IRS Updates Safe Harbor Conditions for Management Contracts When Using Tax-Exempt Bonds

Certain management contracts with professional service providers can now look to new guidance on revised and broader safe harbor conditions to avoid being characterized as a private business using bond-financed property. The conditions under Revenue Procedure 2016-44 (Rev. Proc. 2016-44) relate to projects financed with the proceeds of tax-exempt governmental bonds or qualified 501(c)(3) bonds.

The IRS rules, released August 22, 2016, apply to private activity bonds, which is part of a bond issue that meets both private business use and the private security or payments tests.

Private Business Use

Private business use is determined by looking at direct or indirect use of proceeds of an issue by a person in a trade or business other than a governmental unit. A nongovernmental person may be a user of bond proceeds and bond-financed property as a result of:

  • Ownership
  • Actual or beneficial use of property pursuant to a lease
  • Management contract or an incentive payment contract if the contract provides for compensation for services where compensation is based on a share of net profit from the operations of the facility
  • Certain other arrangements

An issue generally meets the private business use test if more than 10 percent of the issue’s proceeds are used for any private business use, according to Income Tax Regulations 1.141-3(a)(1).

Safe Harbor Conditions

The safe harbors originally set forth in Revenue Procedure 97-13, which was later modified by Revenue Procedure 2001-39 and amended by Notice 2014-67, were built upon rigid terms for compensation arrangements and term provisions.

When the procedures were modified, they provided certain conditions where compensation arrangements in management contracts do not result in private business use. All compensation for services is based on permissible arrangements under existing guidance, which include a stated amount, a periodic fixed fee, capitation fee, per-unit fee, or a combination of all the above.

Contracts for Services

Contracts for services that are incidental to the functions of a facility—such as janitorial services, office equipment repair, hospital billing, or similar services—aren’t considered as private business use. In addition, eligible expense reimbursement arrangements are covered under safe harbor rules when a management contract provides compensation consisting of reimbursements of direct expenses paid by the service provider to unrelated parties as well as reasonable overhead costs.

Modification Highlights Under Rev. Proc. 2016-44

  • The revised safe harbor provisions generally permit any type of fixed or variable compensation to the service provider that’s “reasonable compensation for services rendered during the term of the contract.”
  • The revised provisions retain existing constraints when compensation to the service provider can’t be based on a share of net profit arrangements. Conversely, compensation arrangements may include a percentage of gross revenue, adjusted gross revenue, or expenses of a facility, but not both revenue and expenses. If the management contract provides incentive compensation that’s tied to the provider’s performance, then the service provider must meet one or more measurable quality standards.
  • The revised provisions provide guidance for eligible expense reimbursement arrangements.

Rev. Proc. 2016-44 states that it applies a more principles-based approach to safe harbor treatment of management contracts, focusing on factors such as:

  • Control. A qualified user (government or 501(c)(3) organization—with qualified 501(c)(3) bonds) must exercise a “significant degree of control over the use of the managed property.”
  • Risk. Governmental or 501(c)(3) organization must bear the risk of loss upon damage or destruction of the managed property. A safe harbor management contract may not in substance impose the burden of bearing any share of net losses by the service provider from the operation of the managed property.
  • Term. The term of a safe harbor management contract, including any renewal options, and the economic lives of the managed project can’t exceed the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the managed property.

Under Rev. Proc. 2016-44, the revised safe harbors are effective for any management contract that’s entered into on or after August 22, 2016, and an issuer may apply the revised safe harbors to any management contract that was entered into before that date. In addition, an issuer may apply the existing safe harbor provisions to a management contract that’s entered into before August 18, 2017, and that isn’t materially modified or extended on or after August 18, 2017 (other than according to a permitted renewal option).

For more insight on this new guidance on revised and broader safe harbor conditions under Rev. Proc. 2016-44, contact your Moss Adams professional.