Who will pay IRS in Villages bond mess?
by Lauren Ritchie
March 4, 2009
On Sunday, this column examined a preliminary ruling by the IRS warning the government that runs operations at The Villages that $64 million in tax-exempt bonds issued in 2003 are on the verge of being declared taxable -- and it hints that another $200 million may face the same action.
The money from the bonds was used to buy everything in the community from the right to collect future fees, to retention ponds, sewer plants, clubhouses, swimming pools and golf courses. The seller was developer Gary Morse and his family.
About half the monthly amenity fee paid by Villages residents goes to repay the bonds. The fee is $135 if you buy a house today and is less if you bought earlier.
IRS Agent Dominick Servadio, who has been auditing the bonds for more than a year, concluded preliminarily that they should be taxed because:
*The district doesn't qualify under IRS rules as a valid issuer of tax-free bonds.
*The transactions didn't benefit the general public -- a requirement of tax-free bonds -- but instead, only the developer.
*The Village Center Community Development District issued $53 million more than the properties it bought were worth and handed the cash to Morse, who declared it as a gain on the sale on the corporation's 2003 tax return. Issuing bonds for more than 5 percent more than what's needed throws the bonds into the taxable realm under IRS arbitrage rules, the agent contended.
*The appraisal firms that set the value of the properties were tools of the district who did what they were told. They were not independent appraisers, as the IRS requires.
Whoa. So what does all this mean? Armageddon? Or simply scorched earth? The $64 million dollar question -- literally -- is who will pay?
Or is it possible that this will all vanish quietly?
The outcome of any audit is difficult even for experts to predict, but knowing the backdrop against which the story is unfolding helps to put it in perspective.
First off, you should know the IRS has taken a bold interest in community development districts such as the dozen that operate in The Villages. In fact, auditing CDDs for compliance is a priority for the tax-exempt bond division of the agency, according to its published 2009 goals. Part of the IRS' intent this year is to survey such districts and possibly follow up with audits. The head of the bond division of the agency has spoken in speeches about the research the IRS is doing on CDDs.
So Servadio isn't sitting at the end of a tree limb alone, cackling and punching buttons on his little calculator. One can infer that his tough assessment of the district's bonds has the backing of his bosses.
Clues to the dynamics of how this audit is progressing are tucked into the exchange of documents between the IRS and the California lawyer for The Villages, who is among the best tax-exempt-bond-controversy attorneys in the country.
First, the district's lawyer asked Servadio in writing for a meeting with the IRS' Robert Henn, who manages field operations in the IRS division that oversees tax-exempt-bond financing. Servadio ignored the request. Second, there are hints that palms in the district office are sweating, regardless of what officials may say publicly. A letter from the district's lawyer, Perry Israel, to Servadio stated that the district wanted to get this matter cleared up quickly because some of the preliminary rulings "go to the ability of the District generally to issue tax-exempt bonds." Ouch. That would instantly dry up the river of money that flows to Morse.
And, the district has given the standard notice to the standard bond-watching agencies that the 2003 issue is being audited and that the audit is serious. However, the notice also encompasses other bonds that are similar in structure, even though they aren't being audited. Apparently, the district suspects this won't end with the $64 million but eventually will involve about $271 million of recreational-revenue bonds issued over the years.
$18,000 per household?
So, what is likely in this situation?
First, on one end of the scale, it is extremely unlikely that the IRS will drop the audit. You can safely cross that one off the list.
On the other end, if the IRS decides that the Villages district is not a "qualified issuer" of tax-exempt bonds, as Servadio contends, then it might be prudent to step back -- say, approximately to Leesburg. Armageddon would be a tea party compared with the financial explosion and subsequent mop-up that would be involved.
The reason is the stunning size of the sums in the scenario. Consider that the district -- read that "the residents of The Villages" -- still owe about $700 million. That's a liability of about $18,000 for each household in the retirement community, which sprawls across Lake, Sumter and Marion counties. Four important parties are involved in the bond transactions -- the district, Morse, bond buyers and The Villages residents -- and the possible outcomes vary dramatically for each if the bonds are deemed taxable.
Bond buyers are the easiest. Theoretically, they would owe the IRS taxes on the interest they received. However, the IRS views buyers as innocent parties, and it tries to make sure they don't get hurt.
Often, the issuer of the bonds -- in this case, the district -- pays the cost of the bondholder tax liability through a settlement, and the bonds retain their tax-exempt status. The amount usually is 29 percent.
However, this situation is more complicated than someone making a simple mistake. The agent in this case has contended that even the structure of the district is set up to deliberately avoid taxes that should be paid.
And, if the IRS views a bond issue as taxable because the amount sold was more than 5 percent over what was needed -- and the district's bonds do fall in this category -- a whole realm of other possibilities opens, including a settlement structure based on the taxable earnings from the excess money, which is $53 million of the $64 million. And then, of course, you've got to figure in the penalties.
The fates of the Morse family and the district are inextricably entwined -- at least they will be if Servadio has his way.
Through 104 pages of meticulous analysis, the agent built a compelling case that the developer so tightly controls the district trustees -- his employees and business associates -- that they are the same entity. Under that scenario, both the district and the developer together likely would face exposure to whatever sanctions finally are imposed.
And the chances are high that any exposure would include the total $271 million worth of recreational-revenue bonds rather than just the one issue of $64 million.
For the district and Morse, the best-case scenario would be that the IRS is willing to structure a settlement that allows one or both of them to pay the bondholders' liability, and the bonds are allowed to remain tax-exempt. That seems unlikely, considering that the IRS contends that the district doesn't have the authority to issue any tax-free bonds, which puts $700 million in outstanding bonds at risk.
If the situation unfolded about as badly as possible, the district and developer could end up having to redeem $271 million worth of bonds, pay the interest liability of bondholders and face sanctions imposed under a separate rule that punishes people who participate in promoting abusive tax shelters. If it played out like that, the district might never be able to issue tax-free bonds again.
Asked what the effect of having to call such a massive amount of bonds might have on the district's finances, bond attorney Michael Williams of Akerman Senterfitt in Orlando said he didn't know.
"That's an issue where a lot of numbers come into play. They're changing every day if not every minute," he said.
Whatever that means.
Janet Tutt, the district's manager, said it is "premature to assume anything." She did not answer the question of whether the district could redeem the bonds and continue operating.
She did say, however, that the district disagrees very strongly with Servadio's conclusions, and it is preparing a response to his preliminary ruling that it hopes will set some facts straight.
Which brings us to the very important third party, The Villages homeowners. Unfortunately, the community-development districts in The Villages have only one source of money, and that is the people who own the property. The district has the authority to charge fees and to impose property taxes on residents. It has not yet ever used the latter power.
If the district is sanctioned financially, it stands to reason that homeowners would end up reaching into their pockets. But that would depend on how IRS structures any possible settlement. It could create one that fell nearly entirely on the developer, for example.
The IRS can settle an audit at any time. But that too seems unlikely given what's at stake.
Only one thing seems certain: This will unfold slowly as the firefight cranks up. And it is time for homeowners to worry less about their tee time and marvelous activities and more about their future property values and financial liability.
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