The CPA Journal

FEDERAL TAXATION

Management Service Agreements Involving Bond-Financed Space

By Patrick K.O'Hare

Earlier this year, the IRS issued two documents that will be of interest to hospitals with outstanding tax-exempt bonds. They provide additional guidance and flexibility in the permissible terms of certain management service agreements entered into with for-profit entities that involve bond-financed facilities.

Private Letter Ruling 200123057

Released on June 8, 2001, Private Letter Ruling (PLR) 200123057 will be of interest to exempt hospitals with outstanding bond issues participating in joint ventures with their medical staff or other for-profit entities that provide management services to the hospital. In essence, the ruling reiterated that the safe harbor requirements for management agreements set forth in Revenue Procedure 97-13, 1997-1 C.B. 632, are just that; deviations from the safe harbors can occur without jeopardizing the bonds' interest exemption.

In PLR 200123057, a hospital used the proceeds of an exempt bond issue to finance its hospital facility and medical clinics. The hospital corporation was also the sole corporate member of a nonprofit, but taxable, subsidiary that employed physicians. The subsidiary entered into a professional services agreement with the hospital to provide professional services to the hospital and its clinics. The hospital appointed a majority of the subsidiary's directors; moreover, the hospital's CEO served on the subsidiary's board.

Revenue Procedure 97-13 defines certain characteristics of management service agreements that do not create a "private business use" if a non-exempt entity provides management services to an exempt entity involving bond-financed property. Under applicable IRS requirements, too much private business use of facilities financed with exempt bonds will destroy the exemption, making interest on the bonds taxable and potentially causing a default on the bonds and acceleration of their principal. Key principles of Revenue Procedure 97-13 include requirements governing the contract term and compensation methodologies that service agreements should incorporate.

Another key provision of Revenue Procedure 97-13, and the one at issue in PLR 200123057, is found in section 5.04(1); it addresses the required governance relationship between the exempt entity (qualified user) and the management entity (service provider). As a general rule, the service provider "must not have any role or relationship with the qualified user that … substantially limits the qualified user's ability to exercise its rights … under the contract." The logic is that if the service provider has control over the qualified user, the service agreement could be used primarily to benefit the service provider rather than the exempt facility. Revenue Procedure 97-13 provides various governance safe harbors that, if met, will satisfy this lack-of-control test. These include a requirement that not more that 20% of the board members of the exempt institution are board members, officers, shareholders, or employees of the service provider; that the CEOs of both the hospital and service provider not sit on each other's boards; and that the parties not be "related parties" within the meaning of various Treasury Regulations that define certain control relationships.

As applied to hospital-physician joint ventures that provide management services to hospitals with outstanding bond issues, these requirements often disqualify the hospital CEO from the board of the joint venture, an outcome that both limits board overlap and minimizes hospital control over the venture.

The ruling does not set precedent, although it does provide valuable insight into the IRS's position. It serves as a reminder that governance safe harbors are only guidelines-depending upon the facts of an arrangement; deviations from safe harbors may be possible to accommodate the business needs of the parties. Significantly, the subsidiary in PLR 200123057 did not comply with these governance safe harbors, both with respect to the role of the CEO and the hospital's control over the subsidiary (making them related parties). Nonetheless, the IRS ruled that because the subsidiary entity could not influence the hospital's rights under the contract at issue, no threat to the bonds' exemption existed. This ruling is consistent with PLR 9823008, which held that, despite the fact that a service contract contained compensation provisions outside of those recommended by Revenue Procedure 97-13, the contract at issue did not convert the arrangement into private business use. Consequently, exempt providers may have additional flexibility (depending upon the particulars) to structure service agreements with subsidiaries and joint ventures entities outside the narrow confines of 97-13.

Revenue Procedure 2001-39

On June 20, 2001, the IRS released Revenue Procedure 2001-39 (published in the Internal Revenue Bulletin, July 9), further amending Revenue Procedure 97-13. As noted, Revenue Procedure 97-13 defines certain permissible compensation methodologies-including a "fixed fee" and a "per unit fee"-that, if followed, will qualify the service agreement for safe harbor treatment. Revenue Procedure 97-13 section 3.05 defined fixed fee to allow for periodic increases in the fee subject to a fixed external standard (e.g., the Consumer Price Index) that "is not linked to the output or efficiency of a [bond-financed] facility." Per unit fees did not have this flexibility, but Revenue Procedure 2001-39 fixes this oversight and similarly allows per unit fees the same type of increase.

Per unit fees, as now amended, are primarily relevant under Revenue Procedure 97-13 in two instances: