Jails in Trouble as IRS Investigates Tax-Exempt Bonds

by Matt Clarke

Jails financed with tax-exempt revenue bonds, including numerous facilities in Texas, are scrambling to sell or refinance their debt following investigations by the Internal Revenue Service (IRS) into whether the bonds are properly classified as tax exempt. County officials in some jurisdictions, meanwhile, are struggling to keep their jails solvent after the private prison companies that operated them pulled out when the IRS began examining the bonds.

The tax-exempt bond investigations stem from a regulation which requires no more than 10% of the payments for bond debt service to come from private parties for the bonds to retain their tax-exempt status. Federal agencies such as the U.S. Marshals Service and Immigration and Customs Enforcement (ICE) often pay local jails to house prisoners and, under tax laws, the federal government is considered a private party – hence the threat to the tax-exempt status of bonds issued to build facilities that hold federal prisoners. When a jail’s population exceeds the 10% limit for revenue generated by housing federal prisoners, the bonds are considered taxable private-activity bonds. The rules are designed to prevent local officials from making money by renting out space in public jails financed with tax-exempt bonds.

The IRS announced on February 9, 2015 that it was closing a two-year review of $35.38 million in revenue bonds issued for the Burnet County Jail in central Texas, according to a notice filed on the Municipal Securities Rulemaking Board’s website. The IRS notice indicated the agency was ending its investigation without revoking the bonds’ tax-exempt status.

“We have made a determination to close the examination with no change to the position that interest received by the beneficial owners of the Bonds is excludable from gross income,” the IRS stated. The notice cautioned, however, that a final decision remains pending: “This a preliminary determination, and is not yet a final position for the IRS on this matter.”

In January 2014, the IRS had initially concluded that the revenue bonds were taxable. Still, the agency’s decision not to revoke the tax-exempt status of the bonds did not solve the jail’s financial problems.

The Burnet County Public Facility Corp., which issued the bonds in 2008 to build the privately-operated jail, defaulted on a $1.26 million payment that was due on February 1, 2015, instead remitting only $327,700. It had previously defaulted on bond payments in 2011.

Burnet County took over the facility in March 2014 after LaSalle Southwestern Corrections, which operated the 592-bed lock-up, terminated its contract. That decision followed an August 8, 2013 notice from the IRS that it was investigating the bonds’ tax-exempt status. According to local news reports, Burnet County leaders looked for another company to run the jail but were unsuccessful.

“In light of the continuing cash flow deficiencies, the existing events of default are not likely to ever be cured and the project is unlikely to generate sufficient project revenues to repay the bonds in full,” the county stated.

Another privately-run jail in Texas, the Maverick County Detention Center, also failed to make full debt payments – although the bond issuer, the Maverick County Public Facility Corp., did manage to pay the interest on $42.3 million worth of revenue bonds issued in 2007, according to trustee UMB Bank. The bank said the county defaulted on a $1.4 million principal payment due February 1, 2015.

“There are insufficient funds in the project fund to transfer to the bond fund to pay the Feb. 1 principal payment,” the bank said. UMB Bank also accused Maverick County officials of violating the county’s obligation under the jail lease in terms of handling revenues.

Management of the 654-bed jail was assumed by the Maverick County Public Facility Corp. after private prison company GEO Group withdrew from its agreement to run the jail on October 31, 2013.

“Since that time, the county sheriff has been operating the project and has informed the trustee that the county has advanced a portion of its own funds to pay various operating costs and expenses,” UMB Bank stated.

“The amount of the loan that was taken out on this facility was just ridiculously too high,” complained Maverick County Commissioner Jerry Morales.

In August 2013, the Crystal City Public Facility Corp. in Texas tentatively agreed to pay a $400,000 settlement to the IRS involving $13.94 million in revenue bonds issued to build the Crystal City Correctional Center, operated by Emerald Correctional Management.

