WASHINGTON - The Internal Revenue Service has released interim guidance on how management contracts and certain accountable care organizations can be structured to avoid excessive private use that would jeopardize the tax-exempt status of bonds.
The interim guidance, which was contained in a notice released Friday, comes after bond and hospital groups sought guidance on management contracts and ACOs. Bond lawyers were generally pleased with the guidance, especially the portion on management contracts.
"I am very encouraged and happy to see this come out," said Antonio Martini, a partner at Edwards Wildman Palmer LLP in Boston and president of the National Association of Bond Lawyers. NABL, the tax-exempt financing committee of the American Bar Association's taxation section, and the American Hospital Association are among the groups that asked for guidance.
The IRS and the Treasury Department are soliciting comments on the interim guidance and related further guidance that is needed. Comments should be submitted by Jan. 22, 2015.
Under federal tax law, governmental or 501(c)(3) tax-exempt bonds can become taxable if the projects they finance have excessive private business use. Bonds generally are considered private-activity bonds if more than 10% of the proceeds are used for private business and more than 10% of the debt service is payable from, or secured by, a private party. The thresholds for these "private business use" and "private payment" tests are lowered to 5% when determining whether bonds issued for 501(c)(3) organizations are tax exempt.
Management contracts can give rise to private business use. The IRS' Revenue Procedure 97-13 has provided some safe harbors about when they don't result in private business use, but in the years since that guidance was released, issuers and borrowers have found it more difficult to meet the safe harbors.
Under a new safe harbor created by the interim guidance, a management contract will not result in private business use if it is five years or less and all of the compensation for services is based on a stated amount, periodic fixed fee, capitation fee, per-unit fee or a combination of the above. The compensation can include a percent of either, but not both, revenues or expenses of the bond-financed facility.
The interim guidance also expands the types of permitted productivity rewards.
Generally, a management contract gives rise to private business use if compensation for services is based on a share of the net profits. Under the interim guidance, productivity rewards for services don't cause the compensation to be based on a share of the net profits if eligibility for the reward is based on the quality of services performed under the contract and if the award amount is "a stated dollar amount, a periodic fixed fee, or a tiered system of stated dollar amounts or periodic fixed fees based solely on the level of performance achieved with respect to the applicable measure." This type of tiered productivity award will be treated as a stated amount or a periodic fee under the new safe harbor.
Nancy Lashnits, an attorney at Steptoe & Johnson PLLC in Phoenix and chair of ABA committee, said that the guidance is similar to what the IRS said in previous private-letter rulings.
Bond lawyers said they like the new safe harbor. The notice does not remove any existing safe harbors from the 1997 document, but several bond lawyers said the new safe harbor appears to encompass or override at least some of the existing ones from the 1997 guidance.
"This is the most significant development in service contracts since 97-13," said Mike Bailey, a partner at Foley & Lardner LLP in Chicago.
The new guidance on management contracts will be particularly helpful in the health care context, bond lawyers said.
President Obama's health-care reform law, the Affordable Care Act, directed the establishment of a Medicare Shared Savings Program. If participants in the program spend less than a benchmark amount and provide a certain level of care for Medicare beneficiaries, they will be eligible to receive payments from the federal government for some of the savings. The IRS said in its notice that governmental and nonprofit users of bond-financed health care facilities will want to enter into management contracts with private parties to provide services at the facilities that will take into account factors relevant to participation in the Shared Savings Program.
Additionally, there is increased incentive under the ACA for hospitals to enter into arrangements with doctors' groups that are longer than the previous industry standard of one-to-three years, said Richard Moore, a tax partner at Orrick, Herrington & Sutcliffe in San Francisco. Bailey said that separate-billing physician contracts are considered per-unit management contracts, and in order for these types of contracts to meet the original safe harbors, the contract could not be longer than three years and had to be terminable after two years.
"In terms of physician contracts, the new five-year contract safe harbor is an absolute home run," Moore said. "It will provide 501(c)(3) and governmental hospitals with dramatically more flexibility to enter into the sort of contractual arrangements with physician groups contemplated by the Affordable Care Act as long as there is not a combination of both revenue and expense sharing compensation or any other individual or combined compensation features that give rise to a net profits interest."
Elizabeth Walker, an attorney at Hall, Render, Killian, Heath & Lyman, P.C. in Indianapolis, said "the new safe harbor is a very exciting development, and appears to provide a great deal of additional flexibility, which is sorely needed in the health care area." The interim guidance also gives criteria that, if all met, will prevent a government or nonprofit from having private-business use in its tax-exempt bond financed facility solely because it participates in the Shared Savings Program through an ACO.
ACOs are health care organizations where doctors, hospitals and other providers join together to coordinate care. They can include both taxable and tax-exempt participants, including hospitals and other organizations that are issuers or borrowers of tax-exempt bond financings.
One condition the IRS stipulated is that the user's share of economic benefits from the ACO has to be "proportional" to the benefits or contributions it provides to the organization. "If the qualified user receives an ownership interest in the ACO, the ownership interest received is proportional and equal in value to its capital contributions to the ACO and all ACO returns of capital, allocations, and distributions are made in proportion to ownership interests," the IRS said.
Martini said that lawyers will have to figure out how to apply the "proportional and equal in value" standard.
Another condition is that the government's or nonprofit's share of the ACOs losses cannot be greater than the share of the benefits the user would be entitled to receive, the IRS said.
Other criteria include that the terms of the user's participation in the Shared Savings Program through the ACO should be established in advance in a written agreement: that the Centers for Medicare & Medicaid Services has accepted the ACO into the program and not terminated the ACO from it; that contracts associated with the ACO be at fair market value; and that the user doesn't transfer the bond-financed property to the ACO unless the organization is a government or, in the case of 501(c)(3) bonds, a nonprofit.
The criteria about when ACOs won't cause bond problems are similar to the conditions included in an earlier IRS notice about when ACOs would not jeopardize nonprofits' 501(c)(3) status.
Bailey said the latest guidance on ACOs a "helpful, limited step" but leaves unanswered questions. The notice only pertains to ACOs participating in the Shared Savings Program, but there are other ACOs as well, he said.
The part of the interim guidance on ACOs applies to bonds sold on Jan. 22, 2015 or later, but can be applied to bonds sold earlier. The part of the notice on management contracts applies to contracts that are entered into, materially modified or extended after Jan. 22, 2015, but can be applied to contracts entered into before then.
Perry Israel, a lawyer with his own firm in Sacramento, Calif., said it is good that the regulators are soliciting comments because ACOs are very new and it is unclear exactly what they will look like. The IRS recognizes that ACOs are a developing area, he said.
