On October 24, 2014, the Internal Revenue Service (the IRS) issued Notice 2014-67 (the Notice) to amplify existing management contract guidance under Revenue Procedure 97-13 (Rev. Proc. 97-13).1 The Notice provides a new five-year safe harbor for management contracts and clarifies the ability of the parties to a management contract to include a productivity award in the contract.2
The Internal Revenue Code of 1986, as amended (the Code), imposes limits on the amount of proceeds of a tax-exempt bond issue that may be used in the trade or business of nonexempt persons. Use of bond-financed property in a trade or business of any person, other than (i) a state or local government unit, or (ii) in the case of qualified 501(c)(3) bonds, an organization described in Section 501(c)(3) of the Code (a 501(c)(3) organization), gives rise to private business use. Private business use may result from a management contract that allows a nonexempt person to use bond-financed property even when the qualified user3 retains ownership and possession of the property. Recognizing that state and local governmental units and 501(c)(3) organizations commonly enter into arrangements with nonexempt entities to manage all or a portion of a bond-financed facility or to provide services at a bond-financed facility, the IRS in 1997 issued Rev. Proc. 97-13 to provide several safe harbors which, if satisfied, would treat such arrangements as not giving rise to private business use.
For the past 17 years, Rev. Proc. 97-13 has served as the cornerstone for analyzing management contracts. Other than the minor 2001 amendment to Rev. Proc. 97-13 made by the IRS in Rev. Proc. 2001-39,4 there has been no formal guidance by the IRS on management contracts since the release of Rev. Proc. 97-13. Although the IRS has issued a number of private letter rulings addressing management contracts that do not strictly adhere to the conditions set forth in Rev. Proc. 97-13, a private letter ruling has no precedential effect, and only the recipient may rely upon it.5
The Notice modifies Rev. Proc. 97-13 by (i) creating a new safe harbor for contracts with a term, including renewal options,6 of not more than five years, and (ii) providing a broader range of incentive arrangements that may be included in management contracts. The Notice emphasizes the basic premise of Rev. Proc. 97-13 that any compensation arrangement that results in a sharing of net profits with a nonexempt person may not be included in a management contract.
New Five-Year Contract Safe Harbor
Under this new five-year contract safe harbor, compensation may be based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee or a combination of the foregoing. Such compensation may also include a percentage of gross revenues (or adjusted gross revenues) of the facility or a percentage of expenses of the facility, but not both revenues and expenses.7 As discussed below, a “tiered productivity award” will be treated as a stated amount or a periodic fixed fee for purposes this safe harbor. Unlike the safe harbors that existed prior to the Notice, the new five-year contract safe harbor added by the Notice does not contain a requirement that the qualified user have a right to cancel the contract without cause or penalty at specified times prior to the expiration of the contract.
The second change made by the Notice to Rev. Proc. 97-13 pertains to productivity awards.8Prior to the Notice, Rev. Proc. 97-13 provided that a productivity award equal to a stated dollar amount based on (i) increases or decreases in gross revenues (or adjusted gross revenues), or (ii) reductions in total expenses, but not both, in any annual period during the term of the contract generally does not cause the compensation under the contract to be based on a share of net profits. The only two “permissible arrangements,” however, under Rev. Proc. 97-13 where an award of any type is expressly mentioned are those covering 10-year and 15-year contracts, requiring 80% and 95%, respectively, of the total compensation under the contract to consist of a periodic fixed fee.9 Presumably that reflected the intention that productivity (or incentive) awards be counted as part of the variable portion of compensation under five-year (50% periodic fixed fee) contracts and as part of the total compensation under two-year (revenue-based) contracts.
The Notice adds a new type of permitted productivity award for services in any annual period during the contract term that is based on the quality of services provided rather than on increases in revenues or decreases in expenditures. Pursuant to the Notice, a productivity award to be paid in any annual period during the term of the contract will not be treated as a sharing of net profits, and will therefore not run afoul of the safe harbors of Rev. Proc. 97-13, if (i) eligibility for the productivity award is based on the quality of the services provided under the contract, e.g., the achievement of Medicare Shared Savings Program quality performance standards, meeting data reporting requirements or achieving specified benchmarks in customer satisfaction surveys (rather than on increases in revenues or reductions in expenses), and (ii) the amount of the productivity award is a stated dollar amount, a periodic fixed fee or a tiered system of stated dollar amounts or periodic fixed fees based solely on the level of performance achieved with respect to the applicable measure.
The Notice also provides that, for purposes of determining whether a compensation arrangement containing a productivity award satisfies the new safe harbor for five-year contracts added by the Notice, a tiered productivity award will be treated as a stated amount or a periodic fixed fee, as appropriate.10 This statement clarifies that a tiered productivity award may be included as part of the compensation provided under a five-year contract, being characterized as either a stated amount or a periodic fixed fee, depending on the structure of the productivity award.11
The changes made by the Notice to Rev. Proc. 97-13 affecting management contracts apply to contracts entered into, materially modified or extended (other than pursuant to a renewal option) on or after January 22, 2015. In addition, the Notice provides that such changes may be applied to contracts entered into before January 22, 2015.
Recommendation for Future Flexibility
It is noteworthy that the Notice keeps in place Rev. Proc. 97-13’s existing two-year, three-year and five-year safe harbor alternatives,12 although those existing contract alternatives do not appear to provide much if any flexibility not provided under the new five-year arrangement set forth in the Notice. One may infer from this that the IRS will continue to study the management contract area and at some later date provide further guidance to the bond community with respect to management contracts. As a preemptive matter and to allow contracts to conform to potential changes in law (whether more favorable or more restrictive), issuers and conduit borrowers should consider including a provision in their management contracts expressly allowing for the qualified user to require an amendment of the contract upon the issuance of further guidance, perhaps along the lines of:
It is the intention of the parties that this agreement satisfy a safe harbor under Revenue Procedure 97-13, 1997-1 CB 632, as amended or amplified, such that the services provided do not result in private business use. In the event that it is determined by nationally recognized bond counsel that this agreement does not satisfy a safe harbor under Rev. Proc. 97-13 (as existing or as amended or amplified by the IRS), the parties shall renegotiate this agreement in good faith so as to satisfy a safe harbor under Rev. Proc. 97-13 (as existing or as amended or amplified).
Request for Public Comments
The Notice solicits comments on the guidance provided. Comments should be submitted in writing on or before January 22, 2015. The addresses, both physical and electronic, to which comments should be sent are set forth in the Notice.