WASHINGTON -- In an unprecedented action, the Internal Revenue Service has begun taxing the interest earnings of holders of a $34 million municipal issue that was sold as tax-exempt in 1984 for the Sevier County, Tenn., Industrial Development Board.
The IRS's action has enraged bondholders and made industry officials worry that investors may desert the market if they can no longer be certain that tax-exempt bonds will always be tax-exempt.
The Sevier County bonds, which were underwritten by Donaldson, Lufkin & Jenrette Securities Corp., Matthews & Wright Inc., and Cumberland Securities Co., were supposed to finance the expansion and rehabilitation of the historic Mountain View Hotel in Gatlinburg, Tenn. But the projects never proceeded, and the bonds were redeemed on Dec. 15, 1987.
An IRS revenue agent, however, this week asked for $6,232 in taxes on $25,125 of interest earned in 1987 from more than $100,000 of the bonds that were held by Joseph Jarabak, a Valparaiso, Ind., resident and, according to his lawyer, long-time investor in municipal bonds who died in March 1989.
The IRS agent, Trina Hiemstra, made the demand in a June 24 letter sent to James S. Bozik, the lawyer representing Mr. Jarabak's estate. "The adjustments are the result of the determination that bonds [issued for] the Mountain View project are not tax-exempt," the letter says, without disclosing why the tax-exempt status of the bonds was being revoked.
Mr. Bozik said he also held a large block of the Mountain View bonds and expects soon to receive a similar bill from the IRS. He said he believes the IRS is going after other investors who held large blocks of the bonds, but not those who held small amounts. "I understand that others are being chased down. But it's not uniform," he said, declining to name other investors.
The IRS and industry officials said yesterday that this is the first public report of the IRS actually taxing interest earnings from a widely held municipal issue.
Mr. Bozik said he was contacted by Ms. Hiemstra in April and told to either agree to an extension of the IRS's three-year statute-of-limitations on the bond issue, which was to expire April 15, or face a written demand for payment of taxes on the bonds' interest within 90 days. The IRS cannot tax investors' earnings after three years from the date the income was reported. He said he agreed to the extension but then was unable to get any further information about the bonds from Ms. Hiemstra or her supervisors.
"I know nothing. I have received no information," he said.
Mr. Bozik was outraged by the demand for the taxes. "These bonds were sold by a national bond house. An opinion that they were tax-exempt was given by a reputable bond firm. And out of the blue comes this," he said.
He said the IRS told him he could request a hearing with the IRS's Office of Regional Director of Appeals or dispute the IRS's claim in the U.S. Tax Court. But he said he believes the bond firms that participated in the deal are responsible for resolving the dispute.
"Certainly the integrity of the industry requires that they be the aggressor here and that they should take care of this," he said.
Peter Christus, a senior vice president at Gabriele, Hueglin & Cashman, the firm that sold the bonds to Mr. Jarabak and Mr. Bozik, said yesterday that he was upset by the IRS's action and its potential adverse effect on the bond industry.
"This could be very damaging to the industry, if individual investors are going to begin getting these disconcerting letters. It makes us look like we're not monitoring and servising what we're selling," he said.
Mr. Christus said he was concerned about the lack of communication between the IRS and bond firms involved with the issue.
"The underwriters know nothing about it. The legal counsel knows nothing about it. The IRS is circumventing these channels and going right to the most innocent victim, the bondholder," he said. "I'd much rather learn about this from the IRS or the industry than from my clients."
Mr. Christus said he was not aware of the IRS's concerns about the bond issue until Mr. Bozik notified him that he had received the letter from the revenue agent.
A spokeswoman for Donaldson, Lufkin & Jenrette said yesterday that the IRS had not contacted the firm about the Mountain View issue. Officials with Cumberland Securities Co. said IRS agents requested documents for the deal earlier this year but did not discuss their concerns.
Mark Blotcher, a partner with Peck, Shaffer & Williams in Cincinati, bond counsel for the deal, said yesterday that the firm has never been contacted by the IRS about the issue but stands behind its opinion that the bonds are tax-exempt. "We are completely in sympathy with the bondholders. We don't think it's right. But we don't know what to do," he said.
Hugh Trotter, the chairman of the Sevier County Industrial Development Board, meanwhile, appeared to be completely in the dark about the bond issue.
He said the bonds were never issued. "We never issued bonds for the Mountain View Hotel. The IRS turned down the issue."
Mr. Trotter may have been referring to the IRS's failure to allow the bond firms involved with the issue to extend its three-year temporary period, during which arbitrage could be earned beyond 1987.
Some of the bond officials close to the deal said the IRS may be taking the position that the Mountain View bonds are not tax-exempt because there was no reasonable expectation at the time they were issued that the proceeds would be used for projects.
They said the IRS also might take the view that the issue violated a $10 million limit for industrial development bonds. According to former congressional aides, Congress enacted a tax law that prohibited issuers from getting around a $10 million limit on the amount of industrial development bonds they could issue by splitting a project up into several pieces, each of which had different ownership, and then selling separate bond issues for each piece. The tax law as enacted in 1984 was retroactively effective for bonds issued after Dec. 31, 1983.
The $34 million Mountain View issue was supposed to finance four separate projects, each of which was owned by a separate limited partnership. But the bonds were listed on one official statement and issued at the same time.
But Mr. Blotcher said yesterday that the Mountain View issue qualified for a special transition rule that allowed it to avoid the 1984 restrictions. "It's under a transition rule," he said. "We stand behind our opinion that the bonds are tax-exempt."
Several of the bond firm officials involved in the deal said yesterday that the IRS was investigating it only because Matthews & Wright was involved. They said that the Huff family, which owned the Mountain View Hotel, made a goodfaith effort to rehabilitate and expand it.
One of the family members, James A. Huff, was to have been the developer. "They worked on it for three years trying to develop it, but unfortunately Mr. Huff was working with a lot of family members and he didn't get it done," said one of the bond officials.