January 30, 2001

IRS Reviewing Tax-Exempt Hospital Bonds

Holland & Knight Newsletter
Robert J. Friedman

The Internal Revenue Service (IRS) is currently reviewing numerous issues of exempt 501(c)(3) hospital bonds issued from 1996 through 1999 to finance mergers of hospital or health care systems throughout the country. All together, the bonds being examined represent well over eight billion dollars of debt. Medstar Health, the obligor on debt issued in connection with a merger between Medlantic Healthcare and Helix Health in the District of Columbia, has announced that IRS agents have preliminarily determined that $300 million of debt issued on its behalf may be taxable, and several other systems may receive similar notices from the IRS.

At the beginning of December 2000, Mark Scott of the IRS stated that none of the cases he had gone through had the same facts and that the results of each audit would be different. Although particulars of these transactions may vary, the basic format of each transaction begins with the merger and disappearance of one or more hospitals or health care systems, previously unrelated, into a single survivor (“Newco”). Tax-exempt bonds, including the issues now under review, are then issued as part of and simultaneously with each transaction. Proceeds of these issues are then used to finance the purchase either of membership interests in the merged entities (each, an “Oldco”) or, alternatively, of their assets and liabilities.

Where an Oldco had debt outstanding (the “Prior Bonds”), the indenture(s) related to that debt may have required that the lien of the indenture be defeased with, for example, United States Treasury obligations sufficient to pay principal and interest on any outstanding debt of Oldco.

From the standpoint of the participants in the reviewed transactions, the amounts deposited to the defeasance escrows are no longer proceeds of the new tax-exempt obligations. To the contrary, they have lost that characteristic once expended to acquire Oldco assets or membership interests. Typically, these amounts are deposited to a sinking fund for the Prior Bonds and are restricted to the yield of such bonds.

However, the IRS is questioning whether the obligations being examined, ostensibly issued as “new money” or “acquisition” bonds, should instead be reclassified as refunding bonds. In that case, they may also be classified as “advance” refunding bonds, namely, those bonds whose proceeds are not used for the refundings within 90 days of issuance. If so, special restrictions would have been triggered that are not imposed with respect to new money or current refunding bonds.

Among these special restrictions are limits on the number of times debt may be advance refunded on a tax-exempt basis. This limit might have been exceeded with respect to Oldco debt that had already been advance refunded prior to the merger transaction. In addition, investments acquired with proceeds of advance refunding bonds held in defeasance escrows, such as those established for outstanding Oldco debt, are severely limited as to the yield they are permitted to earn. Failure to satisfy either of these limits could cause the related issue of reviewed bonds to be declared taxable.

Classification of a reviewed issue as one used for new money or refunding purposes may turn on the question whether Newco and its Oldco predecessors are treated as “related” to each other. The answer to these questions involves the analysis of complex legal principles as applied to organizationally and operationally complex health care organizations. Stakeholders in the resolution of these questions include the issuers of the bonds being examined, their bond counsel, the borrowers on whose behalf the bonds were issued and the holders of the bonds.

Yet the interests of these stakeholders may be inherently divergent or become so as the examination process progresses. Consequently, stakeholders should consider the retention of independent counsel as soon as possible after becoming aware that the IRS has commenced review. Critical services to be performed include complex legal and factual analysis, interaction with IRS officials to communicate your perspective effectively, strategic planning of the examination process including evaluation of the advisability of entering into a settlement agreement, or eventually, obtaining judicial review and laying the groundwork so that no avenue of redress or vindication is prematurely foreclosed or compromised.

Holland & Knight believes that it is uniquely qualified to provide these services. The Holland & Knight municipal bond audit group consists of lawyers who have spent over 20 years collectively working at the National Office of the Internal Revenue Service. During this period of time, they issued numerous General Counsel Memorandums and worked on hundreds of private letter rulings, revenue rulings, and revenue procedures that involved Section 103 of the Code. While at the IRS and since leaving the IRS, members of the municipal bond audit group have worked on dozens of audits of tax-exempt bonds and drafted numerous closing agreements that concerned tax-exempt bonds.

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