Like most organizations, the IRS Tax-Exempt Bond Division (TEB) is facing a shrinking budget and a shrinking workforce. In response, the magic word at TEB these days is “efficiency.” As part of that effort, TEB has established policies that seek to maintain uniformity in the settlement amounts that arise from examinations (audits) or within the IRS’ Voluntary Closing Agreement Program (VCAP) for “similarly situated” violations. This effort is part of a broader undertaking by the IRS to achieve standardization in the resolution of violations, with the goal of not only providing greater efficiency, but also providing greater transparency, clarity, and certainty to taxpayers as to the way settlement amounts are determined.
The specific provisions that will carry forth this effort are likely to be included in revised provisions in the Internal Revenue Manual (IRM), which we have been told are forthcoming. We’ll have plenty to say about those revisions once they come out. But even now, the roots of standardization already exist in the IRM.
Part 4 of the IRM provides guidance to all IRS agents undertaking an audit of any taxpayer. Chapter 81 of Part 4 provides the guidance to agents examining a tax-advantaged bond. Section 6 of Chapter 81 tells the agent what the closing agreement must contain and also tells the agent how to calculate the amount to be paid to resolve the violation.
Similarly, IRM Part 7, Chapter 2, Section 3 provides guidance to agents reviewing a submission for a VCAP settlement for a tax-advantaged bond. Because VCAP involves a borrower who has voluntarily come to the IRS to disclose a violation, the settlement amounts are designed to be more favorable than settlement amounts to be paid as a result of an audit that uncovers violations of the same character.
Both IRM 4.81.4 and IRM 7.2.3 attempt to achieve uniformity of settlement amounts for similarly situated violations. Two questions arise. First, what does the phrase “similarly situated” mean? Second, when violations are distinguishable, what difference in the settlement amount is appropriate?
Consider this example. A governmental entity issues tax-exempt bonds in 2007 and loans the money to a small non-profit, 501(c)(3) entity (Borrower 1) to build a new facility. Borrower 1 signs all of the bond documents at closing, including a tax certificate that has post-issuance compliance procedures attached. Those procedures require Borrower 1 to review any management agreements for the facility with counsel before executing such an agreement. Borrower 1 uses the bond proceeds to construct the facility and just prior to opening the facility enters into a 10 year management agreement with a for-profit operator where the for-profit operator will manage the entire facility. The management agreement provides that the for-profit operator will be paid fixed annual compensation of $100,000 plus 5% of gross revenues but the variable component of the compensation cannot exceed $100,000. Borrower 1 can terminate the management agreement without cause after 3 years. But, if Borrower 1 terminates without cause, it must pay the manager a penalty of $500,000. Borrower 1 does not consult with counsel before executing the management agreement. This penalty provision causes the management agreement to fall outside the safe harbors from private business use set forth in Revenue Procedure 97-13. Thus, there will very likely be impermissible private business use of the facility and impermissible private payments received in connection with the facility. Therefore the bonds are private activity bonds and potentially could lose their tax exempt status. In 2014, the IRS audits the bonds.
Now let’s add a twist to this example. All of the facts are the same except that Borrower 2 did consult with their counsel, a well-respected law firm with a prominent public finance practice, and their counsel advised it that the 10 year provision must be reduced to 5 years. Borrower 2 makes that change and the operator agrees. The counsel then advises Borrower 2 that the management agreement would not jeopardize the tax exempt status of the bonds. The counsel missed the penalty provision and their advice was incorrect. In 2014, the IRS audits the bonds.
Borrower 1 and Borrower 2 have a management agreement that is not a qualified management agreement. In that sense, Borrower 1 and Borrower 2 are similarly situated, and both audits seem like they would fit under the “Identified Violation” for “Excessive Nonqualified Use” in IRM 184.108.40.206.2.4. But Borrower 1 did not follow its post-issuance compliance procedures while Borrower 2 did follow the post-issuance procedures and reasonably relied on its counsel’s advice. Thus, it would certainly seem fair to conclude that Borrower 1 and Borrower 2 are not similarly situated. In a public forum at the Bond Attorney’s Workshop held a few weeks ago and sponsored by the National Association of Bond Lawyers, the Director of the Tax Exempt Bond Division, Rebecca Harrigal was asked about the alternative examples described above. The Director confirmed that the two fact patterns should not be treated as similarly situated. The Director did not elaborate so there is no standard to determine what the difference would be in settlement amounts in the two situations. She stated that an issuer will need to show a “reasonable basis for departure” from the resolution standards where they would otherwise apply.
The IRS is focusing on increasing efficiency by standardizing closing agreement amounts where possible, and we are likely to see them lean more heavily on the resolution standards, even where they apply only by analogy.
Thus, when a bond issue is audited or a borrower discovers a violation and is considering whether to self-report in a VCAP submission, the tax lawyer involved will have to make judgments about whether the facts can be distinguished from other potentially similar fact patterns in which the IRS has entered into a settlement and, if the facts are distinguishable, how much difference that distinction will mean in the settlement amount to be paid. It will be imperative to document a “reasonable basis for departure” from any resolution standard that might apply. Then the tax lawyer will have to engage with the IRS agent to arrive at a mutually agreeable determination as to whether the borrower involved in the audit or VCAP is similarly situated to other borrowers who have settled or whether there is a distinction and, if there is a distinction, how much that distinction is worth in terms of a reduced settlement payment.