*(d) Avoiding Management Contract Problems

p. 830. Insert following the last paragraph of the section:

On October 24, 2014, the IRS issued a new notice that modified the safe harbors established in Revenue Procedure 97‐13 by adding a new five‐year contract safe harbor and expanding the scope of permitted productivity awards to include quality‐based incentive payments. The notice also offered interim guidance for determining whether private business use includes the use of tax‐exempt, bond‐financed facilities by a charitable organization or a state or local government entity in the Medicare Shared Savings Program (MSSP) through an accountable care organization (ACO).^76.1

The notice identified the challenge facing exempt organizations participating in the MSSP, noting that organizations using a facility financed with tax‐exempt bonds must structure their participation in an ACO so that it neither jeopardizes their charitable tax‐exempt status nor causes them to be engaged in an unrelated trade or business. The IRS established the position that the participation of a qualified user in the MSSP through an ACO will not result in private business use of a facility financed with tax‐exempt bonds if all of the following conditions are met:

• The terms of the qualified user's participation in the MSSP (including its share of MSSP payments or losses and expenses) are set forth in advance in a written agreement negotiated at arm's length.
• CMS has accepted the ACO into, and has not terminated the ACO from, the MSSP.
• The qualified user's share of economic benefits derived from the ACO (including its share of MSSP payments) is proportional to the benefits or contributions the qualified user provides to the ACO. If the qualified user receives an ownership interest in the ACO, the interest is proportional and equal in value to its capital contributions to the ACO, and all ACO returns of capital, allocations, and distributions are made in proportion to ownership interests.
• The qualified user's share of the ACO's losses (including its share of MSSP losses) does not exceed the share of ACO economic benefits to the qualified user.
• All transactions entered into by the qualified user with the ACO and its participants, as well as by the ACO with the ACO's participants and any other parties, are at fair market value.
• The qualified user does not contribute or otherwise transfer the property financed with tax‐exempt bonds to the ACO unless the ACO is a governmental person, or in the case of qualified tax‐exempt bonds, either a governmental person or a charitable organization.

The IRS further anticipated in the notice that qualified users of hospitals or other healthcare facilities that are financed with tax‐exempt bonds will enter into management contracts with nongovernmental persons to provide healthcare services at their facilities that will take into account the quality performance standards and Medicare fee‐for‐service expenditures relevant to participation in the MSSP. Under the IRS's private business use test, a qualified user must structure its management contracts with respect to those facilities so as to avoid private business use.

This notice amplifies the permitted productivity rewards and the types of permissible arrangements described in Revenue Procedure 97‐13 that do not result in private business use, provided all other requirements are met. Under the new, more flexible standard, a productivity reward for services in any annual period during the term of the contract does not cause the compensation to be based on a share of net profits of the financed facility (and thereby private business use) if:

• The productivity award is based on the quality of the services provided under the management contract rather than increases in revenues or decreases in expenses of the facility; and
• The amount of the productivity award is a stated dollar amount, a periodic fixed fee, or a tiered system of stated dollar amounts or periodic fixed fees based solely on the level of performance achieved with respect to the applicable measure.

Revenue Procedure 97‐13 is further amplified in the notice by adding a new permissible arrangement under a management contract that does not constitute private business use. Under this option, all of the compensation for services must be based on a stated amount, a periodic fixed fee, a capitation fee, a per‐unit fee, or a combination of those. Compensation for services also may include a percentage of gross revenues, adjusted gross revenues, or expenses of the facility (but not both revenues and expenses). The term of the contract, including all renewal options, may not exceed five years. The contract need not be terminable by the qualified user prior to the end of the term. For purposes of this permissible arrangement, a tiered productivity award will be treated as a stated amount or a periodic fixed fee, as appropriate.

p. 830. Insert following preceding insert:

*On August 22, 2016, the IRS released a substantial revision to its safe harbors for management contracts involving facilities financed with tax-exempt bonds. In a revenue procedure,^76.2 the IRS provided more expansive safe harbors under which a management contract does not result in private business use for facilities financed with tax-exempt bonds^76.3 or cause the modified private business use test for such property to be met.^76.4

The original safe harbors used by the IRS since 1997^76.5 set forth various management contract arrangements that were permitted based upon the extent to which compensation provided under the contracts was fixed or variable and the term of the contracts.^76.6 They were expanded in 2014 to address developments involving accountable care organizations under the Affordable Care Act, as well as to permit a greater range of variable compensation arrangements for shorter-term management contracts.^76.7

The new safe harbor builds on the 2014 expansion by utilizing a more flexible and less formulaic approach toward variable compensation for management contracts of up to 30 years in duration. The new safe harbor generally permits any type of fixed or variable compensation, provided that it is reasonable, for services rendered under a management contract with a facility financed with tax‐exempt bonds. In the IRS's view, the new safe harbor applies a “more principles‐based approach 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.”^76.8

The revenue procedure provides that a management contract that meets all of the applicable conditions identified, or is an eligible expense reimbursement arrangement, does not result in private business use. In addition, use of property that is functionally related and subordinate to a management contract that meets the safe harbor conditions does not result in private business use.

