WASHINGTON -- This wasn't supposed to happen.
Harbor Bancorp of Long Beach, Calif., and a handful of other bondholders are threatened with having to pay back taxes on the interest they earned from municipal bonds that ran afoul of the tax laws.
The bank is challenging the Internal Revenue Service's right to collect the taxes in a lawsuit that is to be heard by a U.S. Tax Court judge in February.
Other investors, unwilling to be saddled by the huge legal fees that could result from such battles, are simply paying the back taxes.
Three years ago, most municipal industry officials said the IRS would never tax municipal bond investors. It would be too risky politically, they said.
Besides, the bondholders would sue the IRS, forcing the agency into the embarrassing position of having to explain to some judge why innocent widows were being taxed instead of the real perpetrators of the tax law violations.
Even if IRS officials wanted to revoke the tax-exempt status of a bond issue, it would be too difficult and costly to track down the bondholders, they said.
The industry expected the IRS to continue to settle such tax disputes through closing agreements, which protect the bondholder from being taxed once the IRS is compensated for the back taxes by the issuer or the bond firms.
So much for the misguided views of industry observers.
But IRS officials weren't any more accurate in their predictions.
They thought governmental issuers would go to any lengths to negotiate settlements over bad bond deals in order to protect their standing in the market.
The IRS officials also thought that if the IRS decided. at some point, to revoke the tax-exempt status of a bond issue, the bondholders would sue the participants of the transaction, thereby meting out a sort of indirect justice to the real transgressors of the tax laws.
Why was everyone so far off base?
For one thing, no one foresaw that some issuers would take a stand against the IRS. But in early 1991, the Louisiana Public Facilities Authority did. When the IRS warned that it might tax the holders of the $41.58 million multifamily housing issue that the authority sold in 1984, the issuer opted against the settlement route and threatened to bring court action against the agency.
The authority, in effect, won the battle after the IRS ran up against a three-year statute of limitations on the bonds.
A year later, the Riverside County, Calif., Housing Authority also refused to consider a settlement. The authority sued the IRS in a U.S. district court to prevent the agency from taxing the holders -- Harbor Bancorp among them -- of $17.5 million of Whitewater Garden multifamily housing bonds it had issued in 1985.
The city of Galt, Calif., followed suit, so to speak, in another federal court, challenging the IRS' attempts to collect taxes from holders of $29.29 million of governmental improvement bonds that had been issued in 1986.
The dismissal of these lawsuits in 1992 -- by federal judges who agreed with the IRS' lawyers that their courts lacked jurisdiction in these matters -- meant big trouble for bondholders. They began receiving tax bills from the IRS, which can only be disputed in the U.S. tax court, a more comfortable forum for the IRS than the district court.
The bondholders, it has since become apparent, are not only the innocent victims in such situations, they are also the most helpless in terms of defending themselves.
Most individual bondholders do not have the financial resources of a state and local government or a bond firm. Unlike the IRS, they have no access to the names of the other investors that purchased bonds from the same issue.
Without any ability to band together and pool their resources, they are left having to fend for themselves. It does not take long for a bondholder to realize that it is cheaper to pay the IRS a few thousand dollars than to risk having to pay more than that in legal fees to fight the agency.
Investors, in fact, have not sued the issuers and other participants of these deals. Thus far, the only lawsuit against an issuer, the Riverside County Housing Authority, was filed by a developer who is seeking to avoid having to pay the legal fees the authority incurred in its fight with the IRS.
There have been other misguided assumptions and surprises.
Industry officials once warned that investors needed to be assured that their bonds would remain tax-exempt or the municipal market would be ruined. Clearly that hasn't been the case. Even though a number of bondholders have been taxed in recent months, the municipal bond market, as a whole, hasn't seemed to care.
The issuers whose bonds have been the subject of IRS enforcement action have not been deterred from continuing to bring bond issues to market.
Perhaps the biggest error in judgment is on the part of the bondholders. Some of them, including Harbor Bancorp, appear to believe that it makes a difference that they weren't responsible for the tax law violations.
Harbor Bancorp is going to be disappointed.
None of the litigation thus far has been aimed at ferreting out the guilty parties in these deals.
The IRS doesn't care who is to blame for the tax law violations in the Whitewater Garden bond transaction. The IRS doesn't care that Harbor Bancorp is an innocent victim.
The agency's sole intent in the Whitewater Garden tax court case is to prove that the bonds violated the arbitrage rebate requirements. The agency could care less who committed the violations.
The IRS knows that once the tax law violations are proven, the tax laws clearly give it the authority to tax the bondholders.
No, it hasn't turned out the way anybody thought it would.