Private Business Use – Management Contracts

A variety of governmental facilities may be privately managed, including health care facilities, convention and hotel facilities, entertainment and sports facilities, and detention facilities, prisons and jails. Private business use can result from management contracts. This issue snapshot will discuss situations in which management contracts providing for private companies to manage tax-exempt-financed facilities may result in excessive private business use.

IRC Section and Treasury Regulation

IRC Section 141(a) – Private Activity Bond

IRC Section 141(b) – Private Business Tests

Treasury Regulation Section 1.141-2 – Private activity bond tests

Treas. Reg. Section 1.141-3 – Definition of private business use

Treas. Reg. Section 1.141-4 – Private security or payment test

Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)

The following revenue procedures provide safe harbor conditions under which a management contract does not result in private business use of property financed with governmental tax-exempt bonds:

  • Revenue Procedure 2017-13; 2017-6 I.R.B. 787, applies to any management contract that is entered into on or after January 17, 2017, and an issuer may apply this revenue procedure to any management contract that was entered into before January 17, 2017.
  • Rev. Proc. 2016-44; 2016-2 C.B. 316, applies to any management contract that is entered into on or after August 22, 2016 and before January 17, 2017, and an issuer may apply this revenue procedure to any management contract that was entered into before August 22, 2016.
  • Rev. Proc. 97-13, 1997-1 C.B. 632, as modified by Rev. Proc. 2001-39 and amplified by Notice 2014-67, applies to any management contract that is entered into on or after May 16, 1997 and before August 22, 2016, and an issuer may apply this revenue procedure to any management contract that was entered into before August 18, 2017.

Analysis

IRC Section 103 (a) provides that, except as provided in IRC 103 (b), gross income does not include interest on any State or local bond. IRC Section 103 (b) (1) provides that IRC Section 103 (a) shall not apply to any private activity bond that is not a qualified bond (within the meaning of IRC Section 141). IRC Section 141 (a) provides that the term "private activity bond" includes any bond issued as part of an issue that meets the private business use test and private security or payment test.

Private Business Use Test

IRC Section 141 (b) (1) provides generally that an issue meets the private business use test if more than 10 percent of the proceeds of the issue are to be used for any private business use. IRC Section 141 (b) (6) defines "private business use" as use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit. For this purpose, any activity carried on by a person other than a natural person must be treated as a trade or business.

The 10 percent private business use test of IRC Section 141(b)(1) is met if more than 10 percent of the proceeds of an issue is used in a trade or business of a nongovernmental person. For this purpose, the use of financed property is treated as the direct use of proceeds.

In determining whether an issue meets the private business use test, it is necessary to look at both indirect and direct use of proceeds. Proceeds are treated as used in the trade or business of a nongovernmental person if a nongovernmental person, as a result of a single transaction or a series of related transactions, uses property acquired with the proceeds of an issue.

Both actual and beneficial use by a nongovernmental person may be treated as private business use. In most cases, the private business use test is met only if a nongovernmental person has special legal entitlements to use the financed property under an arrangement with the issuer. In general, a nongovernmental person is treated as a private business user as a result of ownership; actual or beneficial use of property pursuant to a lease, a management contract, or an incentive payment contract; or certain other arrangements.

A "management contract" is a management, service, or incentive payment contract between a governmental person 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.

Generally, the lease of financed property to a nongovernmental person is private business use of that property. For this purpose, any arrangement that is properly characterized as a lease for federal income tax purposes is treated as a lease. In determining whether a management contract is properly characterized as a lease, it is necessary to consider all the facts and circumstances, including the following factors: (1) the degree of control over the property that is exercised by a nongovernmental person; and (2) whether a nongovernmental person bears the risk of loss of the financed property.

A management contract with respect to financed property (when not properly characterizable as a lease) may result in private business use of that property, based on all of 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 operations of the facility. A management contract with respect to financed property results in private business use of that property if the service provider is treated as the lessee or owner of financed property for federal income tax purposes.

