IRS Charts New Course on Management Contracts for Facilities Financed by Tax-Exempt Bonds

October 11, 2016
Publications

The Internal Revenue Service recently announced a major change in its treatment of management contracts related to facilities financed by tax-exempt bonds. Such contracts are entered into by governmental entities and nonprofit associations that are exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code (collectively, “issuers”). Issuers use these contracts to outsource the management of a variety of facilities, including hospitals and water and wastewater facilities. The new rules are set forth in Revenue Procedure 2016-44, and generally will apply to any management contract entered into on or after August 22, 2016, although issuers may elect to continue to apply the old rules until August 18, 2017.

The treatment of management contracts has been a focus of the IRS for decades, as it has long taken the position that the use of the facility by the service provider may result in “private business use” of the facility. This is significant, as the presence of private business use in a facility financed with tax-exempt bonds may result in the underlying bonds losing their tax-exempt status. While the private business use rules are very complex, generally speaking, if more than ten percent – five percent in the case of facilities owned by 501(c)(3) nonprofit associations and for certain unrelated or disproportionate uses of facilities owned by governmental entities – of a bond-financed facility is tainted by private business use, the IRS may determine the bonds to be taxable private activity bonds.

The IRS published final regulations on management contracts in 1997, at 26 C.F.R. §1.141-3. Section 1.141-3 defines a management contract as any “management, service, or incentive payment contract between a governmental person and a service provider under which the service provider provides services involving all, a portion of, or any function of, a facility.” Section 1.141-3 adopts a facts and circumstances test for determining whether a particular management contract results in private business use, while also providing that a contract generally results in private business use if it provides for compensation based, in whole or in part, on a share of net profits from the operation of the facility.

Certain contracts enumerated in section 1.141-3 are deemed not to be management contracts. These include contracts for services solely incidental to the primary function of the facility; contracts granting admitting privileges by a hospital to a doctor; certain contracts to provide for the operation of a public utility facility; and service contracts where the compensation consists solely of reimbursements for actual and direct expenses.

Recognizing that the facts and circumstances test would introduce uncertainty as to the tax implications of a management contract, the IRS created five safe harbors, through its publication in 1997 of Revenue Procedure 97-13. A contract that met all of the requirements of one of the five safe harbors would be deemed to not result in private business use, giving an issuer certainty that its contract would not affect the tax-exempt status of its outstanding bonds.

The safe harbors announced in Rev. Proc. 97-13 varied based on the maximum term of the contract and the specific mix of compensation paid to the service provider. Longer contracts of ten or fifteen years had to be based substantially (80% or more) on fixed fee compensation, i.e. the service provider’s compensation under the contract had to be based on a specified amount that could only be increased by a specified, objective, external standard, such as the Consumer Price Index. Shorter contracts of five years or less offered issuers greater flexibility in the mix of compensation offered to the service provider, permitting compensation based on per-unit-of-service or per-person-served standards (commonly seen in the healthcare industry), although the specific mix of compensation permitted varied depending on the safe harbor that was chosen. Contracts greater than fifteen years did not qualify for a safe harbor. And, at no time could compensation be based on a share of net profits, consistent with section 1.141-3.

Furthermore, the service provider could not have a role or relationship with the governmental entity or nonprofit association that substantially limited the entity’s ability to exercise its rights under the contract. This requirement was deemed met if (1) not more than 20% of the voting power of the governing body of the entity was vested in the service provider; (2) the parties did not share chief executive officers; and (3) the parties were not “related parties” as defined elsewhere in the regulations by the IRS.

The safe harbors announced in Rev. Proc. 97-13 proved far too rigid and difficult to apply for many issuers. A contract had to be carefully structured to meet the requirements of the safe harbor, limiting the ability of the parties to set terms based on their own needs. This often hamstrung negotiations between parties, and stifled the ability of parties to select a mix of compensation appropriate for a particular facility.

The IRS began to address these issues in 2014, through the publication of Notice 2014-67, which expanded the use of productivity awards and created a sixth class of safe harbor that provided greater flexibility in the mix of compensation permitted to be paid to the service provider. While intended principally to address issues that had arisen for hospitals and other healthcare organizations in the wake of the Affordable Care Act (Obamacare), the new rules announced in Notice 2014-67 also applied to government issuers and other 501(c)(3) nonprofit associations.

The IRS has now chosen to simply abandon the rigid, formulaic rules set forth in this prior official guidance. Instead, it has adopted what it calls a “principles-based approach,” that is focused on the following four factors: (1) issuer control over projects, (2) issuer bearing of risk of loss, (3) the economic life of the managed project, and (4) consistency of tax positions taken by the service provider. In addition to these four factors, the management contract must still continue to meet the compensation and control requirements that have long been a hallmark of official IRS guidance on this topic.

First, the management contract must provide that the issuer retain a “significant degree of control over the use of the managed property.” The IRS explains that this requirement is met if the contract requires that the issuer approve the annual budget, capital expenditures, dispositions of property, rates charged, and the types of services provided.

Second, the management contract must provide that the issuer bear the risk of loss if the managed property is damaged or destroyed. The issuer can, however, obtain insurance against such loss, and impose penalties on the service provider if the provider failed to meet the standards set forth in the contract, resulting in the loss.

Third, the management contract must have a term no greater than the lesser of (1) thirty years, or (2) 80% of the economic life of the managed property. This “economic life” requirement is perhaps the most noteworthy aspect of the new rules, as under prior guidance contracts could only have a maximum term of fifteen years and still qualify for a safe harbor. The ability to enter into a contract for up to 30 years should create additional opportunities for public-private partnerships involving bond-financed facilities that before were unavailable because the maximum contract length of fifteen years was either unfeasible or placed too many restrictions on compensation to make it economically attractive to service providers.

And fourth, the management contract must not permit the service provider to take a tax position that is inconsistent with its role as a service provider. This restriction appears intended to prevent the service provider from realizing tax benefits generally reserved to property owners, such as depreciation.

The new rules do not change the long-standing prohibition seen in the prior guidance on contracts containing compensation based on net profits. The biggest difference now is that issuers and service providers have much greater flexibility in negotiating the form and the mix of compensation. The compensation mix may continue to include incentive payments for meeting service goals (although such goals cannot be tied to net profits or net losses).

Finally, Rev. Proc. 2016-44 continues the prohibition on the service provider having a role or relationship with the issuer that limits the issuer’s ability to exercise its rights under the management contract. The existing safe harbor to this rule that was originally set forth in Rev. Proc. 97-13 is generally continued, with only minor adjustment.

The new rules for management contracts announced by the IRS apply both to governmental entities and 501(c)(3) nonprofit associations. Issuers that are considering a management contract for a facility financed by tax-exempt bonds should consult counsel early in the process, to ensure that counsel has an opportunity to revise the contract to ensure compliance with the new rules.

Timothy J. Horstmann is a public finance and tax attorney and member of the Public Sector Group of McNees Wallace & Nurick LLC. He regularly advises governmental and 501(c)(3) nonprofit associations on the tax implications of transactions involving tax-exempt bond-financed property. He can be reached at thorstmann@mcneeslaw.com.