WASHINGTON — Some transaction participants appear to be rushing to market questionable Build America Bond, bank-qualified or other municipal bond deals before tax incentives expire at the end of the year and risking Internal Revenue Service enforcement action for violations of tax requirements, according to market sources.

They are trying to get deals done before the Dec. 31 expiration date of programs or tax incentives authorized by the American Recovery and Reinvestment Act in 2009. They are doing so even though the deal structures raise date-of-issuance questions, or the projects to be financed with the proceeds are not far enough along or even feasible enough to warrant bond financing, the sources said.

Perry Israel, a lawyer with his own municipal bond practice in Sacramento, likened the situation to the one that existed in 1985 when market participants were trying to rush muni deals to market before Tax Reform Act's bond restrictions took effect.

"Lawyers should be careful that transaction participants don't do anything that could cause the IRS to question whether the bonds were actually issued before the end of the year," Israel said.

He said market participants should remember the Harbor Bancorp case that went all the way to the U.S. Supreme Court, though the justices declined to take it up.

The IRS claimed that the bonds — rushed to market by former underwriter Matthews & Wright for the Riverside County Housing Authority in late 1985 to skirt the Tax Reform Act's tougher arbitrage restrictions — were not actually issued before those restrictions took effect. The IRS said the interest earnings on the bonds were taxable and was unsuccessfully challenged by bondholders Harbor Bancorp., a bank based in Long Beach, and Edward and Elena Keith, residents of Pebble Beach. They ended up paying the taxes.

Asked about the rush-to-market concerns, Cliff Gannett, director of the IRS' tax-exempt bond office, said: "Our compliance program is going to be cognizant of this problem, the fact that there could be bonds going to market because this small window exists and not because there are valid projects or projects ready to go. Obviously if there's over-issuance, that's a problem for us, especially for direct-pay bonds."

Israel and other lawyers said the TEB office "has staffed up a lot more than in the past," adding: "We should be seeing more enforcement."

Gannett said TEB has roughly 100 examiners and compliance agents as well as tax-law specialists, analysts and managers.

He said the IRS is examining a "significant" number of abusive transactions, including cases under section 6700 of the tax code, which gives the agency the authority to go after dealers, bond counsel or other promoters of abuse, as well as cases stemming from whistleblower tips.

Gannett declined to be more specific about the number. He said the IRS is increasingly loaning out its municipal bond experts to other federal agencies that are probing abusive muni transactions, but declined to elaborate.

Israel said next year could be significant for the Justice Department's antitrust cases over muni bond reinvestments if the jury trial begins hearing the case against CDR Financial Products. In October 2009, the government charged the firm with bid-rigging of municipal investment and derivatives contracts over an eight-year period.

The current trial date has been scheduled for September, but CDR is trying to get the trial moved to a federal court in Los Angeles rather than Manhattan.

Looking ahead to the coming year, Gannett said BABs will continue to be a major focus of the IRS' compliance program, potentially for years to come. That is particularly so given the surge of BAB issuance at the end of this year as Congress failed to extend the program beyond Dec. 31 in the tax act signed into law Friday by President Obama.

BABs "are going to be with us for quite a while — for years and years and years," Gannett said. "We've got our work cut for us. I think we're going to have to stay focused on BABs and other direct-pay bonds.

IRS agents are reviewing every Form 8038B — which muni issuers file for a new BAB issue — to make sure the bonds properly qualify as BABs. They also are reviewing every Form 8038CP that an issuer files seeking federal subsidy payments for BABs to make sure the requested payment amounts are correct.

Under the tax law, BABs can only be sold to finance capital improvements and cannot be sold with more than a de minimis amount of premium, which is defined as 1/4 of 1% of the stated redemption price at maturity for the bond, multiplied by whichever comes first: the number of complete years to maturity or the first optional redemption date.

The agents reviewed roughly 2,300 BAB forms filed during fiscal 2010, which ended Sept. 30, and are expected to review another 3,000 or more in fiscal 2011, Gannett said. There has been a huge surge in BAB issuance in November and December as issuers worried Congress would not continue program at a 35% subsidy rate or at any rate.

"We have this very large volume of information returns that will be coming in the first half of next year and we'll be looking at all of these," Gannett said. "That's going to be a significant challenge for us."

As a result of the reviews of the forms filed for deals done in fiscal 2010, IRS agents have referred at least 19 BAB issues for audit and are considering referral of another dozen because of potential tax-law problems, Gannett said.

IRS agents also have found problems with payment requests, he said. There have not been any instances of outright fraud, where someone is masquerading as an issuer to get a government payment for a fictitious BAB issue. But a number of issuers have asked for higher payments than they are due, according to Gannett.

On top of BAB-specific issues, all of the rules that apply to tax-exempt bonds also apply to BABs so the IRS will have to look at compliance with those as well, he said.

"I do not think that the termination of the BAB program is going to have much effect on the number of BABs that are audited by the IRS," said Charles Cardall, a partner at Orrick, Herrington & Sutcliffe in San Francisco. "They've already decided what they want to look at in BAB transactions."