Private Security or Payment Test

The private security or payment test relates to the nature of the security for, and the source of, the payment of debt service on an issue. The private payment portion of the test takes into account the payment of the debt service on the issue that is directly or indirectly to be derived from payments (whether or not to the issuer or any related party) in respect of property, or borrowed money, used or to be used for a private business use. The private security portion of the test takes into account the payment of the debt service on the issue that is directly or indirectly secured by any interest in property used or to be used for a private business use or payments in respect of property used or to be used for a private business use.

The security for, and payment of debt service on, an issue is determined from both the terms of the bond documents and on the basis of any underlying arrangement. An underlying arrangement may result from separate agreements between the parties or may be determined on the basis of all of the facts and circumstances surrounding the issuance of the bonds. For example, if the payment of debt service on an issue is secured by both a pledge of the full faith and credit of a state or local governmental unit and any interest in property used or to be used in a private business use, the issue meets the private security or payment test. Usually, a bond issue secured by the revenues of the bond-financed facility will meet the private security or payment test if the facility meets the private business use test.

The payments taken into account as private payments are payments in respect of property used or to be used for a private business use. Both direct and indirect payments made by any nongovernmental person that is treated as using proceeds of the issue are taken into account as private payments to the extent allocable to the proceeds used by that person. Payments need not be directly derived from a private business user to be taken into account. Payments for a use of proceeds include payments (whether or not to the issuer) in respect of property financed (directly or indirectly) with those proceeds, even if not made by a private business user. Payments made by members of the general public for use of a facility used for a private business use (for example, a facility that is the subject of a management contract that results in private business use) are taken into account as private payments to the extent that they are made for the period of time that property is used by a private business user.

Property used or to be used for a private business use and payments in respect of that property are treated as private security if any interest in that property or payments secures the payment of debt service on the bonds. For this purpose, the phrase any interest in is to be interpreted broadly and includes, for example, any right, claim, title, or legal share in property or payments. The property that is the security for, or the source of, the payment of debt service on an issue need not be property financed with bond proceeds. For example, unimproved land or investment securities used, directly or indirectly, in a private business use that secures an issue provides private security. Private security (other than financed property and private payments) for an issue is taken into account, however, only to the extent it is provided, directly or indirectly, by a user of proceeds of the issue. Thus, a mortgage or other security interest in privately used property that secures the bond issue is private security if financed with bond proceeds or provided by a user of the bond proceeds.

Treas. Reg. Section 1.141-4 provides detailed guidance on the proper allocation of payments and determining whether the amount of private payments or private security causes the issue to meet the private security or payment test.

Safe Harbors Under Revenue Procedures

There are several revenue procedures that provide safe harbors against private use arising from management contracts. If a management contract covering a bond-financed facility stays within the confines of these safe harbors, the general facts and circumstances analysis under Treas. Reg. Section 1.141-3 is not applied, and no private activity arises from the manager’s special legal entitlements to use the financed property pursuant to the contract. The effective dates for these safe harbors are listed above in Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources). Generally, if a management contract is materially modified after the effective date of one of the revenue procedures, it becomes subject to that procedure harbor rather than a previous one.

Rev. Proc. 2017-13

Rev. Proc. 2017-13 modifies, amplifies, and supersedes Rev. Proc. 2016-44, discussed below, to address certain types of compensation to provide continuity with previous safe harbors existing before Rev. Proc. 2016-44, the timing of payment of compensation, the treatment of land, and methods of approval of rates. To be within the safe harbor provided by Rev. Proc. 2017-13, a management contract must meet all the following conditions, or be an eligible expense reimbursement arrangement, as defined in the revenue procedure:

