WASHINGTON -- The means the Internal Revenue Service has chosen to crack down on at least one abusive bond deal will produce exactly the opposite of what it wants.
The IRS is attempting to tax the interest earnings of bondholders in waht appears to be an abusive $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.
When the case first came to light a couple of weeks ago, it appeared as if the IRS had made few or no attempts to try to negotiate a closing agreement with the issuer before going after the bondholders.
But details of the case that have since emerged show that, starting five months ago, the IRS tried to get the industrial development authority that issued the bonds to pay $1.4 million to make up for tax revenues lost because of the deal. In exchange, the IRS would agree not to tax the bondholders.
However, the authority steadfastly maintained the deal was legitimate and refused to enter into a closing agreement. At that point, the IRS felt it had no choice but to use its ultimate weapon of declaring the bond taxable.
But the plot thickens, because it turns out that the IRS does not appear to be going after all the 160 bondholders in the deal. Instead, it seems to have targeted just four individuals and one bank that supposedly held large amounts of the bonds.
The indications are that it would be too costly and time consuming to go after all the bondholders, so the IRS is trying to send a message to the market that abusive deals won't be permitted by making an example of a few bondholders.
Unfortunately, those means will not produce the end the IRS wants.
Make no mistake, it cannot be said often enought that the IRS should ruthlessly track down and punish every perpetrator of the billions of dollars worth of abusive tax-exempt escrow and black box bond deals that were rushed to market in the mid-1980s.
But that means going after the issuers, underwriters, and bond counsel that fosited the deals off on the market -- not innocent bondholders.
Normally, when a bond issue is declared taxable, the bondholders joint together and sue the issuer, which in turn usually goes after the other participants in the deal to force a settlement that protects the bondholers.
By only going after a few bondholders, however, the IRS has left those few in a position where it would probably cost more to sue than it would cost to pay the tax.
As a result, the bondholders probably won't sue and the issuer, underwriter and bond counsel are all likely to get off scot-free.
Wrose yet, the means employed by the IRS are actually sending a messag that will encourage future abuses, because the perpetrators are being told, in effect, that they will not have to pay for their sins.