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Public Finance Matters

Updates on recent public finance and municipal bond developments

Three Strikes and Recovery Act is Out

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust puts an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself.  Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal.  Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As  we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of  the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were  a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

You Can Lead a Horse to Water, But You Can’t Call it an Airplane: Supreme Court Oral Arguments Suggest Puerto Rico’s Recovery Act May Recover

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

  • Due to Justice Scalia’s death and Justice Alito’s recusal, only 7 Justices heard the case and only 4 votes are needed for a majority.  Almost all of the questioning at oral argument came from Justices Sotomayor, Kagan and Breyer, plus a couple noteworthy questions from Justice Ginsburg.  With the standard disclaimer that questions at oral argument are not necessarily predictive of a Justice’s votes, it seems clear from the questioning that Justice Sotomayor will vote to reinstate the Recovery Act and is the most passionate of the Justices about the issue, and, even if the relatively silent Chief Justice Roberts and the silent Justice Kennedy and Justice Thomas vote to affirm,  the questions and musings of Justices Kagan, Breyer and Ginsburg suggest that Justice Sotomayor could sway them to her position and thereby obtain the 4 votes necessary for reversal of the First Circuit’s holding and reinstatement of the legislation.
  • All that can be said about the actual statutory language that the Supreme Court will interpret is that the drafting does not represent Congress’s finest work.  (Justice Breyer provided the only moment of merriment on the Scalia-less panel when, after a suggestion that the opaque statutory language requires a contextual reading, he responded, “That may be, but I can’t say that an ‘airplane’ means a horse.”) There is no relevant legislative history, so it is not clear that Congress, when it amended the Bankruptcy Code to exclude Puerto Rico’s (and the District of Columbia’s) government instrumentalities from Chapter 9 eligibility, thought about the question of how that would or should impact Puerto Rico’s and D.C.’s right to enact their own insolvency statutes.  So while nominally a statutory interpretation case, this is, on a technical level, almost purely a “what makes the most sense” case.
  • The First Circuit was persuaded that it would make no sense for Congress to act affirmatively to withhold from Puerto Rico the right to authorize its insolvent instrumentalities to file for bankruptcy under Chapter 9, while intending that Puerto Rico have the right to authorize such filings under some insolvency statute of its own creation.  That seems almost unassailably correct; basic common sense suggests that whatever distrust of Puerto Rico must have motivated Congress to close the door to Puerto Rico’s ability to authorize its instrumentalities to file under Chapter 9 cannot be reconciled with Congressional intent that Puerto Rico be allowed to authorize such filings under its own version of an insolvency statute that might be identical to, or differ in unpredictable ways from, Chapter 9.
  • However, Puerto Rico seems to have gotten some traction before the Supreme Court with the proposition (which the First Circuit correctly rejected) that Congress cannot have intended to leave Puerto Rico’s instrumentalities in a “no man’s land” where they had no access to Chapter 9 and no access to an alternative insolvency regime. The short answer is that there is a high likelihood that Congress, if it had an intent on the matter when it eliminated Puerto Rico instrumentalities from Chapter 9 eligibility, precisely intended that Puerto Rico instrumentalities would not have access to an insolvency process unless and until Congress specifically authorized the applicable process (as it is currently being pressed to do by Puerto Rico and the U.S. Treasury.)  Such federal control would be and is consistent with Puerto Rico’s status as a U.S. territory, however it is labeled in the Bankruptcy Code.
  • Justice Sotomayor also raised the issue of whether the principles of federalism and state sovereignty that make the federal Chapter 9 available only to instrumentalities of states that have elected into the Chapter 9 regime would be violated if Chapter 9 were the only insolvency regime available to a state, i.e. whether interpreting Section 903 of the Bankruptcy Code as applicable to states that have not exercised such option (as well as to Puerto Rico and D.C., which have no such option to exercise) would be unduly coercive and raise Tenth Amendment issues.  The First Circuit left that question unaddressed on the grounds that Puerto Rico is not protected by the Tenth Amendment.  But as Section 903 applies to any “State”, if the Supreme Court interprets it, and its restriction on a “State’s” ability to enact insolvency legislation for its instrumentalities, as applying to Puerto Rico, it also will be interpreting it as applying to the 50 states, including those that have not opted to authorize their instrumentalities to use Chapter 9.  Whether or not any of the other Justices would view such an interpretation as presenting a substantial Tenth Amendment concern cannot be discerned from the oral argument, but the Court often interprets ambiguous statutes in a manner that avoids a potential constitutional concern, and Sotomayor’s apparent invocation of that principle may be targeted at her fellow Justices as a counterweight to the proposition that Congress, in eliminating Chapter 9 access for Puerto Rico’s instrumentalities,  must have intended to preclude any access to bankruptcy by such  instrumentalities absent direct authorization by Congress.  In divining what Congress intended by Section 903, Sotomayor appears to be suggesting, the Supreme Court cannot focus myopically on what Congress would have intended for Puerto Rico.
  •  As we have previously discussed, even if the Court revives the Recovery Act, the Recovery Act is, from Puerto Rico’s perspective, a problematic, and possibly ineffective, insolvency process.  A principal purpose of bankruptcy is to adjust, restructure and impair contracts.  The federal government is not subject to the constitutional restriction on impairment of contracts, and therefore the federally-enacted Chapter 9 process can impair debts and contracts.  Puerto Rico, and therefore its Recovery Act, have been held to be subject to the constitutional restriction on impairment of contracts.  A couple of the Justices noted this constraint, both in questioning what benefit Puerto Rico would derive from a reinstatement of the statute and as a potential protection that Congress might have taken into account if it did not intend to preclude non-federal insolvency law.  If the Recovery Act is reinstated and used by Puerto Rico, one can expect years of litigation on the question of whether any debt adjustment (or other contract adjustment) effected thereunder does or doesn’t meet the high bar of public necessity and unavailability of reasonable alternatives required for such adjustment not to constitute an unconstitutional “impairment.”
  • Puerto Rico’s persistence in seeking reinstatement of the Recovery Act reflects a calculus that an insolvency process that produces a legally questionable and potentially unenforceable result is better than no process, and provides creditors more incentive for consensual resolutions than no process.  Chapter 9 eligibility for Puerto Rico’s instrumentalities, and, if Congress were to grant it, “super Chapter 9“ eligibility for Puerto Rico itself,  would clearly, in Puerto Rico’s view, constitute a far more advantageous and conclusive process.  However, there is some risk to Puerto Rico that if the Supreme Court reinstates the Recovery Act before Congress acts on federal legislation to address Puerto Rico’s financial woes, the revival of the Recovery Act would undercut any Chapter 9 momentum, leaving Puerto Rico with its legally wobbly Recovery Act.  But Puerto Rico appears willing to gamble that the Supreme Court will issue its decision after Congress has done whatever it will do, and, in any event, to believe that a constitutionally vulnerable local bankruptcy statute in the hand is worth a constitutionally bulletproof federal bankruptcy statute in the bush.

