WASHINGTON - The Internal Revenue Service has formally declared that the interest earned on the $17.5 million Whitewater Garden black box bond issue is taxable and has begun notifying some bondholders that they owe back taxes on the earnings.

Officials with Harbor Bank of Long Beach, Calif., said yesterday they received a letter from the IRS on, July 30 saying the bank owed $19,763 in back taxes on the interest earned during 1988, l989, and 1990 from $250,000 of Whitewater Garden housing bonds held by the bank.

Other Whitewater Garden bondholders have received similar letters from the IRS, according to William Rosenberger, the executive director of the Riverside County, Calif., Housing Authority, which issued the bonds as tax-exempt in December 1985. He said he did not have the bondholders' names.

This appears to be only the second time the IRS has tried to tax the holders of a bond issue that is widely held by public investors. Last year, the IRS began taxing holders of a $34 million issue that had been sold as tax-exempt in 1984 for the Sevier County, Tenn., Industrial Development Board.

The letter to Harbor Bank was sent just three days after a U.S. district judge in California dismissed a lawsuit the county authority had filed last year to prevent the IRS from either collecting arbitrage or taxing the interest earnings from the bonds. The suit was brought after the IRS contended in February 1991 that the bonds were subject to arbitrage rebate requirements.

Harbor Bank officials said yesterday they will file a petition in the U.S. Tax Court challenging the Internal Revenue Service's determination that it owes taxes. The IRS letter, which said the agency had determined the bonds were taxable, gave the bank 90 days from July 30 to petition the U.S. Tax Court to reconsider that determination.

Bank officials also said they are considering filing a lawsuit against the county authority to force it to assume the tax liability on the bonds. "Our position is that this should be between the county and the IRS, and not the investor and the IRS, because they were represented as tax-exempt bonds to us and we bought them as tax-exempt." said, Melissa Lanfre, chief financial officer for the bank. Ms. Lanfre said the bank, whose assets total about $165 million, purchased the Whitewater Garden bonds from Bear, Stearns & Co. in July 1986 and held them until February 1992. She said the bonds represented about 25% of the bank's investments in municipal obligations, which are part of an investment portfolio totaling between $20 million and $25 million. Ms. Lanfre also said the bank has procedural as well as substantive concerns about the IRS letter and will seek a waiver of the letter, known as a 90-day notice, on grounds that it violated the IRS' own procedures.

"We were not given the correct service process that taxpayers normally get." Ms. Lanfre said. Taxpayers are supposed to get 30-day notices from the IRS before 90-day notices, but the bank never got a 30-day notice, she said.

Ms. Lanfre said she was told the IRS wanted to assess the bank for back taxes before the end of 1993, when a statute of limitations would prevent it from collecting taxes on interest earned during 1988.

But a federal lawyer who has represented the IRS in tax cases said the IRS is not required to send taxpayers 30-day notices. Under the tax laws, he said, the IRS must send taxpayers so-called 90-day deficiency notices.

The notices inform them that they owe taxes and that they have 90 days in which to contest that finding in the U.S. Tax Court. At IRS can send the taxpayer an assessment of taxes.

The IRS has the right to seize the taxpayer's property or assets if the taxpayer fails to petition the U.S. Tax Court during the 90-day period before the assessment is sent, the lawyer said.

As an alternative to going to the U.S. Tax Court, the taxpayer can pay the back taxes and seek a refund in either the U.S. district court in the taxpayer's jurisdiction or the U.S. Claims Court. the lawyer said.

The IRS letter to Harbor Bank stems from a dispute, with the Riverside County Housing Authority over whether the Whitewater Garden issue is subject to arbitrage rebate requirements.

But in the letter to the bank, the IRS said the bonds do not qualify for exemption because they violated private-activity bond restrictions. The letter says the bonds were private-activity bonds, or industrial development bonds, that did not fall within the categories of these bonds permitted to be tax-exempt. The letter also said the county authority failed to hold a public hearing before the bonds were issued.

The IRS said in the letter that it was refraining from saying the bonds were not tax-exempt under arbitrage requirements because of "existing legal constraints."

The lawyer who represents the IRS in tax cases said the IRS letter was probably drafted before the authority's suit against the IRS was dismissed by Judge Consuelo Marshall of the U.S. District Court for the Central District of California in Los Angeles. The judge had granted a preliminary injunction against the IRS preventing it from collecting arbitrage or revoking the tax-exempt status of the bonds under the tax law's arbitrage restrictions.

The IRS has contended that the issue was not validly sold until Feb. 20, 1986, after the rebate requirements took effect. It is among dozens of deals that Matthews & Wright, a former underwriter of municipal bonds, rushed to market to beat arbitrage restrictions.

The bonds were purchased with a rubber check and warehoused with a sham bank. The authority says it was unaware the check was bad or the bonds were warehoused, and believed the bonds were validly issued on Dec. 31, 1985.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.