Safe Harbors for Management Contracts Liberalized by IRS Notice 2014-67

It’s not often that the IRS liberalizes its rules. It has done so with Notice 2014-67, which was published in December 2014 and was effective January 22, 2015. The Notice provides interim guidance for state or local governmental entities or Section 501(c)(3) organizations to determine if they will be considered by the IRS to have private business use of their bond-financed facilities as a result of participation in the Shared Savings Program though an accountable care organization (ACO) formed in response to the Affordable Care Act (ACA). The Notice also amends Revenue Procedure 97-13, which provides safe harbors for management and service contracts entered into by entities with tax-exempt bond financings in order to avoid private business use of their bond-financed facilities.

Under ACA, the Department of Health and Human Services (HHS) was directed to establish a Medicare shared savings program to promote accountability for care of Medicare beneficiaries, improve coordination of fee-for-service items and services, and encourage investment in infrastructure and redesigned care processes for high quality and efficient service delivery. The aim is to have groups of health care providers come together to provide coordinated high quality care to Medicare patients with a financial incentive for doing so at a lower cost. In many instances, the doctors, hospitals and other providers joining together to coordinate care will include both taxable and tax-exempt participants.

Entities with tax-exempt financing were concerned that entering into an ACO arrangement would create private business use and thereby create a risk that bonds could be declared taxable by the IRS. The Notice addresses that concern by expanding the types of permitted productivity rewards that can be used in management or service contracts with private parties. It also establishes certain criteria that, if satisfied, would preclude a tax-exempt entity from having private business use of its facilities solely by participating in the Shared Savings Program through an ACO.

Within that framework, the Notice creates a new category of contracts that meet the safe harbors for management and service contracts entered into with respect to bond-financed facilities. This category includes contracts with a term of 5 years or less that have compensation based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee, a productivity award, a percentage of revenues, a percentage of expenses, or any combination of those measures other than a percentage of net income (i.e., a measure that includes both revenues and expenses, which has always been prohibited). This covers essentially all of the types of compensation that are permitted by the existing Rev. Proc. 97-13 safe harbors. The contract does not have to be terminable by the hospital prior to the end of the contract term.

Fortunately for tax-exempt borrowers, this new, more flexible safe harbor from private business use for management contracts is not limited to use in connection with an ACO arrangement. While the development of the new safe harbor was prompted by the need for guidance with respect to ACOs, a state or local governmental entity or Section 501(c)(3) organization can use these more flexible terms in negotiating management contracts with respect to any bond-financed facilities.

This is an improvement over the existing 5-year safe harbor under Rev. Proc. 97-13 in several important respects. First, an entity is now permitted to have a binding contract for a full 5 year term. The early termination provision required by the Rev. Proc. 97-13 safe harbor was often a point of contention between issuers or conduit borrowers and private parties. Second, the existing 5-year safe harbor required that at least fifty percent of the compensation payable to the private party under the agreement be fixed. The new 5-year safe harbor allows the private party and the issuer or conduit borrower much more flexibility with respect to compensation under the agreement. Third, Notice 2014-67 permits a new type of annual incentive payment based on satisfying quality performance standards. Rev. Proc. 97-13 allowed a similar productivity award based only on achievement of certain quantitative measures (e.g., revenue thresholds or cost reduction targets).

The compensation arrangements and other rules under the existing safe harbors for contracts with a term of 5 years or less are still available, but the new 5-year arrangement under Notice 2014-67 should be more useful in almost every case.

Notice 2014-67 specifically permits application to existing agreements. As a result, the new safe harbor features of Notice 2014-67 can be included in new contracts and existing contracts can be amended to incorporate the new provisions without jeopardizing the tax exemption on outstanding bonds.