WASHINGTON -- An unprecedented court challenge to the IRS' right to tax bondholers is scheduled to begin today in the U.S. Tax Court in Los Angeles.

The case is being brought by Harbor Bancorp, a bank based in Long Beach, Calif., and Edward and Elena Keith, residents of Pebble Beach, Calif., who are challenging the Internal Revenue Service's right to collect a total of $67,833 in back taxes on their interest earnings from Whitewater Garden and Ironwood black box bonds.

The IRS contends Harbor Bancorp owes $19,763 and the Keiths owe $48,070 in back taxes because the $17.5 million Whitewater Garden and $13 million Ironwood multifamily housing bond issues violated tax laws and are not tax-exempt.

The bondholders insist that the bonds did not violate tax laws, but argue, even if they did, that the IRS does not have the right to tax the bondholders because they are innocent of any wrongdoing. The IRS' sole remedy in such tax disputes is to either reach a settlement agreement with the issuer or disqualify the issuer from future bond issues, they say.

Judge Julian I. Jacobs is expected to preside over a 10-day trial that may hear testimony from about 40 witnesses, including IRS officials from Washington; Neil Arkuss, a lawyer with Palmer & Dodge in Boston who is serving as the government's expert witness; Arthur A. Goldberg; and James Newman.

Goldberg, the former executive vice president of Matthews & Wright Inc., the defunct municipal under-writing firm, is believed to have been the chief architect of a circular cashless closing scheme for roughly two dozen bond deals, including Whitewater Garden and Ironwood, that were rushed to market in the mid-1980s to beat the tax law's new arbitrage rebate restrictions.

In these deals, the bonds were purchased with checks from an under-capitalized credit union and temporarily warehoused in an unlicensed, offshore shell bank for several weeks until they were sold to public investors for cash.

Newman, a former lawyer and special tax counsel for the Whitewater Garden and Ironwood deals, is credited with helping to design the black box structures that were used for them and dozens of other bond issues.

In these deals, called black boxes because of their complex circular structure and numerous participants, bond proceeds seemed to disappear and to ultimately be locked into longterm guaranteed investment contracts that paid debt service on the bonds, rather than being available for the projects.

In a trial memorandum filed with the tax court, the IRS says Goldberg will decline to answer substantive questions about Matthews & Wright, under his Fifth Amendment right against self-incrimination. Newman, the IRS says, will not voluntarily testify without immunity from the Justice Department.

Goldberg and Newman pleaded guilty to charges related to specific bond deals years ago in separate plea agreements with different U.S. attorneys.

The $17.5 million of Whitewater Garden bonds and the $13 million of Ironwood bonds were issued by the Riverside County, Calif., Housing Authority to build apartment projects. The Whitewater Garden project was never built. The bondholders contend the project was not built because of a sewer connection problem. The Ironwood project was built under the name Cross Creek Village, but not with bond proceeds, according to the federal government.

The issue date of both issues is a major source of dispute in this case.

Harbor Bancorp and the Keiths claim the bonds were issued on Dec. 31, 1985, the date they were purchased with a check.

The IRS, however, says that since the check was no good, the Dec. 31 "issuance" was a "sham" and the bonds were not validly issued until Feb. 20, 1986, when they were remarketed and sold to investors for cash.

The IRS contends that because the bonds were not issued until 1986, they are "arbitrage bonds" and are subject to arbitrage rebate requirements, which took effect for tax-exempt multifamily housing bonds issued after 1985.

The IRS says that even if the bonds were issued in 1985, they would still be taxable because the housing authority had no reasonable expectations that arbitrage would not be earned or that the proceeds would be used for housing. Housing authority officials executed so-called no-arbitrage certificates for the bonds that were blank and filled in later, the IRS says.

The IRS contends the bonds also are not tax-exempt multifamily housing bonds because the proceeds were never used for residential rental housing. Under the tax law, for multifamily housing bonds to be tax-exempt, "substantially all of the proceeds" must be used for residential rental housing, a portion of which must meet low-income limits.

In addition, the Whitewater Garden bonds are taxable because the housing authority failed to publish a notice of a public hearing on the bond issue, the IRS says. While the hearing notice requirement "may appear trivial or overly technical, it is an absolute statutory prerequisite to tax-exempt status of the bond issue," the IRS' trial memo says.

Harbor Bancorp and the Keiths, in their trial memo, say they will show that the bonds were validly issue on Dec. 31, 1985, under federal tax and securities laws and California laws. "Under general contract law, a check [or share draft] is considered good and valuable ..." they say.

The bank and the Keiths say they will "produce overwhelming evidence" that the housing authority "acted with diligence and reasonableness" in establishing its reasonable expectations that the bonds would be used for their intended purpose.

Even if it is determined that the bonds were issued in 1986, the bonds are not arbitrage bonds, they say. The arbitrage status of bonds is determined on the issue date, they say. Further, the IRS' own rulings make clear that the arbitrage status of bonds depends on the actions of the issuer and not on the conduct of third parties unrelated to an issuer, they say.

The bond documents did not authorize Matthews & Wright or anyone else to purchase guaranteed investment contracts. Therefore, the GICs are not "allocable" to the bonds, they say.

The bonds do qualify as tax-exempt multifamily housing, the bank and Keiths say, because the tax laws and rules require only that the issuer and bond documents set forth the financing intent "as of the date of issue."

The three bondholders claim the housing authority satisfied the hearing notice requirement.

The bank and Keiths say that the IRS' attempts to tax them is "not authorized under the regulations" and "is contrary to announced IRS policy, past and present."

"No tax policy is a sound one that places the burden of proof on the bond investor," they say. "Such a tax policy will result in uncertainty for investors, chill the municipal securities market and create unnecessary litigation," the two parties say.

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