When you enter into a closing agreement with the IRS to fix a problem with a tax-exempt bond issue, the IRS will often require a penalty payment in an amount relating to the “taxpayer exposure” on some or all of the bond issue. Taxpayer exposure “represents the estimated amount of tax liability the United States would collect from the bondholders if the bondholders were taxed on the interest they realized from the bonds during the calendar year(s) covered under the closing agreement,” as section 126.96.36.199.3.1.1 of the Internal Revenue Manual says. To make this estimate of the tax that the IRS would’ve collected on the bonds, one must choose an appropriate hypothetical tax rate. In the past, the IRS has typically used 29% as tax rate, representing the IRS’s approximation of the average investor’s highest tax bracket.
On July 16, the IRS modified this hypothetical tax rate for interest on tax-exempt bonds accruing in tax years after 2017, in a memorandum from Christie Jacobs, the Director of the Indian Tribal Governments and Tax-Exempt Bonds section of the IRS. For tax years after 2017, the rate will be “the sum of (i) the backup withholding rate on interest payments . . . and (ii) the net investment income tax rate” measured as of the date on which the parties execute the closing agreement. So, for example, for a closing agreement entered into this year, the backup withholding rate is 24%, and the net investment income tax rate is 3.8%, so the taxpayer exposure rate would be 27.8%.
The memo does not explain why the IRS moved to this formulation and away from using an approximation of the average investor’s highest tax bracket as the rate for measuring taxpayer exposure. For now, it will reduce the amount of the penalty slightly.