Cost of Disputed Bonds Could Be $5 Million

An Internal Revenue Service investigation into Orange County’s sale of $200 million in tax-exempt bonds could cost the county about $5 million in back taxes and land one more blow to the county’s heavily bruised image.

The IRS has said it is investigating whether the one-year tax-exempt bonds sold by the county the summer before it filed bankruptcy in 1994 are instead taxable securities.

If the bonds are deemed taxable, either investors or the county will have to pay back taxes on the interest earned. If investors are liable, they’ll likely try to force the county to reimburse them. The IRS also could levy penalties against the county, though tax lawyers couldn’t estimate the amount of such fines.

“When the IRS comes in, you’re in big trouble. It can be very costly and take years to settle,” said Zane Mann, publisher of the California Municipal Bond Advisor, a newsletter in Palm Springs.

Lawsuits stemming from IRS audits of the Riverside County Housing Authority have dragged on for years. In other bond-sale audits, the federal agency settled for $14.3 million from the city of East St. Louis, Ill., and $4.7 million from the territory of Guam.

Orange County officials would not comment on the investigation.

Possible back taxes would total about $5 million, but sources said the amount isn’t certain. That’s because bond proceeds were placed in the county’s investment pool, which collapsed in December 1994. The taxes due would be based on the difference between the lower interest rate--4.5%--paid on most tax-exempt bonds, and the higher interest rate--about 6%--paid on taxable securities.

The county bonds under question are the Series A bonds, which raised $171 million, and the Series B bonds, which raised $31 million.

Other local governments--the cities of Irvine, Anaheim and several school districts--sold similar bonds, but their lawyers said they had not received any notice about possible IRS investigations. Those government entities are under investigation by the Securities and Exchange Commission.

However, because the same law firm that reviewed the county’s bond issues also worked on short-term borrowings for the schools, the IRS may investigate those deals at a later date, sources said.

The IRS audit might have been sparked by an order issued against the county in January by the Securities and Exchange Commission. The SEC said the county failed to disclose that its calculations on the size of the two bond offerings “placed the tax-exempt status in jeopardy.”

Issuing tax-exempt bonds is a special privilege granted by Congress to local governments such as Orange County to help them raise money cheaply. The local governments, though, must abide by strict rules or face IRS investigations and sanctions.

“These types of audits almost never happen, although the IRS has stepped up its efforts in recent years,” said Gary Downs, a public finance attorney in Los Angeles. “The IRS has done a few audits in California, but almost never on note deals.”

The IRS probe damages Orange County’s battered image even more on Wall Street. The inquiry is not expected to keep major investors from buying the county’s $800 million in recovery bonds this spring, but it doesn’t help.

“It’s another thing for people to beat on the county about, but it’s not like they don’t have enough things already,” said Jon Schotz, who has represented the pool participants in the county’s bankruptcy recovery plan.

Several large bond fund managers said Friday that it was too early to tell whether the IRS review would prompt them to avoid buying Orange County’s recovery bonds.

The county’s financial advisor, Christopher Varelas of Salomon Bros., said the probe doesn’t jeopardize the county’s recovery plan or its ability to emerge from bankruptcy protection on schedule.

Under federal tax laws, the county can sell annual tax and revenue anticipation notes based on revenue it expects to collect during the year.

Tax laws limit the amount of money that entities can borrow through bond issues each year and the amount of interest that can be earned. In addition, the laws limit what the proceeds can be used for.

Typically, lawyers review bond deals and render opinions that the bonds are being sold for purposes permitted under IRS laws, that the proper amount is being sold and that the interest earned won’t exceed IRS limits.

The Los Angeles law firm of LeBoeuf, Lamb, Greene & MacRae worked on both county bond deals and gave opinions saying the bonds were in line with tax codes. An SEC investigation of LeBoeuf’s role is pending.

While IRS officials said they could not comment on the Orange County investigation, IRS bond specialist Ronald Cunningham said the agency found some problems in tax-exempt bond deals elsewhere and now is beginning a random nationwide municipal bond audit program.

“They’ve found some [that] should be taxable,” he said. “So right now we are examining bonds to see what the situation is out there.”

One of the more well-known IRS bond audits occurred in Riverside County, where legal wranglings over the IRS findings are continuing.

The Riverside Housing Authority sold $30.5 million in bonds in 1986 for two apartment projects, one of which was never built. The IRS determined that the deals earned too much interest for tax-exempt securities and declared the bonds taxable, asking bondholders to pay back taxes.

That prompted a long court battle by bitter investors who argued that they were innocent parties and should not be forced to pay for violations committed by the housing authority, which put together the bond deals.

In 1989, the territory of Guam and its underwriters, not bondholders, were found liable by the federal agency. They paid the agency $4.7 million to settle a bond dispute and the IRS did not declare the bonds taxable.

A similar settlement occurred in March 1994, when the city of East St. Louis agreed to pay $14.3 million for extra interest earned on a $223-million bond deal sold in 1985 for a port that was never built.