WASHINGTON - A lawsuit filed in the U.S. Tax Court by a bondholder over Whitewater Garden bonds will have a major impact on the tax status of more than 30 other bond issues the Internal Revenue Service is investigating, the IRS said late last month.
The IRS made the statement in a successful motion that asked the court not to consider the lawsuit that Harbor Bancorp & Subsidiaries filed against it on Oct. 29 as a "small tax case" so that the court's decision in the case would be precedent setting.
Harbor Bancorp filed the suit to prevent the IRS from collecting $19,763 of taxes on interest earned from $250,000 of the bonds in 1988, 1989, and 1990.
The $17.5 million Whitewater Garden bond issue was issued as tax-exempt by the Riverside County, Calif., Housing Authority on Dec. 31, 1985, to finance an apartment project. But the project was never built.
The IRS has contended the bond issue is not tax-exempt because it violated private-activity bond and arbitrage rebate requirements. In the motion filed with the court late last month, the IRS said the case will require the court to resolve "important tax policy and taxpayer compliance issues" that apply to all tax-exempt bonds.
"As this is the first such case to come before this court, the decision herein will constitute precedent for the resolution of the tax-exempt status of not just this bond issue but the more than 30 bond issues nationwide that [the IRS] is presently examining or challenging," the IRS said.
The IRS told the court that "what is at stake in this case" is not just Harbor Bancorp's alleged tax liability but whether the IRS will be able to collect taxes on up to $55 million of interest earned from all of the issues under investigation or subject to ongoing enforcement actions.
The IRS also said it planned to consolidate all other Riverside County authority-related bond cases with this one, should other taxpayers contest IRS claims that taxes are due on the interest earnings from their bonds.
The IRS said the Whitewater Garden case will revolve around a number of important legal issues, including when the original issuance of the bonds occurred and whether the case should be governed by the tax laws that became effective in 1954 or those that took effect in 1986. These two sets of tax laws have slightly different requirements for when bonds are considered to be issued.
The IRS said the case also win probably address other tax law issues, such as:
* Whether an issuer's failure to publish a notice of a public hearing for a proposed private-activity bond issue is sufficient to disqualify the bonds for tax exemption.
* Whether tax law provisions that say private-activity bond proceeds can be invested in certain exempt functions are satisfied if bond proceeds are invested in a life insurance annuity contract that pays the debt service on the bonds.
* Whether the Whitewater Garden bonds are arbitrage bonds if the proceeds were invested in the life insurance contract.
The court agreed with the IRS' motion that the case not be tried as a small tax case. Small tax court cases, which involve tax liabilities of less than $10,000, are more informal than normal cases, IRS officials said. Decisions in such cases do not constitute precedent and cannot be appealed by either party, they said.
The Whitewater Garden issue is one of more than two dozen deals that were rushed to market and closed without cash by Matthews & Wright Inc. in the mid-1980s to avoid new tax law restrictions. Matthews & Wright Inc. is no longer in the municipal business. These deals were warehoused and not sold to public investors for cash until months after they closed.
The IRS told the Riverside County authority in 1991 that it would have to rebate the $2.25 million of arbitrage earned from the deal, or the bonds would be declared taxable. The IRS contended that the bonds were subject to rebate requirements because they were not validly issued until Feb. 20, 1986 - after the rebate requirements took effect.
The Riverside County authority refused to rebate the arbitrage and last year filed suit against the IRS in a U.S. district court to prevent the agency from taxing the holders of the bonds.
The court granted the authority a preliminary injunction preventing the IRS from collecting taxes, but then dismissed the case in July of this year after determining it no longer had jurisdiction. In dismissing the case, the court said that under a new IRS rule, the authority could rebate the arbitrage and then seek a refund.
Just three days after the suit was dismissed, the IRS notified Harbor Bancorp that it owed taxes on the interest it had earned from the bonds. The IRS told the bank that the bonds were taxable private-activity bonds because the proceeds were invested in a long-term guaranteed investment contract rather than the apartment project that had allowed the bonds to qualify for tax exemption. The IRS also said the issuer failed to publish a notice of a public hearing on the bonds before issuing them.
The IRS told the bank that it would not raise the arbitrage rebate issues that it had raised with the authority because of legal constraints, but said it might do so in the future.
Justice Department lawyers representing the IRS said at the time that the letter probably was drafted before the authority's suit was dismissed. They said the IRS was probably reluctant to discuss the arbitrage rebate issues if they were still being litigated.
But in its recent motion to the U.S. Tax Court, the IRS made clear that it still plans to litigate the arbitrage rebate issues along with the private-activity issues.