 

Statutory Liens vs. Consensual Liens: Why it Matters and When it may Not

Posted in Bankruptcy

While secured creditors are entitled to special rights in bankruptcy, those rights may differ depending on whether creditors have a statutory or consensual lien on their collateral. This is primarily because section 552(a) of the Bankruptcy Code provides, in part, that “property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement . . . .” In other words, consistent with the concept that a debtor receive a ‘fresh start’ following a bankruptcy discharge, section 552(a)* strips certain secured creditors of liens in the post-petition property received by a debtor. However, section 552(a) does not apply if a creditor is secured by a statutory lien; a statutory lien ‘flops over’ the petition date and attaches to post-petition receipts of a debtor.

In general, the Code contemplates three types of liens: (1) consensual liens (i.e. a lien created by a security agreement), (2) judicial liens and (3) statutory liens. The primary distinction is that consensual liens are created by a security agreement between a debtor and a creditor, while judicial and statutory liens are created by operation of law and/or an order of a judge and do not require a debtor’s agreement. As the name suggests, a statutory lien arises automatically by statute.

Most statutory liens are obvious; you ‘know ‘em when you see them’. Perhaps that is why caselaw on the subject is so limited. The most substantial analysis of the issue appears in two decisions from the Orange County, California chapter 9 bankruptcy case where noteholders sought continued post-petition payment of pledged taxes and other revenues of the debtor. The Bankruptcy Court concluded that the noteholders held a consensual lien which was cut-off by the bankruptcy filing. The District Court disagreed, finding that the noteholders were secured by a statutory lien. Despite the reversal, we think the Bankruptcy Court got it right.

The Bankruptcy Court enumerated the key characteristics of a statutory lien: “the lien is automatic, and there is no need for any consent by the borrower or designation of revenues.” For example, a statutory lien is created if a statute provides that debt issued pursuant to that statute shall be secured by a lien on property specified by that statute. The lien is automatic, there is no need for any consent of the borrower. If instead a statute provides that a borrower may borrow money and may pledge property to secure such borrowing, any lien granted by the borrower pursuant to the statute would be consensual.

One area where the consensual/statutory lien distinction may not be as significant is in a chapter 9 bankruptcy case when a creditor has a lien on ‘special revenues’ (as defined in section 902(2) of the Code). This is because, pursuant to section 928, a creditor’s consensual lien on special revenues ‘flops over’ the petition date and attaches to post-petition receipts—much like a statutory lien does in all instances. However, it may still be preferable to have a statutory lien on special revenues because, in addition to the ‘flop-over’ effect, section 928 also subordinates a creditor’s lien to “necessary operating expenses” of the project or system. Since by its terms it appears that only consensual liens are addressed in section 928 (referencing “any lien resulting from any security agreement. . .”), section 928(b)’s subordination mechanism may not affect statutory liens on special revenues.

* All section references are to the Bankruptcy Code.

Draft Treasury Legislation Would Give Puerto Rico Access to “Super Chapter 9” and Chapter 9 Bankruptcy

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

 

A draft of the U.S. Treasury’s proposed debt restructuring legislation began circulating earlier today.  The draft legislation would give Puerto Rico, as well as other U.S. territories, and their municipalities access to U.S. bankruptcy court under a new chapter of the U.S. Bankruptcy Code (so-called “Super Chapter 9”) as well as making Puerto Rico’s instrumentalities (but not Puerto Rico itself) potentially eligible to file for bankruptcy under existing Chapter 9. The prospects for bipartisan cooperation on some form of such legislation appear somewhat more promising than those for the confirmation of a new Supreme Court justice, but whether this trial balloon will fly remains uncertain.

Some initial observations:

  • The legislation would provide access to bankruptcy to Puerto Rico and other U.S. territories (Guam, American Samoa, Northern Mariana Islands and U.S. Virgin Islands) and their municipalities.
  • The availability of bankruptcy to a territory and/or any “municipality” (i.e. political subdivision, public agency, instrumentality or public corporation of a territory) would be conditioned on the establishment of a Fiscal Reform Assistance Council (Council) at the request of the applicable territory’s Governor.  The Council would consist of 5 members appointed by the President of the United States and would have to approve any such bankruptcy filing.  The Council would have a variety of oversight powers including budget and debt issuance approval powers.
  • The legislation preserves the concept of “special revenue” bonds that benefit from more protective provisions under Chapter 9, such as the continued application of a lien on special revenues to such revenues arising after the filing of the bankruptcy petition, and the inapplicability of the bankruptcy stay to the application of special revenues to payment of debt service on special revenue bonds.  However, the definition of “special revenues” is narrower under the draft legislation than it is under Chapter 9.  As under Chapter 9, “special revenues” include “receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems.”  However, for Puerto Rico and other territories, the draft legislation would not include as “special revenues” “special excise taxes imposed on particular activities or transactions,”  “incremental tax receipts from the benefited area in the case of tax-increment financing,” “other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions” or “taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to finance the general purposes of the debtor.”  Accordingly, debtors that under the legislation could file under either Chapter 9 or this new chapter would have an incentive to file under this new chapter if their revenues would constitute “special revenues” under Chapter 9 but not under the new chapter.
  • The legislation creates a one-year stay (from the date of establishment of a Council) on (i) the commencement or continuation of any action or proceeding that seeks to enforce a claim against the territory and (ii) the enforcement of a lien on “or arising out of” taxes or assessments owed the territory.  Note that the stay becomes effective without regard to whether a bankruptcy petition is filed.
  • A territory may be a debtor upon the establishment of a Council and approval of the filing by the Council.  A municipality of a territory must, in addition, be specifically authorized by territory law to be a debtor.
  • In contrast to Chapter 9, a debtor need not be insolvent in order to be eligible to file for bankruptcy under the proposed new chapter.
  • A territory and its municipalities may file bankruptcy petitions and plans of adjustment jointly.
  • If the debtor is a territory, the presiding judge in the bankruptcy is appointed by the Chief Justice of the U.S. Supreme Court.  If the debtor is a municipality filing separately from a territory, the presiding judge is appointed by the chief judge of the applicable federal circuit court of appeals (the 1st Circuit, in the case of Puerto Rico).
  • Among the various conditions for confirmation of a plan, noteworthy conditions include that “the plan does not unduly impair the claims of any class of pensioners.”  The draft legislation does not define what is meant by “unduly.”
  • The legislation provides a limited degree of protection for Puerto Rico’s general obligation bonds, including as a plan approval condition that “if feasible, the plan does not unduly impair” the claims of holders of the territory’s general obligation bonds that are “identified in applicable nonbankruptcy law as having a first claim on available territory resources.”   Notably, this protection is provided “if feasible” whereas there is no feasibility requirement on the protection of pensioner claims.  Again, the protection of general obligation bonds, “if feasible” is against being “unduly” impaired, without clarity as to what constitutes undue impairment.  Oddly, the implication is that general obligation bonds can be “unduly impaired” if it is not feasible to “duly” impair them.
  • The draft legislation makes many but not all of the general provisions of the Bankruptcy Code, many but not all of the provisions of Chapter 9, and some of the provisions of Chapter 11, particularly those relating to plan confirmation,  applicable to a bankruptcy involving a territory or a territorial municipality.

Que Certa, Certa: Supreme Court Creates Uncertainty with “Cert” Review of Puerto Rico Recovery Act

Posted in Bankruptcy

By LEN WEISER-VARON, BILL KANNEL and ERIC BLYTHE

It is said that muddy water is best cleared by leaving it be.  The Supreme Court’s December 4 decision to review the legality of Puerto Rico’s local bankruptcy law, the Recovery Act, despite a well-reasoned First Circuit Court of Appeals opinion affirming the U.S. District Court in San Juan’s decision voiding the Recovery Act on the grounds that it conflicts with Section 903 of the U.S. Bankruptcy Code, suggests, at a minimum, that at least four of the Justices deemed the questions raised too interesting to let the First Circuit have the last word. This discretionary granting of Puerto Rico’s certiorari petition further muddies the already roiling Puerto Rican waters.

As a result of the Supreme Court’s granting of the Commonwealth’s petition for a writ of certiorari, eight Justices will hear the case (Justice Alito has recused himself), with oral arguments likely in March, 2016.  A decision would then be expected in June, 2016, coinciding with the Commonwealth’s fiscal year end.  At first glance, the decision to grant “cert” appears to be a victory for the Commonwealth (according to SCOTUSblog, over the past three terms the Supreme Court has reversed approximately 72% of cases it has accepted for review).  Of course, the Supreme Court could weigh-in in a manner or on a topic that does not fully resolve the status of the Recovery Act.  At the very least, the review may hinder creditor negotiations and the chances of a consensual resolution.  And a consensual resolution may be Puerto Rico’s best hope.

Even as Puerto Rico legislators laud the Supreme Court’s decision, their pleas for alternate solutions—namely, Chapter 9 eligibility and/or a voluntary debt exchange—continue.  They argue that, absent these solutions, the territory will reach its breaking point before the Supreme Court rules.  The reappearance of the Recovery Act as an arguable solution to Puerto Rico’s quest for a debt restructuring process will likely only contribute to the gridlock in Congress regarding Puerto Rico’s campaign for Chapter 9 eligibility or for “Super Chapter 9” legislation that would enable it to restructure its general obligation debt.  Consensual creditor resolutions may be the Commonwealth’s most realistic option; indeed, the Commonwealth was hopeful it could implement a voluntary debt exchange by May, 2016.  But that was before cert was granted.

Creditors may now be even more wary of negotiating given the greater uncertainty the Supreme Court’s review engenders.  Parties striking deals with the Commonwealth and its entities are going to want to make sure the arrangements reached are “Recovery Act remote”, “Chapter 9 remote”, “Super Chapter 9 remote” and “Whatever the heck Congress, the courts or the Puerto Rico legislators do remote”.  Given the uncertainties regarding Recovery Act implementation (if/when/how), creditors may be unwilling to bear these risks and may choose to leave the muddy water be, for now.  That could be disastrous for Puerto Rico.

Finally, even if the Supreme Court reinstates the Recovery Act, the Recovery Act may still be an ineffectual vehicle for debt restructuring.  Because it is not enacted by the federal government, any plan confirmed under its provisions will be subject to a variety of constitutional challenges under the contracts clause and the takings clause of the U.S. Constitution.

The future’s not ours to see.

ABLE Programs and Beneficiaries Boosted by Helpful Guidance from IRS and Social Security Administration

Posted in Section 529 plans

By LEN WEISER-VARON

The Stephen Beck, Jr., Achieving a Better Life Experience Act of 2014 (ABLE Act), one of the few recent examples of bipartisan cooperation on a new category of tax and budget expenditure, is both well-intentioned in its principles and cumbersome in its details, another example of the proposition that a camel is a horse designed by a committee.  Recent and imminent actions by regulators at the United States Treasury and Social Security Administration evidence commendable dedication to sanding off some of the rougher edges of the ABLE legislation.  Such beneficial regulatory guidance reflects, in both substance and timing,  extraordinary attention by federal regulators to concerns raised by the state instrumentalities charged with establishing and administering ABLE programs and by disability advocacy groups that have pushed and prodded to make this new form of savings and investment account for individuals with severe disabilities a reality.  Aided by this healthy cooperation among regulators, administrators and beneficiaries and the developments described below, ABLE programs should become available in various states during 2016.

  •  Treasury Issues Favorable Advance Guidance for ABLE Program Administrators

Treasury issued proposed ABLE regulations on June 29, 2015, has received comments on those regulations and is expected to publish a revised version of such regulations as final regulations when feasible taking into account the regulatory process.  It is anticipated that some ABLE programs will be launched in advance of the issuance of such final regulations.  However, the National Association of State Treasurers’ College Savings Plan Network (CSPN) (which now includes entities involved in establishing Section 529A ABLE programs as well as  entities involved with Section 529 college savings programs) had requested advance guidance from Treasury on three points which, if not resolved by Treasury prior to its issuance of final regulations, could have delayed the structuring and launching of ABLE programs.  On November 20, 2015, Treasury issued Notice 2015-81, providing such expedited advance guidance and agreeing with CSPN’s requested resolution on each of the three points.

