WASHINGTON -- The test case challenging whether the IRS has the right to tax municipal bondholders entered its final phase this week as a U.S. Tax Court judge received final reply briefs from both sides and began his deliberations.

Judge Julian I. Jacobs is not expected to issue a ruling for several months, lawyers familiar with the case said.

In their final submissions to Jacobs, lawyers for the Internal Revenue Service and bondholders attempted to shoot down each others arguments, which had been made in briefs filed in September and throughout the 10-day trial in May.

The IRS, for example, denied the bondholders' contention that taxing interest on the Whitewater Garden and Ironwood bond issues would have a chilling effect on the municipal bond market.

"It would be more logical to assume that enforcement action which promotes honesty and fair dealing in the bond market would facilitate an efficient market," the IRS brief states.

But lawyers for the bondholders continued to insist that taxing the interest on the bonds would undermine investor reliance on tax-exempt bonds and would threaten to "diminish or eliminate entirely the willingness of the average investor to select a municipal bond for his or her investment portfolio. By doing so [the IRS] seriously jeopardizes the ability of state and local governments to fund public works through tax-exempt bond offerings."

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

Harbor Bancorp., a bank based in Long Beach, Calif., and Edward and Elena Keith, residents of Pebble Beach, Calif., initiated the case before the tax court to fight the IRS's decision to revoke the bonds' tax-exempt status.

The issue date of both issues remains in dispute. Harbor Bancorp and the Keiths claim the bonds were issued on Dec. 31, 1985, the date they were purchased with a check. That date is also the day before tough arbitrage restrictions approved by Congress became effective.

But the IRS says that since the check was no good, the Dec. 31 issuance was a "sham" and the bonds were not validly issued until Feb. 20, 1986, when they were remarketed and sold to investors for cash.

Even if the judge finds that the debt was validly issued in 1985, the IRS brief argues the bonds are taxable on the grounds the issuer did not establish a reasonable expectation that bond proceeds would be used for housing rather than to earn arbitrage.

But in their final brief filed this week, lawyers for the bondholders say there was no evidence presented at the trial to support that contention. The Riverside authority "never expected, and did not authorize, the purchase of long-term guaranteed investment contracts with bond proceeds which would be used to pay debt service on the bonds," the lawyers' brief says.

IRS lawyers, in their final brief, say that if the court rules that the bonds are tax-exempt, "despite the numerous failures to satisfy [federal bond rules], then the United States and not the responsible parties will lose because a federal subsidy will have been misapplied."

Lawyers for the service also disagreed with the bondholders' argument that it is unfair to tax them because they were innocent third parties in the transaction with no control over the behavior of the underwriter or the issuer.

"Many other provisions of the code expose taxpayers to the risk of taxation from unknown acts of third parties over whom the taxpayer has no control," such as limited partners in partnerships and participants in qualified deferred compensation plans, the IRS says in its brief.

But the lawyers for the bondholders warned that, left unchecked, the IRS's power to revoke the tax exemption on municipal bond issues will be "an unfettered way to collect revenue." When a bond is declared taxable, "the average investor will be left without a practical remedy," according to the brief.

"In most cases, the cost to the investor to litigate such a case will exceed the amount of the proposed deficiency." That would probably lead investors to file class action suits against issuers, trustees, and other participants in the bond deal, the brief states. "Because the service will not be a party to such actions, the fundamental question of whether the [IRS's] determination of taxability was correct may never be decided."

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