Long Beach bank challenges IRS over municipal bond tax penalty.

Little Harbor Bancorp of Long Beach has become the first bondholder to challenge the Internal Revenue Service on its right to tax income earned from municipal bonds that have lost their tax-exempt status due to tax law violations.

The bank must reply this week to a July 30 filing by the IRS with the U.S. Tax Court that states the facts of the case as the feds see it. The IRS action was, in turn, a response to the bank's October 1992 petition countering the IRS claim to back taxes.

Harbor Bancorp, according to Chief Financial Officer Melissa Lanfre, acquired $250,000 in Riverside County's Whitewater Bonds in August 1986. From 1988 to 1990, it earned $58,125 in interest income from the bonds which it did not include as gross income on its tax returns. The IRS challenged the exclusion on July 30, 1992, claiming the bonds did not conform to code, and ordered the bank to pay $19,763 in back taxes and earned interest.

According to the Internal Revenue Code, "interest gross income does not include interest on any state or local bond" unless the bonds are among some listed exceptions.

"There are about 100 pages of exceptions," said Brian Casaly, technical coordinator for the Los Angeles district of the IRS. "Every bond has different requirements that it must meet to be qualified for tax exemptions."

Although the bonds' actual issue date is in question, it is agreed that they were issued by Riverside County's Housing Authority to finance construction of a multi-family rental housing project called Whitewater Garden Apartments.

According to IRS statements, a number of improprieties were committed by the Riverside County Housing Authority and its contracted underwriters in issuing the bonds.

The IRS alleges that the Housing Authority issued more bonds than it was authorized to issue, approved a blank arbitrage certificate, and failed to hold a public hearing or inquire into the feasibility of the project. What's more, no construction had been undertaken when the property was foreclosed in May 1988.

The $17.6 million bond issue was underwritten and "purchased" by New York-based underwriters Matthews & Wright, Inc. on Dec. 31, 1985. The "purchase" was made through a series of transactions involving various intermediaries and an offshore "bank" chartered in the Northern Marianas Islands.

According to the IRS, "The Whitewater check was never deposited into regular banking channels; if it had been, it would have been dishonored."

Despite this, on Feb. 20, 1986, Matthews & Wright wired $18.1 million from the sale of the Whitewater bonds to the offshore "bank." The IRS claims that "Feb. 20, 1986, was the date on which the bonds were first issued" since payment for the bonds was not forthcoming until that date. This is an important distinction because in 1985 bonds issued by Riverside County's Housing Authority "were exempt from the state volume caps restricting the issuance of tax-exempt bonds." In 1986, they were no longer exempt due to changes in the law.

Furthermore, the IRS alleges that from Feb. 20, 1986, to the present time, interest payments on the bonds were funded exclusively by drawing on a letter of credit. The letter of credit was issued by a Delaware corporation.

The IRS says that on Feb. 20, 1991, it notified the Housing Authority that if it failed to pay the U.S. government $2.25 million in rebatable arbitrage charges, "interest paid on the bonds would not be excludible from gross income."

Riverside County's Housing Authority responded by filing a complaint for declaratory and injunctive relief in June 1991. On July 22, 1992, the District Court dismissed all of the Housing Authority's claims in the injunction action. No appeal was taken, so the decision is final.

And that leaves Harbor Bancorp sifting through the "facts" set forth by the IRS on the bonds it bought. The IRS has cancelled an Oct. 12 tax court date with Harbor Bancorp, but the bank still must answer to the IRS by Aug. 28 regarding the tax agency's statement of facts presented in the case.