LOS ANGELES - The federal tax court judge overseeing the Whitewater Garden and Ironwood black box bond case this week voiced strong concern over an IRS remedy that can penalize bondholders, whom he referred to as "innocent" parties in the proceeding.

In comments both on and off the court record, Judge Julian I. Jacobs has made it clear that he is troubled over a solution that entails having the Internal Revenue Service declare the bonds taxable.

Lawyers for the Internal Revenue Service have tried to stress that they pursued this avenue only after attempting to negotiate a closing agreement with the Riverside County Housing Authority, the issuer of the bonds. They also have contended that the IRS has a clear right to declare bonds taxable when a transaction apparently violates IRS regulations.

Late Wednesday and yesterday morning, however, Judge Jacobs made various comments that indicate he is concerned about the broader implications of penalizing taxpayers when they had no knowledge of a deal's potential defects.

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. The bank and the Keiths are challenging the IRS' right to collect a total of $67,833 in back taxes on their interest earnings from Whitewater Garden and Ironwood black box bonds.

Among other things, the judge has expressed concern about the potential implications for the municipal securities market if he rules on behalf of the government and lets the remedy stand.

"How can anybody in good faith not worry about this problem," Jacobs asked. Investors might seek to have a "worry factor" built into future pricings as protection against having other deals declared taxable in the future, he said.

Jacobs interjected the remark off the court record - meaning it will not appear in the transcript - while an IRS official was testifying yesterday morning. Jacobs remarks, however, do not indicate that he will rule in a particular way in the case.

Lawyers from Bryan Cave, the law firm representing the bondholders, called two IRS officials to testify in an attempt to show that the decision to tax bondholders contradicted past and present IRS policy.

Michael Montemurro, branch chief in the individual tax devision of the IRS in 1985, was called to give restricted testimony pertaining to grand jury testimony that he gave regarding a separate Guam multifamily bond issue.

The Bryan Cave lawyers particularly focused on Montemurro's grand jury testimony to the effect that the IRS wants to protect bondholders and not disrupt the market by making interest earnings taxable.

Montemurro testified that that was his understanding of the IRS policy at the time unless there were "material misrepresentations of fact" surrounding the execution of a no-arbitrage certificate by the issuers.

The term "material misrepresentations" was never defined by the IRS, Montemurro said, and the scope of protection provided for bondholders was "always somewhat in dispute."

Marcus Owens, director of the exempt organizations technical division of the IRS, also was called to testify yesterday morning about a speech he gave earlier this year to an American Bar Association meeting in Houston regarding the new IRS tax-exempt bond enforcement program.

The bondholders' lawyers pressed Owens about certain remarks, including whether the IRS wants to avoid disrupting the market as much as possible. At one point, Judge Jacobs intervened to clarify if the IRS is worried about disruption of the market, to which Owens replied, "the answer is yes."

Juan Keller, the Bryan Cave lawyer who questioned Owens, also pressed the official on whether "bondholder beware" should be the standard in cases where the IRS cannot reach resolution with an issuer over an arbitrage dispute.

Judge Jacobs intervened again to clarify whether bondholders indeed could expect "the worst" in such cases and possibly see an issue declared taxable. Owens testified that that is the current law, "for better or worse."

At around this point in the questioning, Judge Jacobs went off the court record to underscope some of his broader concerns about questions being raised in the case. If it is shown in this case, for example, that arbitrage profits went into the hands of the underwriters rather than the county, Jacobs wondered what the likelihood was of the IRS and the issuer reaching a closing agreement when the issuer will argue it did not get the money in the first place.

The end result, he said, is that "innocent taxpayers" get dragged into court because of the remedy of declaring the issue taxable.

Jacobs said: "I wouldn't be surprised" to see Congress try to address this dilemma if the tax court upholds the government's action to tax the bonds. Jacobs also suggested Owens may want to raise this concern when upon returning to Washington D.C., and the judge prompted some laughter in the courtroom when he said "I would bless you" if Owens could make the case "go away."

Other testimony over the last two days has focused on the handling of the bond sales themselves. Bryan Cave lawyers have attempted to show that local officials did not realize anything was amiss with the deals. On cross-examination, however, lawyers for the IRS have tried to show that various discrepancies in the bond documents and other material should have raised a red flag.

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 Ironwood project was built under the name Cross Creek Village, but not with bond proceeds, according to the federal government.

Part of the dispute centers on the issuance date for the bonds. Harbor Bancorp and the Keiths claim the bonds were issued on Dec. 31, 1985, the date they were delivered.

The IRS, however, contends the issuance was a "sham" because it involved a so-called black box structure featuring a cashless closing scheme.

The IRS claims the bonds were not validly issued until a remarketing in 1986, which would qualify the debt as "arbitrage bonds" subject to arbitrage rebate requirements for tax-exempt multifamily housing bonds issued after 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.