  • The payments to the service provider under the contract must be reasonable compensation for services rendered during the term of the contract. Compensation includes payments to reimburse actual and direct expenses paid by the service provider and related administrative overhead expenses of the service provider.
  • The contract must not provide to the service provider a share of net profits from the operation of the managed property. Compensation to the service provider will not be treated as providing a share of net profits if no element of the compensation takes into account, or is contingent upon, either the managed property’s net profits or both the managed property’s revenues and expenses for any fiscal period. For this purpose, the elements of the compensation are the eligibility for, the amount of, and the timing of the payment of the compensation. Further, solely for purposes of determining whether the amount of the compensation meets this requirement, any reimbursements of actual and direct expenses paid by the service provider to unrelated parties (as defined in the revenue procedure) are disregarded as compensation. Incentive compensation will not be treated as providing a share of net profits if the eligibility for the incentive compensation is determined by the service provider’s performance in meeting one or more standards that measure quality of services, performance, or productivity, and the amount and the timing of the payment of the compensation meet the requirements of the revenue procedure.
  • 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. An arrangement will not be treated as requiring the service provider to bear a share of net losses if:
    1. The determination of the amount of the service provider’s compensation and the amount of any expenses to be paid by the service provider (and not reimbursed), separately and collectively, do not take into account either the managed property’s net losses or both the managed property’s revenues and expenses for any fiscal period; and
    2. The timing of the payment of compensation is not contingent upon the managed property’s 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) will not be treated as bearing a share of net losses as a result of this reduction.
  • Certain types of compensation are protected. For purposes of the conditions prohibiting net profits arrangements or the imposition of net losses on the service provider (previous two bullet points), without regard to whether the service provider pays expenses with respect to the operation of the managed property without reimbursement by the qualified user, compensation for services will not be treated as providing a share of net profits or requiring the service provider to bear a share of net losses if the compensation for services is: (a) based solely on a capitation fee, a periodic fixed fee, or a per-unit fee; (b) permitted incentive compensation (eligibility determined by meeting standards measuring quality of services, performance or productivity; or (c) a combination of these types of compensation. The revenue procedure defines capitation fee, periodic fixed fee and per-unit fee.
  • Certain deferrals of payment to the service provider are permitted. Deferral due to insufficient net cash flows from the operation of the managed property of the payment of compensation that otherwise meets the conditions prohibiting net profits arrangements or the imposition of net losses on the service provider will not cause the deferred compensation to be treated as contingent upon net profits or net losses if the contract includes requirements that:
    1. The compensation is payable at least annually;
    2. The qualified user is subject to reasonable consequences for late payment, such as reasonable interest charges or late payment fees; and
    3. The qualified user will pay such deferred compensation (with interest or late payment fees) no later than the end of five years after the original due date of the payment.
  • The term of the contract, including all renewal options (as defined in Treas. Reg. Section 1.141-1(b)), is no greater than the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property. For this purpose, economic life is determined in the same manner as under IRC Section 147(b) as of the beginning of the term of the contract. A contract that is materially modified with respect to any matters relevant to this requirement is retested as a new contract as of the date of the material modification.
  • 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). For this purpose, for example, a qualified user may show approval of capital expenditures for a managed property by approving an annual budget for capital expenditures described by functional purpose and specific maximum amounts; and a qualified user may show approval of dispositions of property that is part of the managed property in a similar manner. Further, a qualified user may show approval of rates charged for use of the managed property by either expressly approving such rates or a general description of the methodology for setting such rates (such as a method that establishes hotel room rates using specified revenue goals based on comparable properties),or by including in the contract a requirement that the service provider charge rates that are reasonable and customary as specifically determined by, or negotiated with, an independent third party (such as a medical insurance company).
  • The qualified user must bear the risk of loss upon damage or destruction of the managed property (for example, upon force majeure). A qualified user does 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.
  • The service provider must agree that it is not entitled to and 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.
  • 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 role or relationship that is prohibited if:
    1. 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;
    2. 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
    3. 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 (as defined in Treas. Reg. Section 1.150-1(b)).
  • For purposes of this safe harbor against prohibited roles or relationships, the phrase “service provider” includes related parties (as defined in Treas. Reg. Section 1.150-1(b)) and the phrase “chief executive officer” includes a person with equivalent management responsibilities.
  • A service provider's use of a project that is functionally related and subordinate to performance of its services under a management contract for managed property that meets the conditions of Rev. Proc. 2017-13 does not result in private business use of that project. For example, use of storage areas to store equipment used to perform activities required under a management contract that meets the conditions of the safe harbor under the revenue procedure does not result in private business use.