In particular. Notice 2015-81 affirms that, notwithstanding contrary language in the proposed regulations, the final regulations under Internal Revenue Code Section 529A will provide that:

  1. An ABLE program will not be required to track or report the use of distributions from an ABLE account.  Although an ABLE program will need to report the amount of distributions and allocate distribution amounts to earnings or return of basis, it will not need to determine the amount of each distribution used by the account beneficiary for, respectively, non-housing qualified disability expenses,  housing-related qualified disability expenses, or expenses that are not qualified disability expenses.  The ABLE account beneficiary, however, will need to maintain records sufficient to allocate ABLE account distributions to qualified or non-qualified expenditures for tax purposes, and, in certain instances as discussed below, to  qualified non-housing, qualified housing or nonqualified expenditures for Supplemental Security Income (SSI) eligibility purposes.
  2. An ABLE program will not be required to request the social security number or other tax identification number (TIN) of each third party contributor to an ABLE account at the time a contribution is made, if (as will be the case for most if not all programs) the program has a system in place to identify and reject excess contributions and excess aggregate contributions before they are deposited into an ABLE account. (If, however, an excess contribution or excess aggregate contribution is deposited into an ABLE account, the qualified ABLE program will be required to request the TIN of the contributor making the excess contribution or excess aggregate contribution.)
  3. In instances where the ABLE statute conditions ABLE eligibility on the filing of a signed physician’s diagnosis of the relevant disability, an ABLE program will not be required to collect or review such physician diagnosis, but can rely on a certification under penalties of perjury that the individual (or the individual’s agent under a power of attorney or a parent or legal guardian of the individual) has the signed physician’s diagnosis, and that the signed diagnosis will be retained and provided to the ABLE program or the IRS upon request.  Notice 2015-81 indicates that the final regulations will “likely” require that such certification include the name and address of the diagnosing physician and the date of the diagnosis, and “may also provide” that the certification “may” include information provided by the physician as to the “categorization of the disability” that could determine, under the particular state’s program, the appropriate frequency of required recertification.   (The need for annual recertification is another sensitive topic from the perspective of state ABLE program administrators, but the proposed regulations suggest that the final regulations will be sufficiently flexible that states that do not wish to require annual recertification will not be obligated to do so.)  The Notice helpfully states that if the final regulations require more as to the signed physician diagnosis than the certification of its possession by the provider of the certification and that the diagnosis will be retained and provided to the ABLE program or the IRS upon request, such additional requirements will not apply to certifications obtained by an ABLE program prior to the effective date of such final regulations.

Appreciation is due to Catherine Hughes at Treasury and to Terri Harris and Sean Barnett at IRS for their attentiveness and responsiveness to the request for such advance guidance.

  •  Social Security Administration Expected to Issue Favorable Guidance for ABLE Beneficiaries

For SSI benefit recipients, the beneficial treatment of ABLE account balances and distributions for SSI eligibility purposes is at least as important as their beneficial tax treatment.  Although the Social Security Administration has yet to issue formal guidance clarifying that treatment, it is expected to do so through an update to its Program Operations Manual System (POMS) before the end of 2015.  Based on informal communications with and by SSA officials, the treatment is expected to facilitate the use of ABLE accounts without adverse impact on SSI benefits.

Broadly speaking, SSI benefits eligibility is reduced and may be eliminated to the extent the applicable beneficiary has countable assets or countable income in excess of extremely modest amounts.  However, the ABLE Act provides that ABLE account balances are disregarded for SSI purposes except to the extent they exceed $100,000, and that ABLE account distributions for qualified disability expenses also are disregarded except in the case of distributions for housing expenses.

The statutory exclusions leave some ambiguity as to the timing and methodology of determinations that particular ABLE account distributions are excluded from SSI benefits determinations.  The treatment expected to be described in the POMS update is as follows:  Distributions of ABLE account balances of $100,000 or less will not constitute countable income, as such amounts already are owned by the SSI beneficiary at the time of the distribution. Distributions from ABLE accounts will not constitute countable assets if expended within the same month as the distribution is received by the beneficiary from the account, irrespective of the nature of the expenditure.  Distributions from ABLE accounts that are not expended within the same month as the distribution is received by the beneficiary will not be counted as a countable asset if ultimately expended on a qualified disability expense that is not a housing expense.  An ABLE account distribution expended on a housing expense or non-qualified expense in a later month than the month in which the distribution is received may be treated retroactively as a countable asset in all months between distribution and expenditure, potentially requiring the beneficiary to refund SSI benefits received during that period.

Bottom line:  An SSI recipient should not experience any adverse impact from the existence of an ABLE account as long as the account balance is kept at or below $100,000 (probably measured as of each month end), and, subject to confirmation when the relevant POMS update is published by SSA, as long as distributions from the ABLE account are expended in the month of receipt.  Expending ABLE account distributions in a month subsequent to the month of receipt will not produce an adverse result if the expenditure is a qualified disability expense that is not a housing expense, but may create some risk to SSI benefits if the documentation of the expenditure is inadequate or the classification of the expenditure is debatable.

Helpful News from IRS on Student Loan Bonds

Posted in Tax/arbitrage

By MAXWELL D. SOLET

On November 13, the IRS issued Notice 2015-78, providing favorable guidance on topics of interest to providers of “supplemental” or “alternative” student loans financed with tax-exempt bonds and to underwriters of such student loan bonds. Such guidance confirms that loans financeable under such programs include (i) parent loans as well as student loans and (ii) loans that refinance or consolidate prior loans that were or could have been financed on a tax-exempt basis.

Tax-exempt bonds used to finance student loans, so-called “qualified student loan bonds,” come in two flavors under the Internal Revenue Code, those issued to finance federally-guaranteed loans made under the Federal Family Education Loan Program (“FFELP”) and those issued to finance certain loans issued under programs created by the states, generally known as “supplemental” or “alternative” loan programs. While the FFELP program, historically much larger, terminated in 2010, tax-exempt financing for new loans under state supplemental programs has continued in approximately fifteen states.

