Soon, the Internal Revenue Service (IRS) will begin asking governmental issuers of tax-exempt bonds about their compliance with the tax requirements governing those bonds.

Between 200 and 500 governmental issuers will receive a Post-Issuance Tax Compliance Questionnaire from the IRS in the coming weeks. You might be one of them and now is the time to prepare.

New Developments

The IRS continues to ratchet up its scrutiny of tax-exempt bonds. In May 2006, the IRS began mailing Compliance Check Questionnaires to a sampling of 501(c)(3) organizations that were conduit borrowers of tax-exempt bond proceeds. These Questionnaires are not an audit, but they may trigger an audit. The Questionnaires probed compliance with the broad range of tax requirements including arbitrage and rebate rules, how bond proceeds were spent and use of bond-financed facilities. But the centerpiece of the Questionnaire was its inquiry into the procedures the conduit borrowers had in place to comply with the tax-exempt bond requirements after the bonds were issued.

Now the IRS is turning its focus to governmental issuers of bonds.

Completion of a Compliance Questionnaire is voluntary. However, failure to reply to this Questionnaire will raise a red flag with the IRS that will substantially increase the risk the IRS will select a nonresponding entity for an audit. The IRS unit in charge of monitoring tax-exempt bond issuers has specifically stated that a main goal of these Questionnaires is to help the IRS select the issuers most ripe for audit. Steven T. Miller, head of the IRS tax-exempt bond compliance unit, noted, rather ominously, of the governmental issuers who do not respond: "[W]e will be in contact with them later."

In its initial round of Compliance Questionnaires to conduit borrowers, the IRS did not ask when an organization adopted its procedures for monitoring post-issuance compliance with the tax-exempt bond rules. This allowed many conduit borrowers to quickly draw up procedures and then answer "yes," they had adopted such compliance procedures. The IRS has indicated that its future Compliance Questionnaires will ask when post-issuance compliance procedures were adopted. The IRS has said that after-the-fact adoption of compliance procedures is certainly encouraged. Nevertheless, listing an adoption date for compliance procedures after the date an issuer receives a Questionnaire also could raise a red flag with the IRS.

These Compliance Questionnaires are part of the IRS' announced plans for increased scrutiny of issuers of tax-exempt bonds. While no penalties will flow directly from telling the IRS that you do not have post-issuance compliance procedures in place, or from telling the IRS that your post-issuance compliance procedures were put in place only after receiving a Questionnaire, such answers may increase your risk of being audited.