BAB Audit Guidance
With BAB compliance and enforcement actions moving forward, IRS officials have been drafting guidance that will detail the agency's approach to BAB audits and how issuers can dispute any IRS findings of tax-law violations that jeopardize part or all of their subsidy payments.

In the tax-exempt bond arena, if the IRS issues an adverse-determination letter proposing the bonds should not be tax-exempt, the issuer can appeal the finding to the agency's Office of Appeals.

If that office agrees with TEB and a final adverse-determination letter is issued, the issuer can challenge the IRS in court. But no such procedures exist for the taxable BABs.

"We're hoping a revenue procedure will be issued early next year that will address what procedures issuers should use if they find their bonds do not qualify as BABs," or if they disagree with the IRS on the amount of subsidy payment they should receive, Gannett said.

Michael Bailey, a partner at Foley & Lardner LLP in Chicago who chairs a committee that advises the IRS on tax-exempt bonds, said he would like to see the agency adopt the recommendations the panel made on BABs in June with regard to the voluntary closing agreement program.

The committee recommended that BAB issuers that voluntarily report unintentional and relatively minor violations to the IRS under VCAP have their subsidy payments reduced in an amount proportionate to the violation. Gannett said the panel's recommendations are being implemented through changes to the Internal Revenue Manual, which details procedures for IRS agents to follow.

Apart from BABs, the TEB office closed 1,560 muni bond audits during fiscal year 2010, about 350 more than originally estimated. The agency found tax problems in about 70% of those, leading to simple fixes or settlements of tax-law violations, Gannett said.

TEB is projecting it will close about 1,400 muni bond audits this fiscal year, which stretches through Sept. 30, 2011. The office has two types of exams or audits. General exams entail a full-blown inquiry and requests for a lot of information on the bonds. Focused exams are sector-oriented and agents send issuers standardized information-document requests.

Gannett said TEB plans to add pooled financings and advance refundings to the list of bond financings for which it is conducting general audits.

As a carry over from fiscal 2010, the office will continue conducting general audits on qualified student loan bonds and developer-driven deals such as independent, multifunctional special district financings and tax increment financings, he said.

TEB expects to expand its focused audits to multifamily housing bonds, tax and revenue anticipation notes, lease financings and current refundings, according to Gannett. In current refundings, issuers must defease the underlying bonds within 90 days. As a carry over from 2010, it will continue conducting focused audits on airport bonds and costs of issuance for a broad range of debt financings, he said.

Post-Issuance Compliance
Israel also pointed out that the IRS will be looking at the responses that charitable organizations and state and local governments detailed on questionnaires the IRS sent them on post-issuance compliance issues. Among other things, the questionnaires ask if the borrowers and issuers have written procedures in place to ensure compliance with tax requirements after they have issued their bonds.

Gannett said he has been surprised to find that more charitable organizations than governments responded to the survey and indicated they had written post-issuance compliance procedures in place. Some 203 of 207 charitable organizations responded to the survey while only 175 of 200 state and local governments responded, he said.

About 83 cases in the voluntary closing agreement program were closed in fiscal 2010 and that number is projected to stay around 80 for this fiscal year, he said.

Susan Gaffney, director of the Government Finance Officers Association's federal liaison center, said she would like to see better coordination between the issuer community and the IRS on compliance issues so that the GFOA's debt committee can provide guidance to issuers and address some IRS concerns in its best-practices documents.

It's also important so that issuers can better understand IRS concerns and what the agency is trying to accomplish, she said.

"I think an effort on our part is to do a better job of talking to, and working with, the IRS. Issuers need to understand not only what's coming up but also what the IRS is trying to learn about from the questionnaires they've sent to issuers," she said. "We've got to make sure that the issuers are filling out the questionnaires correctly and learning what kinds of things the IRS expects from them."

Gannett said his office has embarked on several growing programs that are proving to be very helpful, including one in which IRS agents and managers develop relationships with state officials in charge of debt issuance or finance.

"That's turning out to be a worthwhile effort," Gannett said, adding there has been a lot of two-way information sharing.

Thus far, IRS field officials have developed relationships with officials in eight to 10 states and are hoping to expand the program to cover all states during the coming year, he said.

The other program involves periodic meetings between IRS and Securities and Exchange Commission officials under a memorandum of understanding that was signed earlier this year. Initially the meetings were monthly and more recently they have been quarterly.

"These meetings have been extremely worthwhile," Gannett said.

While IRS officials are prohibited from sharing any taxpayer information with anyone under penalty of felony charges, the SEC faces no such constraints.

"We discuss our interests and how we can best collaborate and meet those needs," Gannett said. "There's a lot of overlap in our compliance efforts and it's useful to talk. It's helpful to coordinate the overall focus and concerns of each of our compliance programs."

He said TEB is also revising and updating its training programs, including posting information on the IRS website, and is re-working its portion of the site to be more informative.