Notice 2015-78 appears to have been prompted by recent efforts by governmental issuers to provide refinancing of student loan debt through non-federally guaranteed “consolidation loans”, which presented questions on which the IRS had not previously provided guidance.  The IRS also used the notice as an opportunity to address selected other issues applicable to all tax-exempt financed supplemental loans, not just refinancing loans. The Notice clarifies the following:

  • Eligible Borrowers.  Notwithstanding the widespread practice of making higher education loans to parents, a practice provided for by statute under FFELP through the Parent Loan to Undergraduate Students (PLUS) program, the IRS had expressed concerns in the context of ruling request discussions about whether loans to parents were bond-financeable student loans.  Notice 2015-78 clarifies that the student, the parent, or both can be an eligible borrower of a bond-financed “student loan.”  The Notice attempts to provide a similar rule for refinancing loans, stating, “An eligible borrower of a refinancing loan … is the student or parent borrower of the original loan.”  In the refinancing loan context the Notice’s particular wording leaves unclear whether if the sole borrower on the original loan was the parent, the sole borrower on the refinancing loan can be the proud young graduate who wishes to take on the debt through a consolidation loan.  Such a fact pattern clearly satisfies the policy underlying this otherwise expansively drafted notice.
  • Nexus to State.  The Internal Revenue Code requires the student to be a resident of the state which provides the “volume cap” allocation for the bonds or enrolled at an educational institution in that state.  In the case of a refinancing or consolidation loan, there has been some question whether such “nexus” is required to be established at the time the original loan was made or at the time the refinancing loan is made.  The Notice provides the broadest rule, stating that a “refinancing loan,” including a loan which allows the borrower to consolidate prior debt, complies with the statutory nexus requirement either if that requirement was satisfied at the time of the original loan or if it is satisfied at the time of the refinancing loan.  If reliance is placed on nexus at the time the original loan is made,  in the case of a consolidation loan care may need to be exercised to establish nexus for all underlying loans.
  • Loan Size.  The Code limits supplemental loans to “the difference between the total cost of attendance and other forms of student assistance … for which the student borrower may be eligible.”  The “may be eligible” language has resulted in troublesome challenges in IRS audits, where IRS agents have suggested that issuers might be responsible for documenting that students actually had applied for all other potentially available student assistance, or obligated to downsize loans by the amount of other student assistance that was hypothetically available but not received by the student.  The Notice confirms that tax-exempt bond issuers may rely on certifications from the student’s school as to total cost of attendance and as to other student assistance.  Further, the school may rely on definitions provided under the Higher Education Act, including a definition of “estimated financed assistance” which looks only to assistance the student “will receive.”
  • Type of Loans Eligible for Refinancing.  The Notice states that supplemental student loan bonds can be used to refinance not only original loans which were themselves supplemental loans but also other loans, “for example, a FFELP loan or a student loan made by a private lender, provided that the refinancing loan meets all of the requirements for a State Supplemental Loan.”   Although not addressed by the Notice, it should be noted that tax-exempt bonds issued to refinance prior loans, including consolidation of prior loans, generally will require an allocation of state volume cap, which in some states is a scarce commodity.  The need for volume cap may be avoided to the extent the refinancing loans made with proceeds of a bond issue refinance loans financed with other tax-exempt bonds issued by the same issuer or a related issuer and the payoffs on the refinanced loans are applied to redeem such other tax-exempt bonds in a manner that qualifies for the volume cap exception for current refunding bonds.

As a general proposition, the national student loan market is growing and dynamic.  Notice 2015-78 will assist governmental issuers in fulfilling their intended role.

Mintz Levin’s Meghan Burke Awarded Freda Johnson Award for Trailblazing Women in Public Finance

Posted in Uncategorized

We are delighted and proud to share the news that our colleague Meghan Burke has been selected to receive the Freda Johnson Award for Trailblazing Women in Public Finance at the Bond Buyer’s Deal of the Year ceremony in New York on December 3rd. The Freda Johnson award is given annually and recognizes one woman in the private sector and one in the public sector who exemplify the qualities that Freda Johnson, who served as public finance division head at Moody’s Investors Service, brought to the industry as a “trail blazer” and as a “leader, innovator and mentor.” This will be the award’s fifth year and Meghan, who heads Mintz Levin’s public finance practice, is the first recipient chosen for her contributions as an attorneyIn addition to her wealth of public finance experience, Meghan’s professional contributions to the field, volunteer work and mentorship were highlighted in her selection for the award.

Congratulations Meghan!

Can Alphabet Soup Fix Puerto Rico’s Debt Service Issues?

Posted in Workouts

By LEN WEISER-VARON and BILL KANNEL

Last week, the Working Group for the Fiscal and Economic Recovery of Puerto Rico gave the broadest hint yet of the next tactic in Puerto Rico’s ongoing quest to deleverage itself.  Although the details have not yet been articulated, Puerto Rico apparently proposes to blend into a single pot several types of distinct taxes currently earmarked to pay or support different types of bonds issued by a number of its legally separate municipal bond issuers, with the hope that the resulting concoction will meet the tastes of a sufficient number of its differing bond creditors to induce them to voluntarily exchange their various types of bonds for a single type of new debt presumably supported by the new blended tax revenue stream.

According to the “Restructuring Process and Principles” slides released by the Working Group on September 24, “the Working Group is working with the Commonwealth’s advisors to structure a debt-relief transaction that will permit the Commonwealth’s available surplus to be used to make payments on its indebtedness while the initiatives and reforms undertaken as part of the Fiscal and Economic Growth Plan take hold.”  Per the release, “[t]he consensual negotiation and ultimate transaction will seek to involve not just creditors of one governmental entity, but instead the creditors of many entities, as part of a single, comprehensive exchange transaction. The  goal of this approach is to avoid a piecemeal strategy that may result in uncoordinated and inconsistent agreements with creditors, litigation among creditor groups, and a lower chance of success.”

As the saying goes, good luck with that.

The Working Group’s trial balloon is short on details as to which existing debt would be involved in the contemplated “single, comprehensive exchange transaction.”  Given the magnitude of the Working Group’s projected funding gap,  after other proposed corrective measures are undertaken, of $14 billion from FY 2016 to FY 2020, and given that direct and guaranteed general obligation bonds and COFINA sales tax bonds  constitute approximately $34 billion out of Puerto Rico’s approximately $71 billion in outstanding public sector bonds, it seems virtually certain that, at a minimum, the contemplated “super-exchange” would involve the g.o. bonds and the COFINA bonds.  Other types of bonds supported, directly or on a contingent basis, by Commonwealth tax revenues are of substantially lesser magnitude and, in many instances, also are payable from independent revenue streams. Some or, depending on the Working Group’s appetite for complexity, all of those other types of bonds also are likely to be targeted for the to-be-negotiated “super-exchange”; as listed in the Working Group‘s September 9 report, they include bonds issued by HTA, GDB, PBA, PFC, PRIFA, UPR, PRCCDA, PRIDCO, GSA and ERS.

