Arent Fox’s public finance group has successfully closed its fifth defense of an IRS audit of a client’s 501(c)(3) bond issue with another “no change” result.  The IRS has increased its audit efforts, and we have had success in defending clients in Maryland, Virginia and the District of Columbia whose bond issues have come under examination.

While the IRS has indicated publicly a great deal of interest in possible improper bidding on investments of bond proceeds and swaps (both integrated and non-integrated), these cases suggest no unusual or disproportionate inquiry into these areas; if anything, the major focus of inquiry has seemed to be “bad use” of facilities, particularly arising from post-issuance management contracts and/or research contracts.

While it may not be possible to truly generalize; certain guidance in connection with the defense of these audits can be offered.

1. Get your counsel involved immediately—the IRS takes these audits seriously and appreciates it when the borrower does too;

2. Respond to every inquiry as promptly as possible—the IRS expects the borrower to be so deeply engaged in monitoring their deals that they expect borrowers to have data at their fingertips;

3. Be forthcoming and open (although, of course, do not volunteer beyond what is asked for)—this may be common sense, but field agents are, after all, human and courtesy engenders courtesy;

4. In most cases, the mere opening of an audit does not itself constitute a matter which requires disclosure, either as a “material event” under continuing disclosure agreements or under GAAP—until a specific loss contingency is identified, an audit itself does not indicate a change in risk (and in fact, our 5-to-0 track record supports this view). Note, the IRS will generally not officially tell a borrower whether an audit is random or the result of a “rat letter” or from a problem identified by the IRS internally. Note, the IRS will not generally officially tell a borrower whether an audit is random or the result of a “rat letter” or from a  problem identified by the IRS internally, but informally we have gleaned that each of these bases have underlay one or another of these audits.

In light of this increased audit activity and the new 990 Schedule K, it may be appropriate to remember that your best defense may be a good offense—if you do not have an internal protocol for monitoring and tracking (and preventing excessive) bad use, adopt one; if you do not have good records on historic bad use, reconstruct them now.  Remember, responses on the 990 and in connection with an audit are subject to perjury penalties, and “I do not know” (or, as Steve Martin famously advocated telling the IRS, “I forgot”) does not work in this setting.

If you would like to discuss developing a protocol or monitoring methodology, reconstructing past compliance or a tax controversy matter, please contact your Arent Fox bond group lawyer or Richard Newman or David Dubrow.

Richard A. Newman
newman.richard@arentfox.com
202.857.6170

David L. Dubrow
dubrow.david@arentfox.com
212.484.3957