Poker has a well-established hierarchy of winning hands. If you’re holding a full house, you’ve got a right fine hand, but if you reach for the pot when the last bets are called and another player has four deuces, you will at best be the object of ridicule and at worst the subject of grievous bodily harm or death (it all depends on with whom you are playing). Legal authorities also have a strict order of priority. The most extreme adverse consequences that can befall one who forgets the priority of winning poker hands are unlikely to meet one who forgets which legal authorities take precedence over others, but it’s good practice to be mindful of the hierarchy of legal authorities.
The recent issuance of Rev. Proc. 2017-13 is a case in point. As Bob Eidnier discussed in his recent post on this Revenue Procedure, the Internal Revenue Service issued it in response to requests from the National Association of Bond Lawyers and others for clarification of Rev. Proc. 2016-44 (which superseded Rev. Proc. 97-13) that a management contract does not result in the manager receiving net profits from the managed facility (and, thus, in private business use of the tax-exempt bond proceeds that financed that facility) if the qualified user of the facility pays the manager a form of compensation permitted under Rev. Proc. 97-13 (percentage of gross revenue or expense (but not both), per-unit fees, capitation fees, periodic fixed fees, and certain types of incentive compensation) and the manager also bears some amount of the cost of operating the managed facility. Stated another way, NABL requested that the IRS make clear that the various management contract compensation arrangements permitted under the Rev. Prov. 97-13 safe harbors from private business use not be treated as the sharing of net profits of the managed facility under Rev. Proc. 2016-44.
The IRS responded to this request by issuing Rev. Proc. 2017-13 to supersede Rev. Proc. 2016-44 and to make it clear that a compensation arrangement under a management contract that consists of per-unit fees, periodic fixed fees, capitation fees, and/or certain incentive compensation will not result in the manager obtaining a share of the net profits of the managed facility where the manager also bears some portion of the cost of operating the facility. Thus, with the exception of a share of gross revenue (or expense) of a managed facility, each form of compensation set forth in a Rev. Proc. 97-13 safe harbor from private business use for management contracts is expressly permitted to be within the Rev. Proc. 2017-13 safe harbor from private business use.
The clarification given by Rev. Proc. 2017-13 is welcome, but was it necessary? And, in the case of the exclusion of a share of gross revenue from the Rev. Proc. 2017-13 safe harbor, is this clarification detrimental? Bob correctly notes in his post several reasons why the manager’s receipt of a share of the gross revenue of the managed facility does not result in private business use where the manager also pays some portion of the expense of operating the facility. Moreover, an analogy to poker demonstrates that the clarification provided by Rev. Proc. 2017-13 was both unnecessary in the case of the Rev. Prov. 97-13 compensation arrangements specifically referenced by Rev. Proc. 2017-13, and it was not detrimental in the case of the Rev. Proc. 97-13 compensation arrangements that Rev. Proc. 2017-13 omits.
Much like those who think a pair of aces is always the best poker hand, public finance tax lawyers treat private letter rulings issued by the IRS as the ultimate authority in this area of the law. The former aren’t mindful of the hierarchy of poker hands, and the latter have forgotten their high school civics regarding the primacy of various legal authorities. The U.S. Constitution is the ultimate legal authority in matters of federal tax law, followed by statutes, and then by Treasury regulations. Section 141(b)(6)(A) of the Internal Revenue Code provides that in the case of tax-exempt bonds, private business use “means use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit.” Treas. Reg. § 1.141-3(b)(4)(i) interprets the meaning of private business use in the case of management contracts and provides as follows:
“a management contract . . . with respect to financed property may result in private business use of that property, based on all the facts and circumstances. A management contract with respect to financed property generally results in private business use of that property if the contract provides for compensation for services rendered with compensation based, in whole or in part, on a share of net profits from the operation of the facility.”
The IRS established in Rev. Proc. 97-13 safe harbors from private business use for management contracts that can apply based on the mix of compensation paid under the contract and the term of the contract. Given both the dictate in Treas. Reg. § 1.141-3(b)(4)(i) that a management contract results in private business use if the compensation under that contract is based, wholly or partially, on the managed facility’s net profits and the primacy that Treasury regulations have over other administrative guidance from the IRS, the IRS could not enshrine in the Rev. Proc. 97-13 safe harbors from private business use compensation arrangements that effect a sharing of the managed facility’s net profits between the manager and the qualified user. To do so would be the equivalent of claiming that a pair of kings beats three queens.
Thus, regardless of whether Rev. Proc. 97-13 is superseded, a management contract that would satisfy a Rev. Proc. 97-13 safe harbor from private business use (including a contract whose term does not exceed five years and that compensates the manager with a percentage of the gross revenue of the managed facility, with the manager paying the expense of operating the facility) cannot on a facts and circumstances basis result in private business use of the managed facility. The Rev. Proc. 97-13 safe harbors on their face do not effect a sharing of net profits, and these safe harbors have existed for nearly 20 years without any suggestion from the IRS that any of those arrangements could effect a sharing of net profits. Just as a flush always beats a straight, the IRS cannot in a revenue procedure contravene a Treasury regulation, which means that a management contract that satisfies a Rev. Proc. 97-13 safe harbor by definition cannot generate private business use, regardless of whether Rev. Proc. 97-13 has been superseded.
Finally, there is one type of management contract that will always be within a safe harbor from private business use, regardless of how the IRS modifies those safe harbors. Section 1301(e) of P.L. 99-514, The Tax Reform Act of 1986, is an uncodified statute that provides as follows:
“The Secretary of the Treasury or his delegate shall modify the Secretary’s advance ruling guidelines relating to when use of property pursuant to a management contract is not considered a trade or business use by a private person for purposes of section 141(a) of the Internal Revenue Code of 1986 to provide that use pursuant to a management contract generally shall not be treated as trade or business use as long as—
(1) the term of such contract (including renewal options) does not exceed 5 years,
(2) the exempt owner has the option to cancel such contract at the end of any 3-year period,
(3) the manager under the contract is not compensated (in whole or in part) on the basis of a share of net profits, and
(4) at least 50 percent of the annual compensation of the manager under such contract is based on a periodic fixed fee.”
Given the unfettered authority Congress has under the U.S. Constitution to enact federal tax laws, and the precedence that statutes have over any administrative promulgation, the foregoing safe harbor from private use for management contracts is the royal flush of such safe harbors. Only a subsequent act of Congress can cause a management contract that meets the elements of Section 1301(e) of the Tax Reform Act of 1986 to fall outside a safe harbor from private business use.