Lengthening and liberalizing contracts with tax-exempt entities

Health care organizations that qualify for tax-exempt status under Internal Revenue Code Section 501(c)(3) are able to issue tax-exempt bonds to finance the construction of a health care facility. To protect against such bonds becoming taxable bonds, a health care organization must ensure that there is no "private business use" of the facility, which is use by a non-governmental person in such person's trade or business. One way in which "private business use" can arise is through deemed beneficial use of financed property pursuant to a management contract. For example, private business use of a hospital financed with tax-exempt bonds could arise if the hospital enters into a contract with a company to provide management services for the entire hospital or other services for a specific department of the hospital, including but not limited to contracts with medical groups to provide anesthesia, emergency room, pathology or radiology services. ----- Rev. Proc. 97-13 In 1997, the Internal Revenue Service issued advice (Rev. Proc. 97-13), which set forth the safe harbor conditions under which a management contract does not result in private business use. The conditions contained in Rev. Proc. 97-13 focused on the term of the management contract, the type of compensation paid under the contract and the relationship between the parties to the contract. Depending upon whether the compensation was a fixed amount or consisted of variable fees, the permitted term of a management contract under the Rev. Proc. 97-13 safe harbor ranged from two years to 15 years. As a result, most agreements between hospitals and hospital-based physicians, such anesthesiologists, emergency room physicians and pathologists, usually only have a two-year term. ----- New advice The IRS issued new advice (Rev. Proc. 2016-44) in August 2016 that supersedes Rev. Proc. 97-13, and expands the safe harbor for avoiding private business use with respect to management contracts. Instead of basing a permitted term on the type of compensation, Rev. Proc. 2016-44 simply provides the permitted term under the safe harbor can be no greater than the lesser of 30 years, or 80 percent of the weighted average reasonably expected economic life of the managed property. Consistent with Rev. Proc. 97-13, Rev. Proc. 2016-44 also requires that a contract must provide for reasonable compensation for services rendered, must not provide the service provider with a share of net profits from the operation of the managed property, and the service provider must not have any role or relationship with the owner of the facility that substantially limits the owner's ability to exercise its rights under the contract. Rev. Proc. 2016-44 also requires: the contract must not impose upon the service provider the burden of bearing any share of losses from the operation of the managed property; the owner must exercise a significant degree of control over the use of the managed property; and the service provider must agree that it is not entitled to, and will not take, any tax position inconsistent with being a service provider to the owner of the property. A clarification Earlier this year, the IRS issued Revenue Procedure 2017-13 (Rev. Proc. 2017-13), governing any management contract entered into on or after Jan. 17, which modifies, clarifies, amplifies and supersedes Rev. Proc. 2016-44. Under Rev. Proc. 2016-44, a management contract could not provide the service provider with a share of the net profits or require the service provider to bear the burden of any net loss from the operation of the managed property. Rev. Proc. 2017-13 clarifies that compensation for capitation fees, periodic fixed fees, per-unit fees and some forms of incentive compensation will not be treated as providing a share of the net profits of the property and payment of expenses of a service provider without reimbursement from the owner will not be treated as the service provider bearing the burden of losses of the property. Under Rev. Proc. 2016-44, the timing of compensation could not be contingent on net profits or net losses from the managed property. Rev. Proc. 2017-13 clarifies compensation subject to an annual payment requirement and reasonable consequences for late payment (such as reasonable interest or late charges) will not be treated as contingent upon net profits or net losses, provided that the contract includes the requirement the property owner will pay the deferred compensation within five years of the original due date of the payment. Rev. Proc. 2016-44 provided the term of a management contract, including the renewal thereof, cannot be greater than the lesser of 30 years or 80 percent of the weighted-average reasonably expected economic life of the managed property. The IRS received questions concerning whether land should be taken into account when the cost of the land accounts for a significant portion of the managed property. Rev. Proc. 2017-13 clarifies land is treated as having an economic life of 30 years if 25 percent or more of the net proceeds of the issue which finances the property is used to purchase the land. Rev. Proc. 2016-44 provided that the property owner must exercise a significant degree of control over the managed property, and this requirement is satisfied if the contract provides that the owner must approve rates charged for the use of the managed property. Rev. Proc. 2017-13 clarifies that an owner meets the approval of rates requirement when it approves a reasonable general description of the method used to set the rates or when it requires the service provider to charge rates that are reasonable and customary as specifically determined by an independent third party. Rev. Proc. 2017-13 adds clarity to the flexible approach now being taken by the IRS in drafting management contracts with owners of facilities financed with tax-exempt bonds, including the permitted term of such contracts. For example, the terms of agreements between hospitals and hospital-based physicians no longer need to be limited to two years. ----- Barry F. Rosen is the chairman and CEO of Gordon Feinblatt LLC in Baltimore and heads the firm's Health Care Practice Group and can be reached at 410-576-4224 or brosen@gfrlaw.com. Douglas T. Coats leads the Firm's Tax Practice Group and can be reached at 410-576-4002 or dcoats@gfrlaw.com. Published: Thu, Nov 02, 2017