New, More Flexible Management Contract Rules

These Rules apply to contracts to run a cafeteria in a bond-financed facility, the parking lots serving these facilities, and a myriad of other arrangements. The good news for non-profits has been that tax-exempt bonds lower their cost of owning these facilities, but the bad news has been the complexity of the Management Contract Rules embodied, until now, in Rev. Proc. 97-13, as modified by Rev. Proc. 2001-39 and Notice 2014-67.

As part of a trend that includes liberalization of the rules governing the process to cure tax law violations affecting bonds and the simplification of the bond documentation process for bond issues of small and modest size, the Management Contract Rules have also been liberalized in newly released Rev. Proc. 2016-44. Rev. Proc. 2016-44 makes a number of changes to prior guidance, including allowing management contracts of as long as 30 years in duration (as opposed to the old 15-year term limit). The new Management Contract Rules also dispense with various detailed requirements for structuring the compensation, which could be paid to the vendor/service provider (the old Rules had different requirements for contracts of different durations, including various mixes of fixed and variable compensation as the term of the agreement changed). Instead, the new Management Contract Rules impose only a very limited number of general structural requirements to be satisfied in order that a management contract avoid bad tax treatment.

The new Management Contract Rules (Rev. Proc. 2016-44), like the prior Rules, create a safe harbor for certain contracts, but are not proscriptive. Rev. Proc. 2016-44 acknowledges that certain types of contracts are not subject to the Management Contract Rules at all, such as contracts for janitorial service, contracts granting admitting privileges to doctors, and contracts that involve the mere reimbursement of third-party costs. The new Management Contract Rules also acknowledge that some arrangements may not fit within the safe harbor it establishes, but still may not give rise to a tax concern.

The concern that is relevant here is “private business use”—also called by practitioners “bad use” or “PBU.” The bond rules start out by limiting bad use in bond-financed qualified 501(c)(3) facilities to no more than 5% of the use of the facility. The rules go on to reduce that 5% if bond proceeds are used to pay for certain costs incurred in issuing a bond, and then, if applied correctly and in most (but not all) cases, allow that threshold to be increased if taxable debt or equity is also allocated to elements of the financed project. [These allocation rules are not the subject of this discussion.] Management contracts that do not qualify under the safe harbor (and which are not disregarded as in the case of janitorial contracts) generally give rise to PBU.  Consequently, because as noted, PBU is limited in bond-financed projects, effort is often made to structure management contracts to satisfy the safe harbor and thus to not use up the precious resource of “PBU capacity.”

Rev. Proc. 2016-44 imposes certain broad categorical limits and one largely facts-and-circumstances test for the core economics of the arrangement. This common sense approach reflects the basic policy underlying this entire set of rules, which is to assure that the cost savings realized by a non-profit from the use of tax-exempt bonds is not used to subsidize for-profit vendors/service providers.

The fixed rules are as follows:

• No management contract may involve the vendor/service provider being paid, in whole or in part, a portion of the net profits of the activity it is managing, or even having the timing of its payment linked to a net profits determination;
  • Incentive compensation based on either achievement of one or more revenue goals or achievement of one of more expense reduction goals is generally permitted; and
  • Incentive compensation based on quality measures is generally permitted;
• No management contract can shift the risk of losses realized from the managed activity to the vendor/source provider. Phrased another way, the risks and rewards of ownership of the financed facility and of the managed activity conducted in the financed facility must remain with the non-profit owner;
• The term of the contract (including renewal options that are not subject to optional termination provisions in favor of the non-profit) may not exceed the lesser of 30 years or 80% of the weighted average useful life of the financed managed property, determined without regard to land but determined when the contract is entered into or substantially modified;
• The non-profit owner must retain significant control over the managed asset and activity, although control can be evidenced by budget approval, approval of rates charged to third parties (including by the mandate that fees be reasonable and customary as determined by a third party), and other similar indicia;
• The risk of loss by reason of damage or destruction of the financed assets must also be retained by the non-profit (and carrying insurance does not disqualify the non-profit under this test);
• The vendor/service provider must be precluded from taking a tax position inconsistent with management contract treatment (e.g., it may not depreciate the bond-financed facility or take deductions for rental payments for the financed property); and
• No limitations may be imposed on the right of the non-profit to exercise its rights under the contract (including the right to terminate the contract), and the Rules imply that such a limitation arises if there are certain governance overlaps between the non-profit and the vendor/service provider.

The facts and circumstances test included in the Rules is that all compensation must be reasonable.

Left unclear for now are the following:

• Whether early termination penalties remain a problem (we assume they do until further guidance is released); and
• Whether separate bonuses linked on the one hand to revenue growth targets and on the other to expense reductions are permitted.

The new Rules are applicable for contracts entered into after August 22, 2016, and the old Rule ceases to apply for contracts entered into after February 18, 2017. The new Rules may also be applied to pre-existing arrangements.

Rev. Proc. 2016-44 reflects another step in the process of making it easier for non-profits to enjoy the savings that can be realized when they finance their facilities with tax-exempt debt.