A recent article in The Bond Buyer ($) reported that IRS agents have been raising concerns during audits about bond proceeds that remain unspent or that haven’t been spent in a timely manner.  The article reports further that IRS agents are not “buying the argument” that those transactions were originally sized reasonably even though changed circumstances caused projects to be delayed or canceled and proceeds to remain unspent.

We’re seeing the same thing, and we’re hearing from fellow attorneys involved in audits where the 3-year temporary period was not met because of “acts of God” (earthquakes, hurricanes, other weather-related delays, for example) or other unanticipated occurrences outside issuer control (labor strikes, for example) that IRS agents are responding with Catch 22-like arguments.

That is, even where the failure to meet a temporary period was not caused by changed issuer plans, the IRS is arguing that the issuer’s expectations that it would meet the temporary period could not have been reasonable because the issuer failed to spend all bond proceeds within that temporary period. In other words, the issuer could not have reasonably expected to meet the requirement because it didn’t meet the requirement.  And, more significantly, the IRS is making these arguments even where the issuer continues to slowly but surely make progress on the project and the unspent bond proceeds continue to be yield-restricted at the expiration of the temporary period.

Interesting food for thought is why the IRS has targeted unspent proceeds as an audit topic given the financial upheavals affecting municipal issuers since 2009; for example: a much weakened economy; the demise of auction-rate securities, bond insurance, letters of credit, and swaps; and the substantial increase in extreme weather-related damage to numerous bond projects during their construction.

One could very reasonably argue that issuers have ample justification for changed project plans and failure to spend proceeds within their “reasonably expected” original time frame. Is this IRS posture a return to  distrust of issuer business motives (even in an environment where failure to spend proceeds actually costs issuers money who decide—or are required—to keep their bonds outstanding and continue with their projects) and a turning, once again, to IRS implementation of Reg. 1.148-10(a)(3), which provides that failing to spend proceeds in an originally anticipated time frame may cause bonds to be taxable arbitrage bonds because they exploit tax-exempt interest rates even where the proceeds are not invested at a yield materially higher than the bond yield?

We’re also hearing that the IRS is requiring that an issuer call bonds and make a closing agreement payment for failure to meet the reasonable expectations test.  We think that the better view is that issuers can establish the reasonableness of their expectations by maintaining contemporaneous documentation of the reasons why these expectations failed to be met, and by presenting this documentation to the IRS—on appeal if necessary. In other words, issuers should exhaustively document both the reasonableness of their expectations when the bonds are issued and the reasons for a failure to spend new money proceeds within 3 years where that happens. Issuers and their counsel should build a clear, instructive record that will persuade a skeptical IRS agent who will not be as familiar with the project and the changed circumstances.

In the comments, let us know whether you’ve faced these questions and have had success with the above approaches or others.