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, for example.
A. Rev. Proc. 97-13
In 1997, the Internal Revenue Service (IRS) 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 fifteen years. As a result, most agreements between hospitals and hospital based physicians, such anesthesiologists, emergency room physicians, pathologists and radiologists, usually only have a two-year term.
B. Rev. Proc. 2016-44
On August 22, 2016, the IRS issued new advice (Rev. Proc. 2016-44), which 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 that the permitted term under the safe harbor can be no greater than the lesser of 30 years, or 80% 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 that (1) the contract must not impose upon the service provider the burden of bearing any share of losses from the operation of the managed property, (2) the owner must exercise a significant degree of control over the use of the managed property, and (3) 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 owner of the property.
The new safe harbor of Rev. Proc. 2016-44 applies to any management contract entered into on or after August 22, 2016, and an owner may apply the new safe harbor of Rev. Proc. 2016-44 to any management contract that was entered into before August 22, 2016.
Rev. Proc. 2016-44 provides for a more flexible approach in drafting management contracts with owners of facilities financed with tax-exempt bonds, especially regarding the permitted term of such contracts. For example, the terms of agreements between hospitals and hospital based physicians, such as anesthesiologists, emergency room physicians, pathologists and radiologists, no longer need to be limited to two years.
A version of this article was published by The Daily Record on October 30, 2017.