As memories begin to fade of the excitement we all had in trying to decipher the alphabet soup of tax credit bonds enacted during the depth of the recession, the IRS recently reminded us that our interpretations of those often vague rules may soon be put to the test of an audit. On July 20, the IRS issued “IRS Memorandum on Procedures for Conducting Examinations of Direct Pay Bonds” (the “Memorandum”)(see link below) applicable to those tax credit bonds that provide direct US Treasury payments to the issuer. These procedures will be incorporated into section 4.82.6 of the Internal Revenue Manual (IRM). As it turned out, what started as a special election available for only certain types of tax credit bonds quickly overwhelmed in popularity the much less efficient – and thus less beneficial to issuers — tax credit bonds that provided federal income tax credits to the bond holders.
First, a quick reminder of what bonds we’re talking about. As originally introduced in the American Recovery and Reinvestment Act of 2009 (ARRA), the direct pay alternative for tax credit bonds was available only for build America bonds (BABs) and their close – and more generous – cousin, recovery zone economic development bonds (RZEDBs), paying a 45% credit rather than the 35% credit available for BABs. With the popularity of the direct pay option for these bonds, this option was extended to additional tax credit bonds in 2010 by the Hiring Incentives to Restore Employment Act (HIRE, an acronym furthering the perception of some wags that executive branch and Congressional staff may spend more time on clever names than on the substance of the law). The new direct pay bonds, entitled to credits of up to 70% or 100% of the interest payments, were new clean renewable energy bonds (New CREBs), qualified energy conservation bonds (QECBs), qualified zone academy bonds (QZABs) and qualified school construction bonds (QSCBs).
As the name of the Memorandum indicates, it is limited to procedural rules; not substantive rules or guidance. It opens with the general statement that the examination procedures applicable to tax-exempt bonds will also apply to direct pay bonds except as provided in the Memorandum. The Memorandum further provides, however, that an audit will generally begin with review of the Form 8038 required upon issuance of the bonds (i.e., 8038-B for BABs or 8038-TC for other tax credit bonds) and then, if an adverse determination is reached as to availability of the direct payments, an examination of related Forms 8038-CP, filed to claim the credit payments, will be opened when the Notice of Proposed Adjustment is issued for the bonds.
One of the interesting (of course, only to tax geeks aficionados) features of the Memorandum is the amount of detail devoted to applicable statutes of limitation. In the case of tax-exempt bonds, the statute is generally applied by determining the period that the statute would be open for a typical calendar year bond holder who has not agreed to extend the statute. For direct pay bonds, as the Memorandum states, the analysis begins with the rule that the credit payment is treated as the refund of an overpayment of tax (not clear how this squares with applicability of sequestration – I haven’t heard of any other refunds of tax overpayments being subject to sequestration – a topic for another day). The period for assessment of tax (that is, the period during which the “direct payment” can be recovered by the IRS) is described in the Memorandum as three years from the date the particular Form 8038-CP was filed. Two points are worth noting: (1) Not surprisingly, a separate limitations period applies to each Form 8038-CP, and (2) The rule of IRC section 6501(b)(1) treating tax returns that were filed before the due date as though filed on the due date does not apply to Form 8038-CP because the due date for that form was not established by the Code or regulations but by the IRS in the instructions for the form.
The Memorandum also provides guidance to agents in requesting extensions of the limitations period. This is an option available to the IRS in the case of direct pay bonds that generally does not exist for tax-exempt bonds, where only the bond holders could extend the statute (of course in theory the IRS could identify and then solicit extensions from bond holders). If the issuer refuses to extend the limitations period, the IRS will generally issue a “statutory notice of deficiency” (also called the “90-day letter,” described further below) even if the case is not fully developed to preserve its opportunity to recover earlier direct payments.
Additional highlights of the Memorandum:
- Potential noncompliance related to the qualification of direct pay bonds is described by the agent on Form 5701-TEB, as for tax-exempt bonds. The Memorandum says that the resulting adjustments “should be” approved by the agent’s group manager before they are provided to the issuer.
- If the issuer does not agree with the adjustments described on Form 5701-TEB and the resulting adjustments to direct payments, the agent will issue the 30-day letter, which will include all Form 8038-CP periods subject to the proposed adjustment and issue it simultaneously with the Proposed Adverse Determination Letter. The 30-day letter notifies the issuer of its opportunity to protest the proposed assessment to Appeals. The Memorandum says that the 30-day letter also “should be” approved by the agent’s group manager.
- Subsequent Forms 8038-CP filed during the audit will apparently be honored (and paid) but will be associated with any pending Proposed Adverse Determination for consistent resolution.
- If the issuer does not timely protest the 30-day letter (or the statute of limitations is close to expiring and the issuer refuses to extend), the IRS will issue a statutory notice of deficiency (90-day letter). The Memorandum describes the purpose of the 90-day letter as “to ensure the taxpayer [issuer] is formally notified of the IRS’s intention to assess a tax deficiency and to inform the taxpayer of the opportunity and right to petition the Tax Court to dispute the proposed adjustments.” All 90-day letters are subject to a formal review process.
In summary, the Memorandum provides an interesting blend of the audit procedures applicable to tax-exempt bonds and those applicable to private sector taxpayers, a blend that results from the unique combination of tax-exempt bond rules and payments flowing directly between Treasury and direct pay bond issuers.