In evaluating the feasibility of a negotiated exchange that stirs together this alphabet soup of issuers and creditors, we start from the following premises:

  •  Debt service on the g.o. debt has top priority, under the Puerto Rico constitution,  on the Commonwealth’s “available resources.”  Although enforcement of this legal priority would raise some thorny issues, and although much of the g.o. debt may now be held by holders with a basis well below par, there is no clear incentive for many g.o. bondholders to give up  any portion of their legal entitlement to full debt service payment from “available resources” for what the Working Group’s slides characterize as reduced payment from the Commonwealth’s “available surplus.”
  • Debt service on COFINA bonds is payable from a statutorily assigned portion of the sales tax or of any substitute tax such as the VAT.   The statutorily assigned taxes should be sufficient to pay full debt service on the COFINA bonds for the foreseeable future.  Puerto Rico case law as well as a series of Puerto Rico Attorney General opinions support the validity of such an assignment.  Much of the outstanding g.o. debt has been issued and/or purchased with full awareness by the g.o. bondholders that the relevant portion of the sales tax has been assigned to COFINA and its bondholders.  Similar assignments of specified tax revenues to independent bond-issuing authorities have been upheld in other jurisdictions.  The complaint allegedly ready on someone’s shelf seeking an adjudication that the COFINA structure is a legal sham or that the assigned sales tax revenues remain “available resources” for the payment of g.o. debt service may be filed some day, but from our perspective COFINA holders should like their chances in any such litigation.  Absent disproportionate fear of an adverse result in any such litigation, there is no clear incentive for many COFINA bondholders to give up  any portion of their legal entitlement to full debt service payment from the statutorily assigned and pledged sales tax revenues for reduced payment from any other source.
  • What, if anything, could be achieved by Puerto Rico in consensual debt reduction negotiations with holders of other types of debt with more tenuous claims on Commonwealth taxes (due to express clawback provisions, appropriation requirements, lack of a constitutional payment priority or security interest or other factors) is an interesting question, but may be moot in the event of substantial nonparticipation in a “super-exchange” by g.o. and COFINA bondholders, as Puerto Rico cannot achieve the debt service reductions it asserts it needs without substantial buy-in from the g.o. and/or COFINA bondholders.
  • Although the “Restructuring Process and Principles” slides state that “[t]he transaction will be structured to take into account the priorities of the debt that creditors hold”, it is difficult to derive much meaning from that statement.  Any restructuring that reduces debt service payable on the g.o. bonds in order to pay other Commonwealth expenses will disregard the constitutional priority of debt service in application of available resources.  Any restructuring that reduces debt service payable on COFINA bonds in order to apply some of the sales tax/VAT pledged as security to COFINA bonds to instead pay Commonwealth expenses will violate the statutory priority of COFINA bond debt service.  To the extent that the restructuring would be consensual, it may be tautological that there will be no dishonoring of any constitutional or statutory priority, as the participating bondholders will have agreed to any deviation from such priorities.  If one assumes that Puerto Rico intends to seek concessions from the g.o. bondholders and/or COFINA bondholders, the statement that priorities will be “taken into account” in the proposed “super-exchange” can best be read as a statement that other types of tax-supported debt to be included in the proposed “super-exchange” may be offered less favorable exchange ratios than the g.o.’s and/or COFINAs.
  • The difficulties and uncertain outcome of consensual debt reduction negotiations involving PREPA, a single credit payable solely from electricity revenues widely deemed insufficient to cover the associated revenue bonds, do not bode well for the outcome of consensual debt reduction negotiations involving homogenization of numerous separate credits, including some with strong legal claims for full payment of their debt.
  • Negotiated exchanges involving some degree of municipal debt reduction or bondholder concessions have succeeded in certain other contexts, but few that we are aware of in which the issuer did not have access to a bankruptcy option as an alternative. Successful exchanges involving issuers that did not have access to a bankruptcy process (e.g., certain tribal casino bonds) involved debt that did not benefit from strong legal claims on tax revenues of the type held by Puerto Rico’s g.o. and COFINA holders.

Puerto Rico’s announced strategy for dealing with its debt has evolved from ring-fencing its tax-supported debt and attempting to address its public corporation debt with a Puerto Rico bankruptcy statute to targeting its tax-supported debt in a consensual negotiation process.  The Working Group and its advisors may sincerely believe that a “debt lite” consommé can emerge from such pot-stirring, but may also believe that a failed process will provide additional ammunition for what Puerto Rico really wants to address its unwieldy debt structure: enactment of federal “super Chapter 9” legislation that would give it access to a federal bankruptcy process encompassing its g.o. bonds as well as its public corporation debt.

The IRS’s Proposed ABLE Regulations: Obstacles to Launching State Programs, and Potential Solutions

Posted in Regulatory Proposals

By LEONARD WEISER-VARON

The IRS’s recently-published proposed regulations for Section 529A qualified ABLE programs have taken some wind out of the sails of state program administrators and potential program managers who had hoped for regulations that hewed closer to the requirements in effect for qualified tuition programs under Section 529, on which Section 529A was based.  Some state officials and would-be program managers are evaluating whether cost-effective ABLE programs can be launched given what, at first blush, appear to be substantially greater administrative burdens imposed on state programs by the proposed ABLE regulations.

The hesitation provoked by the proposed regulations is understandable when one compares the IRS’s proposed administrative requirements to those applicable to Section 529 programs. Section 529 programs are not required to check whether an account owner is eligible to open an account, are not required to check on an annual basis whether the account owner’s status has changed, and are not required to inquire into or track the use of account withdrawals.  (As originally enacted, Section 529 did make programs responsible for determining whether distributions were qualified or unqualified, a requirement so unworkable that Congress amended Section 529 to eliminate it and make the recipient responsible for documenting the use of the distribution upon inquiry by the IRS.)

In marked contrast, the proposed ABLE regulations would require that ABLE programs do all of the above.

The resulting cost issue for ABLE programs and their potential customers is obvious. Due to statutory restrictions under Section 529A, annual contributions to ABLE accounts cannot exceed an inflation-indexed $14,000; Section 529 accounts have no such limit. Moreover, each state’s 529A program is limited to that state’s residents, unless another state elects to have its residents use the other state’s program instead of establishing its own program.  Section 529 programs, on the other hand, can gather assets from the entire nation.  If one adds to the substantially smaller projected amount of a particular ABLE program’s assets under management the expenses associated with the increased staff and systems programming necessitated by the additional verification and recordkeeping requirements imposed by the proposed regulations, the math is simple: greater expenses divided into fewer assets equals substantially higher program expenses to be recovered from program participants, and therefore reduced investment returns for the future expenses of disabled individuals.