In general, a management contract that satisfies the six applicable conditions of the revenue procedure, or is an eligible expense reimbursement arrangement, does not result in private business use. (An eligible expense reimbursement arrangement is a management contract in which the only compensation is reimbursement of expenses paid by the service provider to unrelated parties or of reasonable administrative overhead expenses.)^76.9 A compliant management contract must meet general financial requirements; it must satisfy certain term restrictions on contract term and revisions; the qualified user must exercise a significant degree of control over the use of the managed property; the qualified user must bear the risk of loss upon damage or destruction of the managed property; the service provider may not take a tax position inconsistent with being a service provider to the qualified user; and the service provider cannot have a role or relationship with a qualified user that substantially limits a qualified user's ability to exercise its rights under the contract.

With regard to the general financial requirements,^76.10 the payments to the service provider must constitute reasonable compensation for the services it renders during the term of the contract. This includes payments to reimburse actual and direct expenses and related administrative overhead expenses of the service provider. The service provider cannot receive a share of net profits from operating the managed property. This will be accomplished as long as no element of the compensation to the service provider takes into account, or is contingent upon, the net profits of the managed property or both the revenues and the expenses of the managed property for any fiscal period. The identified elements of compensation are eligibility, amount, and timing of payment. Reimbursement of actual and indirect expenses that the service provider pays to unrelated parties are disregarded as compensation for this purpose.

As for incentive compensation, it will not be treated as providing a share of net profits under the safe harbor if eligibility for it is determined by the service provider's performance in meeting standards that pertain to quality of service, performance, or productivity, and the timing of the incentive payments meets the requirements of the safe harbor.

In addition, a contract that satisfies the safe harbor may not require the service provider to bear any share of net losses from operation of the managed property. This will not occur as long as the service provider's compensation and expenses under the contract do not take into account the managed property's losses, or its revenues and expenses, for any fiscal period and the timing of payment of compensation to the service provider is not contingent upon the net losses of the managed property. The revenue procedure provides an example of a management contract that qualifies under this section: one in which a service provider's compensation is reduced by one or multiple stated dollar amounts for failure to keep the expenses of the managed property below one or more specified targets.

With regard to the term of the contract and any revisions to it,^76.11 a management contract that qualifies under the safe harbor must have a term, including all renewal options, that is no greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property. If there is a material modification of the management contract, it will be retested as a new contract as of the date of the modification.

To satisfy the safe harbor, a qualified user must also exercise a significant degree of control over the use of the managed property.^76.12 A management contract must require the qualified user to approve the property's annual budget, its capital expenditures, each disposition of property, the usage rates charged, and the general nature and type of use of the managed property. Examples cited by the revenue procedure include a qualified user: approving an annual budget for capital expenditures described by functional purpose and specific maximum amounts; showing approval of dispositions or property in a similar manner; and expressly approving rates charged (or the methodology for setting them) by including a contract requirement that the service provider must charge reasonable and customary rates as determined by an independent third party.

Another requirement of the safe harbor is that the qualified user must bear the risk of loss upon damage or destruction of the managed property.^76.13 This test is not failed when the qualified user insures against risk of loss through a third party, or assesses a penalty on a service provider for failure to operate the managed property in accordance with the standards contained in the contract.

The safe harbor also requires that a service provider agree that it will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property.^76.14 Thus, for example, the service provider cannot agree to take any depreciation or amortization, investment tax credit, or deduction for rent payment with respect to the managed property.

The final requirement of the safe harbor is that the service provider cannot have any role or relationship with the qualified user that substantially limits the qualified user's ability to exercise its rights under the management contract based on all of the facts and circumstances.^76.15 As a safe harbor, the service provider will meet this test if: (1) no more than 20% of the voting power of the qualified user's governing body is vested, in the aggregate, in the directors, officers, shareholders, partners, members, and employees of the service provider; (2) the qualified user's governing body does not include the service provider's chief executive officer or the chair of its governing body; and (3) the service provider's chief executive officer does not also serve as the CEO of the qualified user or any of its related parties.

The revenue procedure also clarifies that any use of a project by the service provider that is functionally related and subordinate to performance of its services under a management contract for managed property and that otherwise satisfies the terms of the safe harbor does not result in private business use.^76.16 It provides as an example the use of storage areas to store equipment that is used to perform activities under a compliant management contract.

The revenue procedure provides that its safe harbors apply to any management contract that is entered into on or after August 22, 2016. In addition, an issuer may apply the safe harbors to any management contract entered into prior to August 22, 2016, and it may apply the 1997 safe harbors, as modified and amplified, to any management contract entered into prior to August 18, 2017, that has not been materially modified or extended on or after that date.

This new safe harbor is of great utility to qualified users and service providers in drafting management contracts that can safely avoid resulting in undesired private business use, and it should be easier to apply. The 1997 safe harbor restrictions on termination provisions and the differing treatment of contracts based on the type of fee used have been eliminated. However, drafters will need to ensure that the specifics of the new safe harbor pertaining to such issues as control over managed property, risk of loss, and inconsistent tax positions have been properly addressed. And as with other IRS rules on reasonable compensation, this new guidance will necessitate that the parties establish a methodology for ensuring reasonableness. The principles set forth in the IRS's intermediate sanctions regulations will be useful in this regard.^76.17 As this Cumulative Supplement went to press, the IRS published additional guidance on the safe harbors for management contracts that substantively changes this Revenue Procedure. This guidance will be analyzed in the 2018 Cumulative Supplement.^76.18