• New IRS Standards for Management Contracts
  • November 17, 2016 | Authors: Courtney A. Strutt Todd; David B. VanSickel
  • Law Firm: Davis, Brown, Koehn, Shors & Roberts, P.C. - Des Moines Office
  • The Internal Revenue Service has been more proactive regarding its efforts to conduct audits on tax-exempt bond financings and has indicated that issuers and borrowers should maintain and follow post-compliance policies and procedures in order to make sure that the interest on the bonds continues to remain tax-exempt.

    One such example where bonds can lose their tax-exempt status is when a 501(c)(3) borrower or a governmental issuer enters into an arrangement with a private party which is a management or incentive payment contract on property that is financed with proceeds of tax-exempt bonds because this may result in private business use. If the contract is considered a management contract under Regulation § 1.141-3 and does not pass the tests under Rev. Proc. 97-13 which make it a qualified management contract, then the contract may cause the bonds to lose their tax-exempt status.

    OLD RULES - Effective Through August 17, 2017

    Below is a summary of the safe harbor tests under Revenue Procedure 97-13 and IRS Notice 2014-67 which can be used to create a Qualified Management Contract and to avoid having any private business use associated with that contract.

    Compesation

     Maximum Term of the Contract (Including all rewnewal Options)

     Other

    At least 95% based on a periodic fixed fee

    The lesser of (1) 80% of the reasonably expected useful life of the financed facilities and (2) 15 years

    A one-time, single, stated dollar amount incentive award during the term of the contract when a gross revenue or expense target (but not both) is reached is permissible

    At least 80% based on a periodic fixed fee 

    The lesser of (1) 80% of the reasonably expected useful life of the financed facilities and (2) 10 years 

    A one-time, single, stated dollar amount incentive award during the term of the contract when a gross revenue or expense target (but not both) is reached is permissible 

    At least 50% based on a periodic fixed fee or all is based on a capitation fee or a combination of a capitation fee and a periodic fee 

    5 years

    Contract must be terminable by the qualified user on reasonable notice, without penalty or cause, at the end of the third year of the contract term 

    All compensation based on a per-unit fee or combination of a per-unit fee and a periodic fixed fee 

    3 years

    Contract must be terminable by the qualified user on reasonable notice, without penalty or cause, at the end of the second year of the contract term

    All compensation based on a stated amount, periodic fixed fee, capitation fee, per-unit fee or combination of the preceding and may also include a percentage of gross revenues, adjusted gross revenues, or expenses (but not both)*

    5 years

    The IRS has informally commented that this standard allows management contracts to be based 100% on variable fees as long as those fees are not based on a net profits arrangement


    *This standard was added by IRS Notice 2014-67 and is applicable to contracts entered into, materially modified or extended, other than pursuant to a renewal option, on or after January 22, 2015 but may be applied to contracts entered into before January 22, 2015.

    NEW RULES

    The IRS has again published new rules on management contracts under Rev. Proc. 2016-44 which applies to management contracts entered into, on, or after August 22, 2016, and may be applied to contracts entered into before such date. The new rules also indicate that the old rules under Rev. Proc. 97-13 may continue to be used as safe harbor tests for management contracts entered into before August 18, 2017.

    Under these new rules there are seven requirements:

    1. Compensation. The contract must provide for reasonable compensation for services rendered with no compensation based, in whole or in part, on a share of net profits from the operation of the facility. For such purposes, compensation to the Contractor will not be treated as providing a share of net profits if no element of the compensation takes into account, or is contingent upon, either the managed property’s net profits or both the managed property’s revenues and expenses for any fiscal period. To make this determination one must look at all the elements of the compensation including the eligibility for, amount of, and the timing of the payment of the compensation. Reimbursements of actual and direct expenses by the Contractor to unrelated parties are disregarded as compensation. Incentive compensation will not be treated as providing a share of net profits if the eligibility for the incentive compensation is determined by the Contractor’s performance in meeting one or more standards that measure quality of services, performance, or productivity and the amount and the timing of the payment of the compensation also meet these requirements.

    2. No bearing of Net Losses on the Managed Property. The contract must not, in substance, impose upon the manager the burden of bearing any share of net losses from the operation of the managed property. An arrangement will not be treated as requiring the Contractor to bear a share of the net losses under Section 5.02(3) if:
    1. the determination of the amount of the Contractor’s compensation and the amount of any expenses to be paid by the Contractor (and not reimbursed), separately and collectively, do not take into account either the managed property’s net losses or both the managed property’s revenues and expenses for any fiscal period; and
    2. the timing of the payment of compensation is not contingent upon the managed property’s net losses.
    One example provided in the Rev Proc. is that a Contractor whose compensation is reduced by a stated dollar amount (or one of multiple stated dollar amounts) for failure to keep the managed property’s expenses below a specified target (or one of multiple specified targets) will not be treated as bearing a share of net losses as a result of this reduction.

    3. Term. The term of the management contract, including all renewal options be no greater than the lesser of thirty (30) years or eighty percent (80%) of the weighted average reasonably expected economic life of the managed property.

    4. Control over use of the Managed Property. The property owner must exercise a significant degree of control over the use of the managed property. This requirement is met if the contract requires the owner to approve the annual budget of the management property, capital expenditures with respect to the managed property, each disposition of the property that is part of the managed property, rates charged for the use of the managed property, and the general nature and type of use of the managed property.

    5. Risk of Loss of the Managed Property. The owner must bear the risk of loss upon damage or destruction of the managed property. The owner doesn’t fail to meet this risk of loss requirement as a result of insuring against risk of loss through a third party or imposing upon the manager a penalty for failure to operate the managed property in accordance with the standards set forth in the management contract.

    6. No Inconsistent Tax Position. The manager must agree that it is not entitled to and will not take any tax position that is inconsistent with being a manager to the owner with respect to the managed property. An example of this is that the manager must agree not to take any depreciation or amortization, investment tax credit or deduction for any payment as rent with respect to the managed property.

    7. No Circumstances Substantially Limiting Exercise of Rights. The manager must not have any role or relationship with the owner that, in effect, substantially limits the owner’s ability to exercise its rights, including cancellation rights, under the contract, based on all the facts and circumstances. This requirement is satisfied if (a) not more than twenty percent of the voting power of the governing body of the owner in the aggregate is vested in the directors, officers, shareholders, partners, members and employees of the manager (or its related parties); (b) the governing body of the owner does not include the chief executive officers (or person of equivalent management responsibility) of manager (or its related parties) or the Chairperson (or equivalent executive) of the manager’s (or related party’s) governing body; and (c) the chief executive officer (or person of equivalent management responsibility) of the manager (or any of its related party) is not the chief executive officer of the owner or any of the owner’s related parties.