IRS Bond Probe May Give O.C. New Problems

SANTA ANA — The Internal Revenue Service is investigating whether Orange County might have improperly sold about $200 million of tax-exempt bonds the summer before it filed for bankruptcy, the county said Thursday.

In what could become another costly nightmare for the county, the IRS has notified the county by mail that it is examining whether the tax-exempt bonds sold in 1994 might instead be taxable securities.

If the IRS finds that the bonds are taxable, bondholders who thought they owned tax-exempt investments must suddenly pay back taxes on interest earned on their bonds. In similar cases, bond investors have filed costly lawsuits against the agency that sold the bonds, which in this case would be Orange County.

“It’s certainly a big deal if the bonds are deemed taxable,” said Christopher “Kit” Taylor, executive director of the Municipal Securities Rulemaking Board, a regulatory agency. “The IRS will go after the bondholders, who will in turn go after the county.”

Orange County said in a statement that it would not comment on the investigation Thursday, but insisted its bankruptcy recovery plan would not be jeopardized. IRS officials could not be reached for comment.

The bonds under IRS scrutiny are one-year bonds sold each year as a way to borrow in advance on revenue that will be collected during the fiscal year.

One of the two bond deals being investigated is a $173.2-million Series A Tax and Revenue Anticipation note sold through PaineWebber Inc., with Leifer Capital, a Santa Monica firm, serving as financial advisor. A Los Angeles law firm, LeBeouf Lamb Green & MacRae, was bond counsel.

Also under investigation is a $31.6-million Series B Tax and Revenue Anticipation note.

The IRS investigation is more bad news for beleaguered Orange County bondholders, who saw the county default on their bonds in 1995 and then agreed to a county plan to delay their payments until this June. The county plans to sell an $800-million bond issue this spring that would allow it to make good its payments to bondholders.

While the IRS’ specific concerns are unclear, some sources said the agency could be investigating whether bond proceeds were used for purposes other than those allowed under tax-exempt bond laws.

The IRS also could be investigating whether the county might have earned more interest on its bonds than is allowed. Under current laws, governmental entities can invest the proceeds from some tax-exempt bonds to earn interest, but the amount earned cannot exceed what local governments pay out in interest to their bondholders. The excess interest must be rebated to the federal government within five years of the bond sale date, with some exceptions.

In 1994, the IRS said it wanted to beef up its program to crack down on abuses in the tax-exempt bond market and would meet regularly with the Securities and Exchange Commission, which has been investigating the county.