As tax exempt health institutions begin reporting in accordance with the recently revised IRS Form 990, it is important to note a new requirement related to disclosure of management/ service contracts with private entities. Specifically, if an exempt organization has received tax-exempt financing, there are strict requirements related to arrangements with persons or entities providing management services and utilizing assets financed with tax-exempt funds. Under the new Form 990, exempt organizations with outstanding tax-exempt bonds must annually report the percentage of such “private use” of bond-financed property, and whether agreements with private parties related to such property comply with the applicable safe harbor.
IRS Revenue Procedure 97-13 provides a safe harbor for permitted service contracts. Compensation must be reasonable and may not be based in whole or in part on net profits attributable to the operation of the bond-financed assets. The structure of the fee to be paid to the service provider must also be specified in advance and based on such structure, the agreement is limited to the potential term and termination notices. Eligible service contracts, which may involve management, service or incentive payments, result in “private use” of bond-financed property to the extent that compensation for services rendered is based on a share of net profits from the facility’s operation and/or the private services rendered involve a portion or any function of a facility financed with exempt funds. Although employment agreements are explicitly excluded from the definition of a service contract, potential agreements include contracts for professional services, medical directors, teaching, food service, on-call coverage and facility or department management.
In most cases, an exempt organization may be able to amend a non-compliant agreement in order to satisfy the safe harbor. In the alternative, there is a 5% private use or “bad money” allowance related to the financed property, to the extent the exempt organization has not already used some portion of that allowance. The exempt organization may also reallocate bond proceeds to alternative uses, or allocate taxable debt or the organization’s own funds, to finance the otherwise non-qualified assets or use. Finally, in the absence of other alternatives, it may be necessary to take other remedial action to preserve the tax-exempt status of the bonds, and such action may include redeeming or defeasing a portion of the bonds which is allocable to the property used in connection with a non-compliant agreement.
Exempt organizations must assess their method for determining what property has been financed with taxexempt bonds and carefully review and confirm that “service contracts” comply with the applicable safe harbors. The organization must also take steps to properly report such compliance on Form 990.