A newly reorganized Internal Revenue Service is making its presence felt in the tax-exempt bond market.
A case in point: its audit of the giant bond issue used to create Ascension Health, the St. Louis-based Catholic healthcare giant.
When Ascension disclosed the audit this month (May 22, p. 8), the year-old merger of Daughters of Charity National Health System and Sisters of St. Joseph Health System paid an immediate financial penalty as the yield on its variable-rate debt jumped. The increase reflected investor worries that the bonds might lose their tax-exempt status, although Ascension officials said they were sure the deal is legal.
The higher yield cost the system $50,000 in additional interest in one week, says Jerry Widman, Ascension's chief financial officer. Higher interest could carry on as long as the audit remains pending.
That's been the case for MedStar Health in Columbia, Md. It saw rates on its approximately $300 million in variable-rate debt increase about 1.5% since the IRS commenced an audit in April 1999, says spokesman John Marzano. That has cost the system about $4.5 million annually.
Audits of high-profile bond deals are just one way the IRS is making waves in the tax-exempt bond market after years of lax enforcement. In fact, the agency's ongoing structural overhaul "may affect the bond area more than any other," says Charles Cardall, a partner at law firm Orrick, Herrington & Sutcliffe in San Francisco.
Cardall is chairman of the tax matters committee of the National Association of Bond Lawyers (NABL).
Although the IRS does not release statistics on its audits, he says, "what we've seen over the last few weeks has been a much more active audit process."
Mark Scott, director of the IRS' new tax-exempt bond unit, says the agency is not trying to make waves.
"We're aware of the market implications of our actions, and we're definitely taking that into account," says Scott, who was appointed March 27.
Previously, policing of tax-exempt bond issues was conducted by a handful of agents within a department who reviewed not-for-profit corporations, rather than a team dedicated to not-for-profit and municipal finance.
Scott says his unit has 30 field agents and expects to increase that number to as many as 45 by Sept. 30. With more staff, he says, audits will become quicker and more common. "And we're going to become more focused, whereas before we'd go out and look at every possible legal and factual issue."
The IRS is also putting "substantial resources" into outreach, Scott says. It has launched a survey of issuers and invited bond lawyers to speak at a training seminar for field agents.
Scott also has said publicly that he will cooperate with the industry to develop intermediate sanctions, which would create guidelines to punish issuers for tax-law violations. Bond lawyers view such guidelines with mixed reactions. Guidelines might encourage compliance by creating uniform penalties, such as fines, which are short of yanking the tax-exempt status of bonds, some experts say.
Both the American Bar Association and the NABL recently released proposals.
It remains to be seen just how friendly the new IRS will be. Those healthcare issuers who have been hit with audit notices may not relish the expense of a protracted defense.
Unlike taxpayers, bond issuers cannot go to court to defend themselves against an adverse IRS ruling, giving the IRS a particularly big stick, Cardall says.
IRS enforcement could put the brakes on the use of new financing structures, experts say. That might be exactly what the agency wants.
Milton Wakschlag, chairman of the tax-exempt financing committee for the ABA's tax section, believes the IRS is trying to accomplish two things: to make its presence felt in the day-to-day operations of municipal finance and put the brakes on innovative financing techniques until it has a chance to weigh in on the techniques' legality.
"The IRS wants to let everybody know that they'll be examining novel finance techniques before too much of a landslide occurs" and such financing schemes pervade the market, says Wakschlag, a partner at the Chicago-based firm of Katten Muchin Zavis.
Adds Cardall: "(The IRS') strategy seems to be, if we see something unique and interesting, we're going to go out and look at it sooner rather than later and develop our own understanding about it and devise our own rulemaking scheme."
In both acquisition financing cases, the hospital systems say the IRS has no reason to suspect wrongdoing but notified the targeted institutions that it is examining the deals to learn more about acquisition financing, which has become a popular vehicle to capitalize newly merged hospital systems. According to legal sources, the agency wants to know if the deals should have been treated as restructuring transactions, which are subject to stricter rules on tax exemption.
Says MedStar's Marzano: "From our position it's unfortunate that MedStar Health has to pay that penalty (higher yield) during the examination process. That's money going to investors instead of going back into the communities you serve."