On August 22, 2016, the Internal Revenue Service (IRS) released Revenue Procedure 2016-44, which modifies the existing safe harbors under which a management contract that affects property financed with governmental tax-exempt bonds does not constitute "private business use." The changes made to the safe harbors are favorable to taxpayers and generally adopt a more flexible approach that should facilitate a broader range of management contracts. The new rules will represent a welcome change for not-for-profit hospitals, schools, and other organizations that own facilities financed with tax-exempt bonds.
In general, interest on state or local bonds (including bonds issued by Section 501(c)(3) tax-exempt organizations through governmental conduits) is excluded from gross income and is therefore exempt from federal income tax. However, this exclusion generally does not apply if, among other things, the governmental issuer or tax-exempt organization (the “qualified user”) uses the property financed by the bonds for private business purposes. One way this can happen is through management contracts.
Subject to certain exceptions, for purposes of the private business use test, a "management contract" is a management, service, or incentive payment contract between a qualified user and a service provider, under which the service provider provides services involving all, a portion, or any function of a facility. For example, a contract for the provision of management services for an entire hospital, a contract for management services for a specific department of a hospital, and an incentive payment contract for physician services to patients of a hospital are each treated as a management contract. A contract could be considered a management contract even if it does not entail “management” services, such as budgeting or oversight of personnel. In short, a contract for nearly any service (other than incidental services) affecting a facility financed with tax-exempt bonds could implicate the private business use rules. This broad definition of “management contract” can create challenges for not-for-profit hospitals, schools, and other issuers of tax-exempt bonds when arranging for services with outside vendors and service providers.
Safe Harbors for Management Contracts
In Rev. Proc. 97-13, 1997-1 C.B. 632 as modified by Rev. Proc. 2001-39, 2001-2 C.B. 38 and amplified by Notice 2014-67, 2014-46 I.R.B. 822 (the “Original Safe Harbors”), the IRS set forth conditions under which a management contract is not deemed to constitute a private business use. These conditions in the Original Safe Harbors include constraints on net profits arrangements, the permitted term of the management contract, the types of compensation, and the relationship between the parties. In general, the permitted length of a management contract’s term depends on the extent to which the compensation is a fixed amount (that is, the greater the percentage of fixed compensation, the longer the permitted term of the management contract). These requirements can lead to difficulties for not-for-profit hospitals, schools, and other qualified users in negotiations with service providers, because the compensation desired by the parties is often not a fixed fee, but this in turn might require a contract whose term is perceived by service providers as too short to justify significant capital investments or the assumption of financial or business risks.
Revenue Procedure 2016-44
Rev. Proc. 2016-44 modifies the Original Safe Harbors and Rev. Proc. 2014-67. In general, the new safe harbor takes a more flexible and less formulaic approach toward variable compensation for longer-term management contracts of up to 30 years. The new safe harbor generally permits any type of fixed or variable compensation that is reasonable compensation for services rendered under the contract, but it continues to impose restrictions on net-profits arrangements and the relationship between the parties (as under the Original Safe Harbors). The new safe harbor is more principles-based, which will be a welcome change to not-for-profit hospitals, schools, and other owners of facilities financed with tax-exempt bonds.
To qualify for the safe harbor under Rev. Proc. 2016-44, management contracts must satisfy requirements relating to (i) general financial arrangements; (ii) the term of the contract; (iii) control of the managed property; (iv) risk of loss; (v) no inconsistent tax positions; (vi) no circumstances substantially limiting the exercise of rights; and (vii) functionally related and subordinate use.
(i) General financial arrangements
The management contract must satisfy the following requirements.
- The payments to the service provider under the contract must be reasonable compensation for services rendered during the term of the contract.
- The contract must not provide to the service provider a share of net profits from the operation of the managed property. Rev. Proc. 2016-44 provides clarifications as to what does and does not constitute a sharing of net profits.
- The contract must not, in substance, impose upon the service provider the burden of bearing any share of net losses from the operation of the managed property. Rev. Proc. 2016-44 specifies conditions under which an arrangement will not be treated as requiring the service provider to bear a share of net losses. For example, a service provider whose compensation is reduced by a stated dollar amount (or one of multiple stated dollar amounts) for failure to keep the managed property's expenses below a specified target (or one of multiple specified targets) is not treated as receiving a share of net losses.
(ii) The term of the contract
The term of the contract, including all renewal options, is no greater than the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property. A contract that is materially modified with respect to any matters relevant to the requirements of the safe harbor is retested as a new contract as of the date of the material modification. This will in some cases permit significantly longer management contracts than under the Original Safe Harbors.
(iii) Control of the managed property
The qualified user must exercise a significant degree of control over the use of the managed property. This control requirement is met if the contract requires the qualified user to approve the annual budget of the managed property, capital expenditures with respect to the managed property, each disposition of property that is part of the managed property, rates charged for the use of the managed property, and the general nature and type of use of the managed property (for example, the type of services).
(iv) Risk of loss
The qualified user must bear the risk of loss upon damage or destruction of the managed property. A qualified user will not fail to meet this risk of loss requirement as a result of insuring against risk of loss through a third party or imposing upon the service provider a penalty for failure to operate the managed property in accordance with the standards set forth in the management contract.
(v) No inconsistent tax positions
The service provider must agree that it will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property. For example, the service provider must agree not to take any depreciation or amortization, investment tax credit, or deduction for any payment as rent with respect to the managed property.
(vi) No circumstances substantially limiting the exercise of rights
The management contract must satisfy the following requirements.
The service provider must not have any role or relationship with the qualified user that, in effect, substantially limits the qualified user's ability to exercise its rights under the contract, based on all the facts and circumstances.
As a safe harbor, a service provider will not be treated as having a prohibited role or relationship if:
No more than 20 percent of the voting power of the governing body of the qualified user in the aggregate is vested in the directors, officers, shareholders, partners, members, and employees of the service provider;
- The governing body of the qualified user does not include the chief executive officer of the service provider or the chairperson (or equivalent executive) of the service provider's governing body; and
- The chief executive officer of the service provider is not the chief executive officer of the qualified user or any of the qualified user's related parties.
(vii) Functionally related and subordinate use
A service provider's use of a project that is “functionally related and subordinate” to performance of its services under a management contract does not constitute private business use (for example, use of storage areas to store equipment used to perform activities required under a management contract).
The new safe harbors in Rev. Proc. 2016-44 apply to any management contract that is entered into on or after August 22, 2016. An issuer may apply the new safe harbors to any management contract that was entered into before August 22, 2016. In addition, an issuer may continue to apply the Original Safe Harbors to a management contract that is entered into before August 18, 2017 and that is not materially modified or extended on or after August 18, 2017 (other than pursuant to certain renewal options).