WASHINGTON--The industrial development bonds issued for a Tennessee hotel project in 1984 are not tax-exempt because they violated the $10 million limit on small-issue IDBs, the reasonable expectations requirement, and other tax laws and rules, an International Revenue Service report concludes.

The findings appear in an IRS report the agency made available late last week to a lawyer representing one of a handful of investors who purchased the bonds and whose interest earnings are now being taxed by the IRS.

The report was sent to James Bozik, a lawyer representing the estate of Joseph Jarabik, a resident of Valparaiso, Ind., who died in March 1989 and who had held about $300,000 of the bonds. The IRS is seeking $6,232 in taxes on $25,125 in interest Mr. Jarabak earned from the bonds in 1987.

The bonds were issued as tax-exempt by the Industrial Development Board of Sevier County, Tenn., to finance the expansion and rehabilitation of the historic Mountain View Hotel in Gatlinburg. But the project never got off the ground, and the bonds were redeemed in 1987.

The IRS report said the Mountain View transaction was structured by Donaldson, Lufkin & Jenrette Securities Corp., Matthews & Wright Inc., and Cumberland Securities Co., to be four separate issuances of less than $10 million each. The issuances were meant for four separate projects so each issue could meet the definition of a small-issue IDB and be tax-exempt.

"However, it is the government's position that the issues do not meet the requirements to be considered as separate issues," the report said, because the proceeds were to be used to construct one facility and were to be lent primarily to one individual, James A. Huff.

The bonds also must be deemed as a single issue under Revenue Ruling 81-216, the report said. That ruling provides that two or more bond issues are a single issue if they are sold at substantially the same time and same rate of interest, pursuant to a common plan of marketing, and with a common or pooled security available to pay debt service.

The IRS report said there could not have been any reasonable expectations at the time of issuance that they would be used for the projects. Mr. Huff had already encountered difficulty in obtaining financing for the Mountain View project before the bond proposal ever surfaced. The bond transaction was structured in a way that made financing even more difficult to obtain, the report said, because for Mr. Huff to get the bond proceeds he first had to obtain alternate financing with triple-A credit backing.

"If [Mr. Huff] could have secured the alternate financing [as he attempted to do] before the bonds had been issued, then their issuance would not have been necessary. Prior to the issuance of the bonds, any financing would have been acceptable, but was unavailable. The rating requirement made the reasonable expectation of securing financing even more remote," it said.

The issue also failed to meet several tests for reasonable expectations that appear in Revenue Ruling 85-182, such as that the necessary credit support be in place before bond issuance, the report said.

"The requirement for alternate financing would appear to be a device to ensure that the project was not completed, but that sufficient arbitrage profits were earned to cover the costs of the issuance," the report said.

Mark Blocher, a lawyer with Peck, Shaffer & Williams, bond counsel for the Mountain View transaction, however, said Mr. Huff "represented and felt, realistically we think, that he could get financing at the time."

The IRS report said the Mountain View issue violated IRS rules for a temporary period, in this case a three-year period during which arbitrage could be earned without restriction. IRS rules say an issuer can earn arbitrage during a temporary period if 85% of the spendable proceeds are spent on the project; the issuer within six months or a year enters into a "substantial binding obligation" to begin or acquire the project; and work proceeds on the project with "due diligence."

Mr. Blocher said there were "no surprises" in the IRS report, based on a quick review of it. "These were all questions and matters that we considered at the time of the closing and when we met with the IRS later to get an extension of the temporary period. We still stand by our opinion," he said. The IRS is seeking taxes from a handful of other investors who also purchased the bonds, including a bank, Ron Sharp, a lawyer who represents the Sevier County board, disclosed yesterday. "They"ve evidently notified several bondholders," Mr. Sharp said. But he refused to identify other bondholders who have received notices.

Mr. Sharp also contends the Mountain View bonds did not violate any tax laws and should be tax-exempt. "This was not done for the sole purpose of raising revenues. It was done to build a project. We had opinions from counsel that the bonds were tax-exempt," Mr. Sharp said.

He said an IRS revenue agent first contacted him about the Mountain View issue in late February or early March. He said he had several telephone conversations and a meeting with the agent, who eventually concluded that the bonds were not tax-exempt.

Mr. Sharp also said the agent told him the Sevier County board could pay the IRS about $1.4 million to cover the taxes owed by bondholders and then the bondholders would not be taxed. But the board would not consider such a payment, he said. "This is a small county, a small town, and we're an industrial development board that has no assets," he said.

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