Committee, and was still undecided at the end of the year.
In the spring of 2007, the district changed its mind and decided to build a 2,500-student high school instead, requiring another $45 million in bonds, which, along with everything else on its funding wish list, failed at the ballot in November 2007.
So, it appears the district created the quandary it is currently in with IRS rules and taxpayers, with taxpayers footing a bill for principle and interest payments in the millions that are not being used to build a new school, while investors may end up being taxed on their tax-free investment.