As a student, I was forced to read a great many books that I was told were literary classics.  I only voluntarily read books about sports, science, science fiction, and historical fiction.  This lack of interest in literary greatness may explain why I ended up as a tax and public finance lawyer.  I am guessing my English teachers would not be surprised by my career choice. On that long list of the classics were books by John Updike, who wrote a series of books about Harry “Rabbit” Angstrom, starting with Rabbit, Run.  In 1971, the second book in the series was published.  It was entitled Rabbit Redux.  As almost anyone who voluntarily took Latin in middle school and high school can tell you, redux is derived from the Latin verb “reducere”, to bring back.  I took Latin involuntarily, just as I read the classics involuntarily, so I could not possibly tell you the derivation of redux.  But, thanks to search engines, I was able to look it up quickly.  Just as Rabbit was brought back in the second Updike novel, so the IRS has brought back the discussion of what is a political subdivision from the annals of history.

Why the redux?  A controversy arose a few years ago as a result of an IRS audit of bonds issued by a Florida Community Development District (typically referred to as “CDD’s”).  That audit led to a request for a Technical Advice Memorandum (“TAM”) TAM 201334038  from the IRS Chief Counsel’s office.  The TAM concluded that the bonds of that specific CDD were not tax-exempt because this particular CDD was not, in the view of the IRS, a political subdivision for federal tax purposes.  The TAM introduced the concept that, along with other longstanding tests of what constitutes a political subdivision, a political subdivision must also be responsible, at least indirectly, to the political process by being subject to the control of an electorate.  A maelstrom ensued about whether that new element was in fact required by existing law and about exactly what it meant to be subject to a general electorate.

The existing law focused on the powers of the political subdivision, specifically having at least a substantial amount of one of three powers: the power to tax, the power of eminent domain, and the police power, sometimes referred to as the “Shamberg Powers” after a federal court case from the 1940’s, involving the original iteration of what is now called the Port Authority of New York and New Jersey, that became the crux of the analysis thereafter.  There are political subdivisions in certain states that have at least one of those powers but are not directly answerable to a general electorate or are answerable to an electorate where the right to vote is based on the ownership of property in the subdivision, not residence in the subdivision.  Some irrigation districts, primarily in the western United States, are set up this way with elections based on a per acre vote.  Many Florida CDD’s, which, by design, often begin as an undeveloped track of land, can begin their existence with a per acre vote and switch to a vote of residents once a statutorily defined threshold of residents is reached as the development is built out.  Thus, when applicable, the Florida CDD statute uses a hybrid approach due to the transition from empty land to a developed community.

After the resulting furor, the IRS announced that it was undertaking a project to better define a political subdivision, a topic the private bar thought was resolved long ago by some court cases and IRS rulings that trace back to the 1930’s that set forth what became the 3 part “Shamberg powers” test described above.  Thus, the IRS has brought back the topic of what is a political subdivision, a political subdivision redux, if you will. The topic had been largely dormant since Shamberg, with only an occasional discussion of what precisely constitutes each of the 3 powers and what constituted a sufficient amount of those powers.  The IRS has invited public comments to assist it in the political subdivision project. The private bar has expressed the view that any new definition of political subdivision be prospective only. Just yesterday the ABA Tax Section released its comments in response to the IRS’ request and those comments request that any new definition or elaboration of the definition of a political subdivision be prospective.

Why do we care about the definition of a political subdivision?  Section 103(a) of the Code states that the interest on a “State or local bond” is excluded from gross income.  Section 103(c) defines a State or local bond as “. . . an obligation of a State or political subdivision thereof.”  Thus, the question of what is a political subdivision is one of the most fundamental questions in tax-exempt bond law.  You cannot have tax-exempt bonds unless the bonds are issued by the correct kind of entity.  Treas. Reg. 1.103-1(b), which dates back to 1972, states that “The term ‘political subdivision’ . . . denotes any division of any State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.  As thus defined, a political subdivision of any State or local governmental unit may or may not . . . include special assessment districts so created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port improvement, and similar districts and divisions of any such unit.”

We are all likely to think we know what a State or political subdivision is and most of the time it is quite obvious.  With the exception of the original 13 states, the states were all formed with the authorization of Congress.  Each state then determined what constituted a political subdivision of that state.  For the most part, federal tax law respects those determinations by a state.

But, at the edges, the question of what is a political subdivision can become harder to delineate.  The question does not arise just in the context of tax exempt bonds.  Thus, the tax-exempt bond community read with interest a recent IRS notice of proposed regulations in the context of public pension plans.  Notice 2015-07 discusses at length whether an employee of a charter school can participate in a public pension plan.

Section 414(d) of the Code defines a governmental [pension] plan as “. . . a plan established and maintained for its employees by . . . any State or political subdivision thereof . . .”  Notice 2015-07 cites two old revenue rulings, Rev. Rul. 57-128 and Rev. Rul. 89-49  and the principles outlined in those rulings as to what constitutes a political subdivision.  But then Notice 2015-07 turns to what the IRS may consider in future guidance.  On that list of elements is “. . . whether the members of the entity’s governing board or body are publicly nominated and elected . . .”  Thus, this electoral concept shows up again in a different area of the tax law but where the definition of a political subdivision is equally important.

Presumably the IRS would not want guidance as to what is a political subdivision for pension purposes to differ from the guidance in the public finance arena.  The IRS seems to be proceeding on parallel tracks in developing the meaning of a political subdivision in both of these areas of tax law.  Thus, the public finance tax lawyers will have to widen their focus as the IRS project to update the definition of a political subdivision unfolds.

How will this concern about an electorate that seems to arise in the IRS’ analysis of what is a political subdivision in both the pension and the public finance context affect whatever guidance comes out of the political subdivision project?  I don’t know, perhaps because I never read any of the subsequent Updike Rabbit novels after Rabbit Redux because no one ever forced me to do so.  Maybe I should go back and read how things turned out for Rabbit to see if it provides any insight into what will happen to the political subdivision redux.