Magazine article Government Finance Review

What to Do When the IRS Audits Your Bonds

Magazine article Government Finance Review

What to Do When the IRS Audits Your Bonds

Article excerpt

Under the IRS's expanded enforcement program, it is much more likely today that a city, county, or special purpose district's bond issues will receive a notice or audit than in the past. As a result, issuers must be prepared to respond to an audit by having a basic understanding of the audit process. This article proved issuers with information on their rights and appeal procedures during the audit process.

In recent years, the Internal Revenue Service (IRS) has significant expanded its enforcement program for tax-exempt bonds. The enforcement program involves the audit of tax-exempt bond issues to determine their compliance with federal tax law requirements.

As a result, the likelihood that finance officers for cities, counties, school districts, and special purpose authorities will be involved with an audit has increased dramatically because of the IRS's increased attention to tax compliance. The IRS currently has 45 field agents conducting audits and has plans to increase the number of agents to 56.

Since the IRS initiated the expanded enforcement program, it has commenced audits on more than 750 bond issues. Of these audits, approximately 430 have been closed, leaving more than 300 audits currently underway. The IRS has sent preliminary determinations of taxability on over 40 of the bond issues it has audited.

Since stepping up its enforcement efforts, the IRS has focused on small issue industrial development bonds, as well as financings for hospital acquisitions, natural gas prepayment contracts, solid waste disposal projects, and stadiums. The IRS plans to look closely at single-family and multi-family housing transactions this year, as well as pooled loan programs and land-based financings. Last year, 89 issuers of private activity bonds were randomly selected for a mandatory survey of compliance with arbitrage rebate rules and 22 were found in violation. As a result, the IRS expects to increase its focus in this area, particularly with respect to variable rate debt and possibly expanding its inquiry to governmental bonds.

The IRS has indicated that the days of not having to worry about audits of tax-exempt bonds are over, and they expect to continue their enforcement efforts. Therefore, now more than that at any time in the' past, issuers must be prepared to respond to an audit by having a basic understanding of the audit process and the issues they will face. The purpose of this article is to provide issuers with information on the audit process, the disclosure issues encountered, appeal rights, and criteria for closing agreements. This will familiarize issuers with what to expect in the event their bonds are audited.

Audit Process

The Audit Letter. Every audit will commence with the IRS sending a letter to the issuer of tax-exempt bonds, even in the case of a conduit bond issue where another party is the true obligor. The opening letter simply identifies the bonds under audit and the name of the IRS examining agents that can be contacted for additional information. The initial letter also will explain generally why the bond issue is being audited as more fully discussed below. The letter also may contain a request by the IRS for information about the bond issue in question (for example, the IRS often requests a copy of the bond transcript.)

The Government Finance Officers Association's Working Group on IRS Audits recently sent the IRS recommendations on modifying its opening letter. These suggestions were designed to provide issuers with a better idea of the reason that the issuer's bonds were selected for audit. The IRS has agreed informally to modify the initial audit letter to explain generally why the bond issue has been selected for an audit.

The reason for an audit set forth in the opening letter from the IRS falls into three categories:

1) the audit of certain types of bond issues the IRS is interested in learning about, but where no specific tax problems have been identified, e. …

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