The Internal Revenue Service recently issued guidance in Rev. Proc. 2016-44 that meaningfully expands the safe harbors pertaining to management contracts affecting bond-financed property such as professional services agreements (e.g., radiology), medical director agreements, on-call agreements, food service agreements and management services agreements. While the new framework offers clarity and increased flexibility for Section 501(c)(3) organizations in negotiating management contracts, particularly longer-term arrangements with service providers, it also presents new challenges and conditions to meet the safe harbor.

The IRS first provided for the conditions under which a management contract would not result in private business use, or would fall within a safe harbor, in Rev. Proc. 97-13. Those conditions included limits on net profit arrangements, contract term, compensation, and the relationship between the 501(c)(3) organization and its service provider. The IRS then “amplified” the management contract safe harbor with Announcement 2014-67, which added a new and very broad category of permissible five-year arrangements.

Rev. Proc. 2016-44 supersedes the existing safe harbor framework, providing 501(c)(3) organizations and their service providers with several new opportunities and challenges in negotiating management contracts affecting bond-financed property:

  • The term of the management contract must be the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property. This is a significant expansion from the Rev. Proc. 97-13 safe harbors regarding contract term.
  • A reasonable compensation structure (fixed or variable) for the services rendered as long as the compensation is not based on a share of net profits from operating the property. Incentive payments are considered reasonable and therefore permitted if eligibility is determined by the service provider’s performance against quality, performance or productivity standards.
  • The contract must not impose upon the service provider the burden of sharing in any net losses from operating the property or bearing the risk of loss for damage or destruction of the property.
  • The 501(c)(3) organization must exercise a significant degree of control over the property. This can include approval of annual budgets, capital expenditures, dispositions, rates charged for use, and general use of the property.
  • The management contract must provide that the service provider is not entitled to, and will not take, any tax position inconsistent with being a service provider. For example, the service provider must agree that it will not take any depreciation, amortization, investment tax credit or deduction for any payment as rent related to the property.
  • The 501(c)(3) organization must have the independent ability to exercise rights over the property and provider contract; the service provider cannot be in the position to influence or control the organization. This requirement aims to ensure that interested parties are not orchestrating management contracts from both sides of the transaction.

For purposes of this safe harbor, a service provider will not be treated as having a prohibited amount of control if:

  • No more than 20 percent of the voting power of the qualified user’s governing body is vested in the service provider’s directors, executives or other employees;
  • The service provider’s CEO (or equivalent executive) is not included on the governing body of the qualified user; and
  • The service provider’s CEO also is not the qualified user’s CEO or the CEO of any of the qualified user’s related parties.

Rev. Proc. 2016-44 applies to any management contract entered into on or after August 22, 2016, but 501(c)(3) organizations and service providers generally may continue to rely on the safe harbors set forth in Rev. Proc. 97-13 and Announcement 2014-67 (as previously modified) for management contracts entered into before August 18, 2017. However, if such contracts are materially modified, extended, or in some cases renewed, on or after August 18, 2017, the updated contract will be subject to the Rev. Proc. 2016-44 requirements.

Also as a reminder, Rev. Proc. 97-13, Announcement 2014-67 (and Rev. Proc. 2016-44) do not apply to all contracts affecting bond-financed property. Certain arrangements will give rise to private business use even if they otherwise fall within the 97-13 safe harbor (e.g., leases), and others will not result in private business use even if they fail to meet the safe harbor (e.g., those solely related to the property’s primary function).