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IRS audits city utility on tax-free sewer bonds

Wednesday, May 12, 2010

The Internal Revenue Service is auditing Lewisburg's sale of $7 million worth of utility bonds sold in 2002 and refinanced twice, according to the utilities' superintendent and an IRS agent.

"Your debt issuance was selected for examination as part of a project initiated by the Service to measure compliance with the arbitrage rebate requirements" under federal law, IRS Agent Michael P. Marshetti wrote to Lewisburg.

Arbitrage is making money on borrowed money when the interest rate on the borrowed money, the cost, is less than the amount of interest income earned on the same money. The federal government frowns on that when the borrowed money is from an income tax-free bond sold by local governments.

Congress permits municipalities, utilities, counties, states and other governmental agencies to sell tax-free bonds that pay interest income to investors. Long ago, federal lawmakers decided the public benefits from such projects, so the U.S. Treasury accepts less income tax revenue as the cost of subsidizing public works projects.

City utility bonds are sold to investors who, in effect, loan money for public projects such as water and sewer lines. Investors accept a lower interest rate in return for what they loaned because the income on such an investment is not subject to income tax.

"At this time," Marshetti wrote in his letter received by City Manager Eddie Fuller, "we have no reason to believe that your debt issuance fails to comply with any of the applicable federal tax requirements.

"The IRS routinely examines municipal debt issuance to determine compliance..." Marshetti said in his letter dated April 1. "As always, we reserve the right to expand this examination to any aspect of your debt issuance."

The debt the IRS is examining, however, is connected to a series of troublesome events reported here in early 2009. Complicated refinancing of bonds about six years ago was backed by American Municipal Bond Assurance Corp. AMBAC's financial stability was downgraded because it had too many sub-prime mortgages, according to the senior vice president of the financial brokerage house in Knoxville that handled Lewisburg's bond sale. Contract provisions required by state and federal law for the bond sale: lowered the utility's bond rating; required a higher interest rate; and a shorter repayment period.

The utility's annual debt payments would have more than doubled and, instead of a 17-year payoff period, a multi-million dollar debt for sewers had to be repaid in seven years.

Faced with that, the city refinanced again and avoided the increased and accelerated debt payment schedule.

"The issue is paid off," City Treasurer Connie Edde said Tuesday. "And we're going forward with a fixed rate" schedule of payments.

The city escaped payments that might be likened to home mortgages with balloon interest rates that were inflated beyond the ability to pay over time.

Asked about the audit and the sewer bond debt that was refinanced again - with payments to separate the city from the broker - Kenneth Carr, superintendent of the Lewisburg Water and Wastewater Department, said, "I don't think Morgan Keegan is being singled out. I don't think Lewisburg is being singled out."

There were several other cities that entered complicated bond refinancing contracts that required refinancing again because AMBAC no longer had assets to counterbalance the bonds.

"It was the insurer who failed, not us," Bob Phillips said Tuesday.

He was mayor when AMBAC called to tell Lewisburg of the trouble and, he said, it was troublesome that it was AMBAC that called instead of the city's bond broker when City Hall could have known about the situation in late 2008.

"At every turn, we did what we were supposed to do." Phillips said. "The water department made the payments, but the city had to be the entity to sign for the debt."

That's routine.

However, when payments were skyrocketing and the payoff time was reduced to seven years instead of 17, Lewisburg's City Council voted to use an escape clause in the contract and refinance the bonds.

Getting out of the contract came with a $358,000 settlement fee.

"I think they're looking at the settlement issue," Carr speculated. The original sum of money - raised by the bonds sold in 2002, "was spent down by the end of 2004."

As a result, arbitrage couldn't be the issue because the money borrowed for the department's pipelines had been spent before a deadline on when arbitrage would be prohibited.

"Arbitrage [issues arise for local governments] when you don't spend the bond proceeds fast enough to meet their spend-down time table... and you earn interest in excess of the interest you pay - and then you have to pay taxes on that," Carr said.

"This IRS thing," Phillips said, "is a mystery to me. I can't see how arbitrage could be involved in that. We borrowed the money and paid off the people whose money was insured by AMBAC."

The IRS Media Relations Officer in Nashville, Dan Boon, was asked for explanations on Monday. "All that is covered by disclosure laws and we'd all have to say no comment."

Dan Smith, an attorney with Adams and Reese in Nashville, was hired by Lewisburg to represent the municipality and its utility. The firm has offices in Washington, D.C., and other major cities in the South. Smith was unavailable Tuesday, but Carr recommended Cindy Barnett, a partner with the firm, as someone to ask.

"We have an attorney-client relationship and cannot talk about an on-going audit," Barnett said Tuesday morning.

Adams and Reese provided Lewisburg with its legal opinion on the refinancing of the utility bonds that were so troublesome in 2009, Carr said.

Lewisburg's Water and Wastewater Board voted on April 15 to hire Adams and Reese to deal with the matter brought to City Hall by Marshetti two weeks earlier. Marshetti's office is in Albany, N.Y.

Marshetti cited "arbitrage rebate requirements under section 148 of the Internal Revenue Code" in his letter. Under the state's open records act, the letter became a public document when received by the city.

Asked what section 148 says, Carr replied, "I haven't a clue. That's why we hired attorneys... It seems nothing ever goes away."