WASHINGTON - California officials and banks breathed a sigh of relief after the Internal Revenue Service announced Friday that interest earned from the state's registered warrants is tax exempt.

"We're very pleased" with the IRS decision, said a spokeswoman for state Treasurer Kathleen Brown.

Steve Nessier, vice president and director of taxes at Wells Fargo Bank, was also happy about the decision. "There is some benefit" from having the interest from the warrants declared tax exempt, he said.

California has issued about $1 billion on the IOUs to state employees and others instead of checks because state lawmakers were unable to agree on a budget before the current fiscal year began July 1. The warrants are promissory notes that bear a 5% interest rate.

"All of us are sailing in unchartered water [with the warrants], and I'm pleased the IRS is doing its part to make this instrument slightly more attractive," state Controller Gray Davis said just before the IRS decision was announced.

The decision, made in Announcement 92-111 released by the IRS on Friday, was good news for holders of the warrants, particularly banks that have been cashing the IOUs and now must hold them until they are paid by the state.

The IRS concluded the warrants were tax-exempt after finding that they had maturities of less than one year and that they were obligations of the state.

Also, the IRS found that neither the state nor the banks, when acting as brokers in buying the warrants, would have to submit 1099 tax forms reporting proceeds from such transactions.

The tax-exempt status of the warrants was questioned by banks and others because of uncertainty over whether they met the registration requirement for tax-exempt debt. Another concern was whether they constituted an exercise of borrowing power by the state.

Under the tax laws, interest from a bond generally is tax-exempt only if that bond is issued in registered form. IRS officials felt that the California warrants were not in registered form because they were treated like bearer bonds. In other words, anyone may cash a warrant, not just the person who receives it. However, bonds are exempted from the registration requirements if they have maturities of a year or less. And the IRS found that the warrants qualified for this exemption.

Ed Fong, a spokesman for the state controller, said Friday the state plans to put the following language on the back of its warrants to satisfy questions about their maturity: "The State Controller has determined that this warrant will be redeemable within one year from the date of issuance."

The tax laws also say that bonds must be "obligations" of a state or local government in order to be tax exempt. Questions had been raised whether the warrants were obligations because they are so unusual, having rarely been used by the state since the Great Depression, and because creditors were involuntarily receiving them. But the IRS found they qualified as obligations.

Treasurer Brown had asked IRS Commissioner Shirley Peterson earlier this month for an exemption from the broker information-reporting requirements so that banks and the state would not have to fill out and submit hundreds of thousands of 1099 forms to the IRS when the warrants were purchased by the banks or when they would be later purchased by the state and retired.

The IRS concluded that the state and banks did not have to comply wit the 1099 reporting requirements because of the enormous administrative burdens they would impose and because of the slim chance that the lack of reporting would lead to a reduction in capital gains.

The 1099 forms serve as a check on compliance with the capital gains tax by requiring brokers to report gross proceeds from the sales of securities.

"It would have been an administrative nightmare" for California if the IRS had concluded the state had to comply with these information reporting requirements, said the spokeswoman for Ms. Brown.

Despite the good news from the IRS, California officials still must contend with banks in the state, such as Bank of America and Wells Fargo, that have warned they will soon stop honoring the IOUs, Bank officials fear that by accepting the warrants they are prolonging the state's budget crisis and insulating state leaders from criticism for their failure to resolve budget issues.

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