And in another case involving a Texas jail, the Fannin County Public Facility Corp. announced a negotiated settlement with the IRS on August 14, 2014, in which the county agreed to pay $1.75 million to settle a claim for back taxes. The corporation had issued $30.78 million in tax-exempt revenue bonds to build a new jail, then entered into an agreement with the U.S. Marshals Service to house federal prisoners at the facility.

Following an IRS investigation, the tax agency concluded that the $8 million the jail received from the U.S. Marshals Service in FY 2013, plus all previous revenue received from the Marshals, was in fact taxable.

To generate revenue for the $1.75 million settlement, Fannin County officials also agreed to issue $31.39 million in taxable Senior Lien Revenue Refunding Bonds; the earnings are targeted to pay the IRS and redeem all the outstanding bonds originally issued in 2008.

Two additional bond issuers have redeemed or plan to redeem jail revenue bonds due to the IRS regulations related to tax-exempt vs. private-activity bonds.

The Industrial Development Authority of the County of La Paz, Arizona stated it will redeem bonds issued in 2013 to finance a detention facility near Holtville, California after Holtville officials announced in September 2013 that the city had entered into an agreement with ICE to house at least 640 federal immigration detainees at the jail for up to five years. According to a notice posted by the Industrial Development Authority, the number of federal prisoners “is reasonably likely to have a material negative impact on the exclusion of interest on the bonds from gross income of the recipient.” As a result, the city’s rental of the jail space to ICE was considered a “negative tax event” under the indenture for the bonds.

Additionally, the West Texas Detention Facility Corp. refunded bonds it had issued to finance a jail as part of a $1.08 million settlement with the IRS. The corporation issued $23.48 million in tax-exempt bonds in 2003 to build the facility in Sierra Blanca, east of El Paso, which is operated by Emerald Correctional Management. According to the jail’s website, it houses both ICE and U.S. Marshals prisoners.

The IRS released a notice in 2013 stating the bonds were not tax exempt due to “the asserted private business (federal government) use of the detention facility financed with proceeds of the bonds by the operator of the facility and by federal agencies whose detainees have been incarcerated therein.”

In south Texas, bonds issued for Willacy County’s $7 million jail in Raymondville are also being audited by the IRS. County Judge John F. Gonzales told the Willacy County Commissioners Court in August 2013 that refinancing the $3 million in outstanding bonds if they lose their tax-exempt status would cost the county around $200,000. Raymondville is home to such a heavy concentration of detention facilities, most housing federal prisoners, that the town has earned the nickname “Prisonville.”

One of those facilities, the Willacy County Correctional Center, experienced a major riot on February 20, 2015 that left the MTC-operated prison in ruins. All of the 2,834 federal prisoners were removed from the facility, which had been built with revenue bond financing and still had $78 million in outstanding debt. Standard and Poor’s downgraded the bonds to junk status the month after the riot, and the county defaulted on its payments in May 2015 according to U.S. Bank National Association, the bond trustee.

Officials say the IRS investigations that have been made public to date are just a few of dozens more that remain pending, in which the agency is examining whether significant numbers of federal prisoners housed at jails financed with revenue bonds mean the bonds do not quality for tax-exempt status. A number of other jails have defaulted on their bond payments not due to tax-related issues, but rather because they could not find enough prisoners to fill the facilities and make them profitable. [See: PLN, Feb. 2012, p.32; March 2011, p.34].

According to an August 2, 2015 report by Bloomberg, “nine of 21 [Texas] counties that created agencies to issue about $1.3 billion in municipal bonds to build privately run correctional facilities ... have defaulted on their debt. A dozen other facilities from Florida to Louisiana to Arizona, many that housed immigrants, have also defaulted.”

Sources: www.bondbuyer.com, http://gritsforbreakfast.blogspot.com, Burnet Bulletin, www.municreditnews.com, Texas Observer, www.bloomberg.com, www.thinkprogress.org

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