A fair reading of the ABLE Act is that Congress intended the IRS, not the state programs, to be the watchdog that would ensure that ABLE programs are used by the disabled and for qualified disability expenses, and intended the Social Security Administration to determine whether ABLE account distributions are used for housing or unqualified expenses (in which case they are factored into the disabled individual’s eligibility for SSI benefits, whereas ABLE account distributions for non-housing qualified disability expenses are disregarded.)  But in an era where federal agency resources, particularly the IRS’s, are stretched, the proposed regulations have been drafted to effectively shift that responsibility, and the attendant costs, to the state programs.

The question the state programs and their potential contractors are struggling with is what exactly these unexpected and unwelcome responsibilities entail, and how much expense has been shifted from the federal government to the disabled community.  If the well-intentioned and long-sought ABLE Act is to achieve its objective, it will be in the interest of Congress, the IRS and the disability community, not just the state programs, to ensure that the administrative burden is reduced to the minimum necessary to make these programs function as intended.

The proposed regulations are not technically binding before they are finalized, and it is possible that, following the current 90 day comment period, the IRS will issue final regulations that lighten some of the proposed burden on ABLE program administrators.  But whether and when any more program-friendly final regulations will be issued is unknown, and the disability community deserves to have access to ABLE programs sooner than the indefinite future.  Unless and until the IRS, by advance notice or other clarification, provides better answers, individual states that wish to go forward with ABLE programs in advance of final regulations will need to reach a comfort level that they can comply with the IRS’s unexpected views on what a state must do to maintain its ABLE program’s beneficial tax status without making the pass-through costs of operating an ABLE program so expensive as to potentially outweigh the tax benefit.

A consensus on what practices are sufficient to comply with the proposed regulations without saddling ABLE programs with impracticable and expensive procedures will take some time to evolve.  Here is an initial perspective:

1)       Account–opening:

The proposed regulations state that “[a] qualified ABLE program must specify the documentation that an individual must provide, both at the time an ABLE account is established for that individual and thereafter, in order to ensure that the designated beneficiary of the ABLE account is, and continues to be, an eligible individual.”

For those account owners who are ABLE-eligible because they are eligible for SSI or SSDI disability benefits, the preamble to the proposed regulations suggests that “[f] or example, a qualified ABLE program could require the individual to provide a copy of a benefit verification letter from the Social Security Administration and allow the individual to certify, under penalties of perjury, that the blindness or disability occurred before the date on which the individual attained age 26.”  This suggestion may be workable if the Social Security Administration will provide such benefit verification letters with respect to the then-current tax year in short order upon request by an individual wishing to open an ABLE account.  Otherwise, if an individual can only provide a prior year benefit verification letter to the state program, states will need to decide whether, in connection with an account opening, they can rely upon the account owner’s certification, under penalties of perjury, that such eligibility status has not changed since the year in which the benefit verification letter submitted to the program was issued by the Social Security Administration.

As to those account owners who are ABLE-eligible under Section 529A because they file an eligibility certification and a physician diagnosis with the Secretary of Treasury, the preamble to the proposed regulations states that “[w]hile evidence of an individual’s eligibility based on entitlement to Social Security benefits should be objectively verifiable, the sufficiency of a disability certification that an individual is an eligible individual for purposes of section 529A might not be as easy to establish.”  The proposed regulations state that “a disability certification will be deemed to be filed with the Secretary [of Treasury] once the qualified ABLE program has received the disability certification”, which “deemed” filing, according to the preamble, is designed  “to facilitate an eligible individual’s ability to establish an ABLE account without undue delay.”

Taking the IRS at its word that the shifting of the certification filing from the Treasury, as specified in the statute, to the states, as specified in  the proposed regulations, is designed to “facilitate” account-opening “without delay,” it seems sensible to interpret the regulations as requiring a state to confirm no more than that a certification facially stating what the proposed regulations require has been signed or e-signed by the account owner (or his or her agent, parent or guardian), and is accompanied by a physician’s signed or e-signed letter facially providing the diagnosis on which the account owner’s certification relies.

Based on the proposed regulations, it appears that the certification filed with the ABLE program by or on behalf of the account owner must be signed or e-signed under pains and penalties of perjury and should state something along the following lines:

“(i)(A) I have the following medically determinable physical or mental impairment: _____________________________.  This impairment results in marked and severe functional limitations (as defined below), and—

(1) Can be expected to result in death; or

(2) Has lasted or can be expected to last for a continuous period of not less than 12 months; or

(B) I am blind (within the meaning of section 1614(a)(2) of the Social Security Act);

(ii) Such blindness or disability occurred before the date of my 26th birthday.

For purposes of this certification, “marked and severe functional limitations” means  the standard of disability in the Social Security Act for children claiming Supplemental Security Income for the Aged, Blind, and Disabled (SSI) benefits based on disability (see 20 CFR 416.906). Specifically, this is a level of severity that meets, medically equals, or functionally equals the severity of any listing in appendix 1 of subpart P of 20 CFR part 404, but without regard to age. (See 20 CFR 416.906, 416.924 and 416.926a.) Such phrase also includes any impairment or standard of disability identified in future guidance published in the Internal Revenue Bulletin. Consistent with the regulations of the Social Security Administration, the level of severity is determined by taking into account the effect of the individual’s prescribed treatment. (See 20 CFR 416.930.)  Conditions listed in the “List of Compassionate Allowances Conditions” maintained by the Social Security Administration (at www.socialsecurity.gov/compassionateallowances/conditions.htm) are deemed to meet the requirements of clause (i) of this certification.”

Based on the proposed regulations, it appears that the physician’s diagnosis accompanying the account owner’s certification must be signed or e-signed by the physician and should state:

“I hereby certify that I am a physician meeting the criteria of section 1861(r)(1) of the Social Security Act (42 U.S.C. 1395x(r)).  I further certify that I have examined ____________ and that, based on my examination, I have determined that s/he has the following physical or mental impairment: ________________________.”

The ABLE program administrator would need to determine that the account owner’s certification has been signed or e-signed in the name of the account owner or by someone who has certified that he or she is the account owner’s agent, parent or guardian, and that the diagnosis inserted in the blank of such certification matches the diagnosis in the blank of the physician’s diagnosis, and that the physician’s diagnosis is signed or e-signed.

