Are Your Management Contracts Still OK?

Nov 08, 2016 at 04:23 pm by steve

New Safe Harbor for Qualified Management Contracts

On August 22, 2016, the Internal Revenue Service released Revenue Procedure 2016-44, which updates conditions under which a management contract will not result in private business use (or "bad use") of property financed with tax-exempt bonds. Compliance with the new safe harbor may be essential to the continued tax-exempt status of related bond issues. Revenue Procedure 2016-44 supersedes its well-known predecessor, Revenue Procedure 97-13.

Facilities financed with tax-exempt bonds are sometimes managed by, or offer services provided through, private companies. For example, university or hospital food services may be provided through contracts with private companies that specialize in these services, or hospitals may contract with private physician groups to provide all radiology or anesthesiology services required by the hospital. When these contracts are "qualified" under Internal Revenue Service rules, use of the bond-financed facilities by the private company or group will not create impermissible private business use of a tax-exempt bond financed facility.

The new safe harbor generally permits longer terms for these contracts in a stated effort to encourage tax-exempt financing for public private partnerships. The new safe harbors may be used for any contract entered into after August 22, 2016. After August 18, 2017, the new documentation requirements will apply to all new and significantly modified management contracts.

Hospitals may continue to apply the existing safe harbors in Revenue Procedure 97-13 (as modified by Revenue Procedure 2001-39 and Section 3.02 of Notice 2014-67) during the transition period between now and the August 18, 2017 effective date. This means that existing and pre-effective date qualified management contracts need not be revised to meet new documentation requirements unless they are extended during this transition period (in a way not permitted under the existing contract), or significantly modified prior to the end of their terms.

The general financial rules and related party rules are similar to the rules currently provided in Revenue Procedure 97-13. As in 97-13, compensation to the service provider may not be based upon a share of the net profits of the managed property, and the compensation arrangement must be reasonable. However, the 2016-44 safe harbor includes new concepts that are not likely to be covered in existing management contracts. For example, the contract term cannot exceed the lesser of (i) 30 years and (ii) 80 percnet of the weighted average economic life of the managed property. If a contract is materially modified, the term limit must be retested as of the modification date. Second, the Hospital must exercise significant control over the managed property demonstrated through requirements that the Hospital approve the annual budget, capital expenditures, disposition of the property, rates charged for use of the property, and general type and nature of the use of the property. Third, the Hospital must bear the risk of loss upon damage or destruction to the managed property; however, the Hospital may insure against loss and penalize the service provider for improper use of the managed property. Finally, the service provider (e.g., the physician group) must treat the contract as a service contract and not as a lease for tax purposes. This may require a covenant in the contract that the service provider will not claim depreciation, amortization, tax credits, deductions for payment of rent with respect to the managed property, or any other "inconsistent" tax position with respect to the managed property.

Revenue Procedure 2016-44 also addresses (i) functionally related and subordinate use, and (ii) eligible expense reimbursements. For item (i), if use meets all the requirements of 2016-44 and is functionally related and subordinate to the "qualified use," then it too will be "qualified use" of the managed property. Storage areas are listed as an example. For item (ii), arrangements to reimburse actual and direct expenses paid by the service provider to unrelated parties, including reasonable related overhead expenses will not create private business use.

In addition to actual service and management contracts, post issuance compliance policies and procedures may need to be revised to reflect the requirements in these new guidelines. Even though Revenue Procedure 2016-44 is not effective until the end of next summer (August 18, 2017), all changes or extensions to existing and pre-effective date contracts must be analyzed during the transition period to determine whether the new requirements have been triggered. Given the long transition period, there may be developments to report before the effective date.

Kathryn "Katy" J. Ottensmeyer is a partner in the Public Finance and Health Law Practice Groups in the Birmingham office of Balch and Bingham. Natalie Majeed is an associate member of the Health Law Practice Group in the Atlanta office. Philip M. Sprinkle II is a partner in the Atlanta office of Balch & Bingham, and serves as co-chair of its Health Law Practice Group.

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