WASHINGTON -- The Internal Revenue Service is trying to tax interest earnings of nearly three dozen firms and individuals that bought tax-exempt bonds issued by the Riverside County Housing Authority in late 1985 to finance the Whitewater Garden apartment project, court papers reveal.

The IRS action was disclosed known late last week when U.S. attorneys asked the U.S. District Court for the Central District of California to dismiss a lawsuit filed by the Riverside authority to block the IRS and Treasury from collecting arbitrage or taxing interest from the $17.5 million Whitewater Garden issue.

"The [IRS] is presently examining the tax liability of the dozens of taxpayers who received interest from [the authority's] bonds in 1988, 1989 and 1990," the U.S. attorneys said in documents filed with the court. "The [IRS] needs to collect information on these taxpayers, audit them, issue them statutory notices of deficiency, and assess the tax, all before the statute of limitations expires," they said. The IRS generally has only three years after the date income was reported in which to collect any taxes owed.

The Whitewater Garden bondholders being pursued by the IRS include five corporations, three trusts, and 25 individuals, according to a written statement from an IRS revenue agent that the attorneys filed with the court.

Arbitrage Rules

The IRS currently is prohibited from either taxing the bondholders or collecting arbitrage from the authority under a temporary restraining order issued on June 21 by Judge Consuelo B. Marshall. The authority had asked for the order as well as a preliminary injunction that would bar the agencies from applying arbitrage rebate requirements to the Whitewater Garden issue.

But the U.S. attorneys told the court last Friday it must dismiss the case because it lacks the jurisdiction necessary to grant an injunction. It is taxpayers -- the bondholders -- and not the authority that are the target of the IRS enforcement action, they said. And two federal laws, the Anti-Injunction Act and the Declaratory Judgment Act, they said, generally prohibit court interference with tax collection activities.

"There is not a single case in the history of this country where a plaintiff has successfully enjoined tax examination, assessment and/or collection activities directed at third-party taxpayers," the attorneys said.

The authority only "has two lawful options" they told the court. One option is to do nothing, in which case the IRS will proceed to tax the bondholders. The other option is to "negotiate with the government" toward a settlement in which the authority would rebate the arbitrage to the government in return for the IRS not taxing the bondholders.

The attorneys also said the Riverside authority has failed to show it would suffer irreparable harm if IRS enforcement action were taken. No evidence has been presented to show the authority is unable to rebate the arbitrage, they said. The government, on the other hand, they said, would be harmed because tax collection activities would be halted.

The authority also has not shown that it could win, based on the substantive issues of this dispute, the attorneys said. At the root of the dispute is whether the Whitewater Garden bonds were validly issued on Dec. 31, 1985, before the arbitrage rebate requirements took effect.

The issue was one of 26 deals Matthews & Wright Inc. rushed to market and closed without cash in the mid-1980s to beat the arbitrage restrictions. Matthews & Wright purchased the bonds with a check from an undercapitalized credit union and then temporarily warehoused them with an unlicensed, offshore shell bank, not selling them to public investors for cash until Feb. 20 1986.

The authority says the bonds were validly issued on Dec. 31, 1985, when they were exchanged for a check, and that it does not matter that the check was not backed with sufficient funds. But the U.S. attorneys told the court the issue date if Feb. 20, 1986, because until then the transaction had no economic substance.

Other Tax Law Violations

"A basic principle of federal income tax law is that objective economic realities are given precedent over the particular form the parties employ," they told the court.

Further, arbitrage rules issued by the IRS in May 1989 state that the issuance data is "the first day on which there is a physical delivery of the written evidence of the bond in exchange for the purchase price" they said.

The bonds violated other tax laws, as well as the arbitrage rebate requirements, they said, including yield restriction requirements and possibly a revenue ruling that said there had to be reasonable expectations at the time of issue that the proceeds would be used for the project. The Whitewater Garden project was never built, but the bonds will remain outstanding until Dec. 1, 1993.

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