Health care organizations benefiting from tax-exempt bond financing are limited in how they can use the net proceeds from a bond issuance. According to the IRS, 501(c)(3) charitable organizations cannot use more than five percent of net proceeds from a 501(c)(3) bond issuance for “private business use,”[1] without risking the tax-exempt status of their bonds.

Management contracts between health care organizations and private or for-profit entities lead to the private business use of tax-exempt financed property.[2] Management contracts are arrangements that compensate providers for the management and performance of services throughout a health care facility or department thereof.[3] The term “management contract” is defined broadly[4] and includes professional services agreements involving private physician groups performing services or managing a hospital department, as well as professional services agreements involving solo-practitioners performing clinical services for hospital patients.  Contracts for janitorial services, office equipment repairs, hospital billing services, and the issuance of physician privileges, however, are not considered management contracts because they are “incidental to the primary governmental function or functions of the financed facility.”[5]

In February 1997, the IRS helped tax-exempt organizations by creating “operating guidelines for management contracts” that, if satisfied, would protect management contracts from being considered private business use.[6] Rev. Proc. 1997-13 stated generally that management contracts that “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” would be protected by the safe harbor.[7]

Rev. Proc. 1997-13 also included in its guidelines “permissible arrangements” that tax-exempt organizations could enter into with service providers, including fixed fee arrangements, per-unit fee arrangements and percentage of revenue or expense fee arrangements.[8] Anecdotally, health care organizations and private or for-profit entities often structure management contracts using the percentage of revenue compensation model. However, the management contract safe harbor requires that this type of arrangement have a term not to exceed two years and a provision that allows the health care organization to terminate the arrangement at the end of the first year upon reasonable notice.[9]

In October 2014, the IRS expanded the management contract safe harbor in a way that affords 501(c)(3) health care organizations greater flexibility to structure management contracts with private and for-profit entities, including those arrangements that use the percentage of revenue compensation model.[10] IRS Notice 2014-67 specifically created a new subsection of the safe harbor that allows health care organizations to enter into management contracts that have a compensation provision based on: a stated amount, periodic fixed fee, capitation fee, per-unit fee, or a combination thereof; or a percentage of gross revenue, adjusted gross revenue or expenses of the facility.[11] The notice also states that “[t]he term of the contract, including all renewal options, [cannot] exceed five years.”[12]

In practice, this means that the management contract, which may incorporate a variety of compensation arrangements, can have an initial term of up to five years followed by a provision for automatic renewal from year-to-year thereafter, as long as both parties have the ability to cancel automatic renewal of the contract.[13] The protections of the expanded management contract safe harbor apply to contracts entered into on or after January 22, 2015 (the “Effective Date”), as well as contracts entered into before the Effective Date, which are materially modified or extended on or after the Effective Date.[14]

The key takeaways are that the new safe harbor protects management contracts involving 501(c)(3) health care organizations with private and for-profit entities from private business use of tax-exempt property using a variety of compensation arrangements. Contracts protected by the safe harbor can have an initial term of up to five years, even if the contract contains a provision for automatic renewal thereafter. While the IRS did not explicitly repeal the “permissible arrangements” under the old management contract safe harbor, the latest expansion of the management contract safe harbor effectively replaces most of the old safe harbor and opens the door to restructuring the term and compensation provisions of management contracts protected from classification as private business use of tax-exempt property.

IRS expansion of the management contract safe harbor, often relied upon by 501(c)(3) tax-exempt health care organizations, was a welcome relaxation of federal regulation in October 2014. As your organization considers negotiating new contracts or renegotiating existing contracts, remember that the revised safe harbor creates new opportunities in 2015.

Contact Information

To discuss more about this client alert, please contact alert author Hilary Bowman; Greg Chabon; or the Womble Carlyle attorney with whom you normally work.

[1] “Private business use” is defined broadly “as use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit.” Definition of Private Business Use, 26 C.F.R. 1.141-3; IRS Rev. Proc. 2007-47; I.R.C. § 141(b)(6).

[2] See id.

[3] IRS Rev. Proc. 1997-13, §3.03.

[4] Under Rev. Proc. 97-13, the term "management contract" means “a management, service, or incentive payment contract between a qualified user and a service provider under which the service provider provides services involving all, a portion of, or any function of, a facility.  For example, a contract for the provision of management services for an entire hospital, a contract for management services for a specific department of a hospital, and an incentive payment contract for physician services to patients of a hospital are each treated as a management contract. Id. The term management contract is defined broadly enough to include physician contracts and incentive contracts.

[5] See IRS Notice 2014-67 at 8.

[6] See generally IRS Rev. Proc. 1997-13.

[7] Id. §5.02.

[8] Id. §5.03.

[9] Id. §5.03(6)

[10] See IRS Notice 2014-67.

[11] Id. at 14.

[12] IRS Rev. Proc. 1997-13, § 5.03 (7).

[13] The definition of a “renewal option” explains that “a provision under which a contract is automatically renewed for one-year periods absent cancellation by either party is not a renewal option (even if it is expected to be renewed).” Id. § 3.08.

[14] IRS Notice 2014-67, §5.