It should be noted that draft tax instructions for Form 5498-QA released by the IRS require a program to report to the IRS annually, for each account and by code number, “the type of disability for which the designated beneficiary is receiving ABLE qualifying benefits.” The code menu on the draft IRS instructions is:

Code 1-  Developmental Disorders: Autistic Spectrum Disorder, Asperger’s Disorder, Developmental Delays and Learning Disabilities

Code 2 – Intellectual Disability: “may be reported as mild, moderate or severe intellectual disability”

Code 3 – Psychiatric Disorders: Schizophrenia, Major depressive disorder, Post-traumatic stress disorder (PTSD), Anorexia nervosa, Attention deficit/hyperactivity disorder (AD/HD), Bipolar disorder

Code 4 – Nervous Disorders: Blindness; Deafness; Cerebral Palsy, Muscular Dystrophy, Spina Bifida, Juvenile-onset Huntington’s disease, Multiple sclerosis, Severe sensoneural hearing loss, Congenital cataracts

Code 5 – Congenital anomalies: Chromosomal abnormalities, including Down Syndrome, Osteogenesis imperfecta, Xeroderma pigmentosum, Spinal muscular atrophy, Fragile X syndrome, Edwards syndrome

Code 6 – Respiratory disorders: Cystic Fibrosis

Code 7 – Other: includes Tetralogy of Fallot, Hypoplastic left heart syndrome, End-stage liver disease, Juvenile-onset rheumatoid arthritis, Sickle cell disease, Hemophilia, and any other disability not listed under Codes 1-6.

The tax instructions state that “the … information will only be used for aggregate reporting purposes as required by law.”

The notion that a state ABLE program established to provide investment accounts should have any role in determining which of the above panoply of medical conditions, if any, an account applicant suffers from sends off all sorts of alarm bells for many of those involved in structuring such programs. This proposed requirement can only be met by the relevant state program, if it can be met at all, by coding into the Form 5498 whatever condition the applicant and the physician have filled in on the forms submitted when the account is established. Even that will require coding additional fields into the ABLE programs’ operating system and may require staff to translate the conditions specified in the application materials into the appropriate code. And in the case of applicants who establish ABLE eligibility via eligibility for SSI or SSDI benefits, the diagnosis may not be apparent from the benefits letter submitted as proof. This is an unwarranted level of complexity and expense for the questionable benefit of then adding up all the painstakingly gathered disability codes into an aggregate report that has nothing to do with the ABLE program’s operations. But unless and until the IRS signals relief from this proposed requirement, ABLE programs that wish to go forward will need to design systems capable of generating such coding, at the expense of ABLE program participants.

2)           Annual recertification:

As noted above, the proposed regulations require that programs specify the documentation that must be provided after an account is opened to establish the account owner’s continued disabled status.  According to the proposed regulations,  “a qualified ABLE program may choose different methods of ensuring a designated beneficiary’s status as an eligible individual and may impose different periodic recertification requirements for different types of impairments.”  The proposed regulations include several impractical suggestions on compliance that presume that the state program has expertise on the likely length of particular disabilities (see the above list) and the likelihood of a cure being found for particular disabilities.  However, the proposed regulations also state: “If the qualified ABLE program imposes an enforceable obligation on the designated beneficiary or other person with signature authority over the ABLE account to promptly report changes in the designated beneficiary’s condition that would result in the designated beneficiary’s failing to satisfy the definition of eligible individual, the program also may provide that a certification is valid until the end of the taxable year in which the change in the designated beneficiary’s condition occurred.”

It seems likely that most states will follow this suggestion and include a requirement of such notice of change in disability status in the participation agreement or similar agreement executed or adopted by an account owner when the account is opened.  There is no reason to think that such a covenant by the account owner is any less “enforceable” than any other contractual agreement by the account owner, but as the proposed regulations are unclear on what the IRS means by “enforceable”, it may be prudent to state that the IRS is a third-party beneficiary of that particular covenant, so that the IRS can enforce it as it sees fit in the event it is breached by the account owner.

3) Tracking distributions:

The most perplexing provision in the proposed regulations states that “[a] qualified ABLE program must establish safeguards to distinguish between distributions used for the payment of qualified disability expenses and other distributions, and to permit the identification of the amounts distributed for housing expenses as that term is defined for purposes of the Supplemental Security Income program of the Social Security Administration.”

The proposed regulations also provide that “[i]f the total amount distributed from an ABLE account to or for the benefit of the designated beneficiary of that ABLE account during his or her taxable year does not exceed the qualified disability expenses of the designated beneficiary for that year, no amount distributed is includible in the gross income of the designated beneficiary for that year.”  Accordingly, for tax purposes, particular distributions are not made for qualified or unqualified purposes, or for housing purposes; instead, distributions may be requested at any point in the year, and then are simply compared in the aggregate to the account owner’s aggregate qualified disability expenses for the applicable tax year.

Because the account owner is not required for tax purposes to link a particular withdrawal to a particular expenditure, it is mystifying how the IRS and the Social Security Administration think programs can discharge this tracking and reporting duty.  No guidance whatsoever is provided on this point in the proposed regulations.  Given that some portion of the disabled community is expected to use ABLE accounts as transaction accounts, a requirement that states demand and examine invoices or receipts for each requested distribution, and determine in each case whether the amount is qualified or non-qualified and, if qualified, relates to housing, would substantially delay distributions and impose staffing requirements on programs or their contractors that would dramatically increase the expense ratios of ABLE investments. A distribution verification requirement is exactly what was amended out of Section 529 by Congress, and Congress did not reintroduce it statutorily when it enacted Section 529A.

This distribution tracking requirement, if not eliminated or clarified promptly by the IRS and the Social Security Administration, risks delaying or stopping many potential ABLE programs, particularly if interpreted to require anything more from the state program than a “check the box” section on distribution request forms.  States that are willing to proceed pending further clarification of this troubling element of the proposed regulations will likely provide account owners with distribution forms that ask that each requested distribution be broken down into subtotals relating to housing expenses, other qualified disability expenses, and unqualified expenses, all as determined and certified by the account owner under pains and penalties of perjury.  The state programs will make the required monthly reports to the Social Security Administration on the basis of such certifications.  Even the tracking of these subtotals and the related systems programming requirements will impose requirements on ABLE programs, and resulting expenses for ABLE program investors, that Section 529 programs are not burdened with and that are properly left between the Social Security Administration and those account owners receiving federal disability benefits.