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Tax-Exempt Financing – New Safe Harbor for Management Contracts Issued by IRS

on Friday, 14 October 2016 in Health Law Alert: Erin E. Busch, Editor

The Internal Revenue Code provides that interest on bonds issued by governmental or 501(c)(3) organizations may be exempt from tax if, in addition to satisfying other requirements, not more than 10 percent of the proceeds of the debt issuance for governmental entities (or five percent for 501(c)(3) organizations) are used in a private business use. Use of tax-exempt financed property by a private party such as a medical practice or for-profit service provider may qualify as a private business use. As a result, traditional service agreements between hospitals and medical practices and other arrangements to manage segments of hospitals’ businesses may be considered management agreements and could cause financings to fail the private business use test. This would result in interest on bonds being taxable.

In order to prevent such a result, hospitals with outstanding tax-exempt debt historically sought to fit management and service agreements into one of a multitude of complex and often burdensome private use safe harbors under IRS Revenue Procedure 97-13. These safe harbors were tied to the length of the agreement and the type of compensation provided to the service provider. If a safe harbor was satisfied then the agreement would be deemed as not a private business use.

Because the safe harbors were extremely technical and complex, on August 22, 2016, the IRS issued Revenue Procedure 2016-44 as a replacement to Rev. Proc. 97-13. The safe harbor implemented by Rev. Proc. 2016-44 is more flexible and less formulaic in its approach, which serves as a significant improvement over Rev. Proc. 97-13.

For a management or service agreement to fit within Rev. Proc. 2016-44, the following elements must be satisfied:

  • Reasonable Compensation – The compensation paid to the service provider must be “reasonable” for the services rendered. Instead of analyzing whether the compensation methodology is a periodic fixed fee, per unit fee or percentage of revenue or expense fee, now, the compensation must only be reasonable.
  • No Net Profits or Losses – As before, compensation cannot be tied to the net profits or net losses of the hospital or any service line or department of the hospital. Importantly, for purposes of many alternative payment methodologies and ACO activity, incentive compensation based on meeting quality, performance or productivity standards is not considered to be based on net profits. Likewise, compensation tied solely to revenue or expenses, but not both, may be permissible.
  • Risk of Loss – The service provider cannot bear the risk of loss due to the damage or destruction of the hospital or managed property.
  • Term – The term of the agreement may be no greater than the lesser of 30 years or 80 percent of the weighted average of the reasonably expected economic life of the property subject to the agreement. This is a significant lengthening of the typical safe harbor contract terms relied upon by hospitals under Rev. Proc. 97-13.
  • Control of Property – The hospital must control the financed property. This means that the hospital must retain authority through the contract over matters such as approval of budgets, capital expenditures, disposition of property, rates charged for use of the property, and the general nature and type of use of the property.
  • Inconsistent Tax Position – The service provider must formally agree that it will not take an inconsistent tax position with regard to the agreement and managed property, for example, by taking amortization or depreciation expense write-offs as if it owned the property.
  • Relationship of Parties – Rev. Proc. 2016-44 maintains the control/relationship tests of Rev. Proc. 97-13 in that the service provider may not have a role in the management of the hospital that would prevent or limit the hospital’s ability to exercise its rights under the contract. This means that the service provider may not have more than 20 percent of the voting power over the hospital, and the CEO/chairperson of the service provider may not serve on the governing board of the hospital.

While Rev. Proc. 2016-44 is a substantial improvement over Rev. Proc. 97-13, there remain a few significant potential road blocks and outstanding questions.

  • To maintain “control” of the property, hospitals must approve of the rates charged for use of the property. This includes professional fees charged by physicians for services provided in the hospital. Formal approval of the professional fees charged by physicians in split-billing arrangements must be granted by a hospital or physician fees must be reasonable and set by an independent third party (e.g. Medicare physician fee schedule). In the past, many spit-bill arrangements only gave hospitals the right to review and potentially object to the physician’s fees, if any rights were given at all. Express approval by the hospital is now required.
  • There is no guidance on what constitutes “reasonable compensation.” However, presumably compensation that would be permissible under traditional IRS private benefit and private inurement standards would be permissible under Rev. Proc. 2016-44.
  • While the potential length of permissible management contracts has been significantly extended, a question remains over the usefulness of this safe harbor for new management or service agreements that are entered into later in the useful life of the financed property.
  • Many hospitals include one or two physician members on their boards. If a physician board member also serves as the chairperson of the local physician practice group board, it would present a problem under Rev. Proc. 2016-44 to the extent the physician practice group has an agreement with the hospital that requires safe harbor protection.

Rev. Proc. 2016-44 supersedes and replaces Rev. Proc. 97-13. Parties may continue to rely on Rev. Proc. 97-13 for prior agreements or they may also rely on Rev. Proc. 2016-44. Agreements entered into between August 22, 2016, and August 18, 2017, may look to either Rev. Proc. 97-13 or Rev. Proc. 2016-44 for safe harbor protection. For agreements entered into after August 18, 2017, only the safe harbor protection offered by Rev. Proc. 2016-44 will apply.

Andrew D. Kloeckner

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