Rev. Proc. 2016-44

Rev. Proc. 2016-44 modified and superseded Rev. Proc. 97-13, Rev. Proc. 2001-39, 2001-2 C.B. 38, and Section 3.02 of Notice 2014-67, 2014-46 I.R.B. 822. Rev. Proc. 2016-44 applies a more principles-based approach than its predecessor, focusing on governmental control over projects, governmental bearing of risk of loss, economic lives of managed projects, and consistency of tax positions taken by the service provider. The provisions of Rev. Proc. 2016-44 are substantially the same as Rev. Proc. 2017-13, but more limited in certain instances. Rev. Proc. 2016-44 did not address certain types of compensation, including capitation fees, periodic fixed fees, and per-unit fees, and certain incentive compensation, and did not address how late payment of service provider fees might result in putting the burden of net losses on the service provider. Under Rev. Proc. 2016-44, for purposes of the limit on the duration of the management contract, economic life is determined without regard to IRC Section 147(b)(3)(B)(ii), thus removing financed land from the calculation. Rev. Proc. 2016-44’s guidance on control of the facility by the qualified user was more limited than under the later revenue procedure. Issuers can apply Rev. Proc. 2017-13 to contracts entered into before its effective date, however, so instances where Rev. Proc. 2016-44 will be applied may be limited.

Rev. Proc. 97-13

Rev. Proc. 97-13 provides safe harbors for management contracts based on limitations of the duration of the contract, including renewal options, that vary depending on the structure of the compensation, such as fixed fees, partially-fixed fees, per unit fees and percentage of fees charged for use of the facility.
To be within the safe harbor under Rev. Proc. 97-13, the contract’s duration and compensation structure must fit into one of several permissible arrangements described in the revenue procedure. In addition, the contract must provide for reasonable compensation for services rendered with no compensation based, in whole or in part, on a share of net profits from the operation of the facility. Compensation based on (a) a percentage of gross revenues (or adjusted gross revenues) of a facility or a percentage of expenses from a facility, but not both; (b) a capitation fee; or (c) a per-unit fee is generally not considered to be based on a share of net profits. Reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated parties is not by itself treated as compensation. Under Rev. Proc. 97.13, a productivity reward equal to a stated dollar amount based on increases or decreases in gross revenues (or adjusted gross revenues), or reductions in total expenses (but not both increases in gross revenues (or adjusted gross revenues) and reductions in total expenses) in any annual period during the term of the contract generally does not cause the compensation to be based on a share of net profits. Further, 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. The revenue procedure provides a safe harbor for this requirement, which differs somewhat from that in Rev. Proc. 2017-13 and Rev. Proc. 2016-44.
Notice 2014-67, 2014-2 C.B. 822, amplified Rev. Proc. 97-13, providing interim guidance. Although Notice 2014-67 deals primarily with exempt organizations participating in accountable care organizations under the Affordable Care Act, it also added guidance permitting tiered and other productivity awards to the management contract safe harbor in Rev. Proc. 97-13.

Issue Indicators or Audit Tips

A violation of IRC 141(b) occurs only if private payment or security is present in addition to private use. Revenue bonds, and bonds secured by a security interest in project revenues or a mortgage on the facility, will have private payments or security if the facility is privately used. Depending on the facts and circumstances, a management contract not meeting the safe harbors of the revenue procedures may result in private use.

Determine if a modification of any older agreement makes it subject to the newer revenue procedures.

To determine all relevant facts and circumstances, consider agreements and relationships between the parties in addition to the documents labeled as management contracts. These other agreements might contain provisions directly or indirectly affecting whether the compensation arrangement under the management agreement meets the safe harbor or whether the qualified user’s rights under the management contract have been substantially limited.
Consider whether the terms of the management contract, or other arrangements, affect the private use or private security or payment analysis, such as:

  • A direct and indirect guarantee
  • Disguised participation in net revenues
  • Lease disguised as management contract

To meet the safe harbors under Rev. Proc. 2016-44 and Rev. Proc. 2017-13, the service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property. The service provider’s failure to comply with this agreement may be evidence that the arrangement is not merely a management contract. For example, if the service provider claims depreciation or amortization deduction, investment tax credit, or deduction for any payment as rent with respect to the managed property, the arrangement might be properly characterized as an installment sale or a lease. Secure returns to confirm the provider is following its agreement. If you find the provider is not filing consistently with its agreement, make a referral to the appropriate business unit and consider whether the tax position agreement in the management contract should be treated as evidence of fraud.