4.6.1.3 Management, Operating, and Service Contracts
Private business use can also arise through contracts allowing private parties to earn fees through the management and operation of governmentally owned facilities. Whether or not a management contract results in private business use depends on all of the facts and circumstances, but the IRS has provided safe harbor guidance78 for “qualified management contracts” that will not be treated as resulting in private business use.
A management contract will result in private use if compensation for services under the contract is based, in whole or in part, on a share of net profits from the operation of the facility or will result in the service provider being the lessee or owner of the bond financed facility for federal income tax purposes. Under new safe harbor guidance provided by the IRS in March 2017, a management contract will not result in private business use if it complies with the following requirements:
REASONABLE COMPENSATION – The fee paid to the service provider is reasonable. Fees determined through a competitive process or fees within a normal range for such services generally will be reasonable.
NO NET PROFITS – Compensation to the service provider cannot be based, even in part, on the net profits of the financed project. This includes directly sharing net profits, as well as designing incentives that are based on a combination of gross revenues and expenses. Incentive compensation based on performance metrics like quality of services or productivity is not necessarily treated as a net profits incentive. Often, payments under management contracts are split between (1) reimbursement for actual service provider costs, subject to the approval of annual budgets by the project owner, and (2) a separate management fee. This type of structure can more easily qualify as a “qualified management contract” than an “all in” compensation structure in which the service provider is paid a comprehensive fee and is entirely responsible for paying all operating costs out of that fee. Even in the context of all in contracts, however, certain types of management fees (one or more of a capitation fee, a periodic fixed fee, a per unit fee, or a fee based on certain performance metrics) are not considered to be net profits arrangements.
NO NET LOSSES – Compensation to the service provider cannot be based, even in part, on the net losses of the financed project. The most common example of a net losses problem is if the fee paid to the service provider is subordinate to the payment of debt service and if the fee would never be paid if there were insufficient funds at the time the fee is due. Subject primarily to some timing limitations, a solution can be for any unpaid fees to accrue with interest. A service provider whose compensation is reduced by a stated dollar amount for failure to keep the managed property’s expenses below a specified target will not be treated as bearing a share of net losses as a result of this reduction. Like the net profits prohibition, all in contracts raise significant concerns, the reimbursement of costs generally is ignored, and management fees that are capitation fees, periodic fixed fees, and per unit fees are not considered to be net losses arrangements, even in all in management contracts.
TERM LIMITATION -The term of the management contract may not be longer than the lesser of 30 years or 80% of the remaining useful life of the financed project. The useful life of a newly constructed project that consists primarily of building construction or improvements should support a 30 year management contract.
CONTROL -The owner of the financed project (generally the issuer, or for qualified private activity 501(c)(3) bonds described below, the 501(c)(3) owner) must exercise control over the project. This control requirement is met if the project owner approves (1) the annual operating budget, (2) any capital expenditures, (3) the disposition of property, (4) the rates charged for the use of the bond financed facility, and (5) the general nature and type of use of the project. For management contracts with cost reimbursement plus a management fee, these control requirements should be satisfied under typical practices.
RISK OF LOSS -The service provider cannot be responsible for replacing the financed project if there is a catastrophic loss.
SERVICE PROVIDER TAX POSITION -The management contract must state that the service provider will not claim any depreciation or amortization deduction, investment tax credit, or deduction for any payment as rent with respect to the project.
LIMITATION ON RIGHTS -Finally, the service provider must not have a role or relationship with the project owner, such as the chief executive officer of the service provider being in a similar position with the project owner that, as a practical matter, would limit the project owner’s rights to take action under the management contract.
Certain types of agreements are generally not treated as management agreements that give rise to private business use, including (1) a contract for services solely incidental to the primary governmental functions of financed facility (for example, for janitorial services, office equipment repair, hospital billing services, or similar services); (2) the mere granting of admitting privileges by a hospital to a doctor (even if conditioned on providing de minimis services) if those privileges are available to all qualified physicians in the area consistent with the size and nature of the hospital; (3) contracts for the operation of facilities consisting predominately of public utility property if the only compensation is the reimbursement of actual and direct expenses and reasonable overhead expenses of the service provider; (4) contracts for services if the only compensation is the reimbursement of the service provider for actual and direct expenses paid by the service provider to third parties.
Under certain circumstances, a management contract may be more properly characterized a lease, particularly when considering (1) the degree of control over the property that is exercised by a non governmental person and (2) whether a non governmental person bears risk of loss of the financed property. A management contract that is characterized as a lease for tax purposes will not be eligible for the safe harbor for management contracts described above and would generally result in private business use.