WASHINGTON -- Five months ago I wrote a column that started with the line, "Hooray for the Internal Revenue Service."
I went on the praise the IRS for becoming more aggressive in going after abusive tax-exempt escrow bond deals just when it appeared as if the agency might allow the mess to keep on festering without bringing the perpetrators to justice.
But now I have to retract my comment and can only conclude that the IRS has lost its marbles.
I originally praised the IRS for calling the bluff of the Louisiana Public Facilities Authority by declaring four housing bond issues taxable and threatening to tax the bondholders if the authority and other participants in the deals, such as the bond counsel and underwriter, did not reach an agreement to compensate the IRS for lost taxes.
But last week, the agency took a quantum leap by actually starting to tax the interest earnings of bondholders in a questionable $34 million escrow deal sold in 1984 for the Sevier County, Tenn., Industrial Development Authority for a hotel renovation project that never got off the ground.
The details of this unprecedented move are quite hazy, but it appears as if the agency made little or no attempt to follow its usual practice of trying to negotiate a closing agreement with the issuer before going after the bondholders.
If the IRS had tried to go after the issuer and the other participants first and they refused to cooperate, it might be justified.
But by immediately trying to tax innocent bondholders the IRS is engaging in counterproductive overkill.
If the IRS goes after bondholders in other deals in the same manner, it could seriously undermine the municipal market by driving away investors, driving up borrowing costs, and hurting the ability of states and localities to finance projects the federal government claims it can no longer afford.
While taxing bondholders has always been the main enforcement tool available to the IRS, it isn't the agency's only weapon and should only be used as a last resort.
Significant new powers given the IRS by the 1989 tax bill allow it to retroactively seize all money received in an abusive bond deal -- permitting it to go after the deal participants who actually committed the abuse. But the agency has never once used those powers.
The IRS action also points up the desperate need for reform of the agency's system of enforcing the tax-exempt bond laws. Many bond lawyers, issuers, underwriters, and even some IRS officials have long felt that an alternative enforcement system should be developed that would penalize abuses without victimizing bondholders.
This incident makes it imperative that market participants start working with the IRS to develop such a system as quickly as possible. In the meantime, the IRS should use the powers it does have to go after the real abusers and not innocent bondholders.