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Exempt bond 'private use' rules updated.

The IRS has recently issued Rev. Proc. 93-19, setting forth the conditions under which it will rule that management or other service contracts will not result in the "private business use" of bond-financed facilities. Excessive private business use may result in loss of bond tax-exemption; Sec. 501(c)(3) organizations may also be subject to a significant unrelated business income tax liability under Sec. 150(b)(3). As a result, management contracts for bond-financed facilities should be reviewed in light of the conditions outlined in the revenue procedure.

The issue has become more prominent as the Service expands its coordinated examinations of large nonprofits. An IRS official recently indicated that there are 24 exempt bond cases pending in the National Office, most of which have arisen as a result of the coordinated examination program.

Sec. 103(b) provides that interest on private activity bonds, other than "qualified" private activity bonds, is taxable to bondholders. A bond will be considered a private activity bond if more than 10% of bond proceeds is used in a "private business use" and more than 10% of bond principal or interest is secured by property used in a private business use (or the income therefrom). When state or local governments issue bonds on behalf of Sec. 501(c)(3) organizations, allowable private business use falls to 5% of net proceeds and may be further reduced by financed bond issuance costs.

"Private business use" generally means direct or indirect business use of bond proceeds--other than as a member of the general public--by a nongovernmental or non-Sec. 501(c)(3) entity. Use of bond-financed facilities is deemed to be a use of bond proceeds.

Private business use of bond-financed facilities may result from a lease, management contract, incentive payment contract, transfer of ownership or certain output agreements with private parties. In addition, private business use may arise when facilities are used to carry on research for private parties (as might be the case with a university). (See the Conference Report to the Tax Reform Act of 1986 (TRA) at 688-689.)

In Rev. Procs. 82-14 (dealing with management contracts generally) and 82-15 (dealing with hospital-related management contracts), the IRS had issued advance ruling criteria for private business use arising from such arrangements. TRA Section 1301(e) directed the Treasury to issue liberalized guidance providing that private business use would not arise from a management contract with private parties when (1) the term of the contract was five years or less; (2) the exempt owner could cancel the contract after three years; (3) the manager was not compensated based on net profits from the facility; and (4) at least 50% of the manager's annual compensation was a fixed fee.

Rev. Proc. 93-19 supersedes both Rev. Procs. 82-14 and 82-15. While generally tracking the requirements of TRA Section 1301(e), Rev. Proc. 93-19 elaborates significantly on the basic criteria, and adds "reasonable compensation" and related-party rules. In addition, Rev. Proc. 93-19 is intended to cover all organizations, including hospitals, in one document.

In addition to prohibiting manager compensation based on net profits, Rev. Proc. 93-19 also requires that any compensation must be reasonable. Compensation will not violate the net income prohibition, however, if it is based on gross revenues less a bad debt or contractual allowance, or if it is based on a per capita fee or per-unit fee. (An example of a per-unit fee is a physician's charge for a specific medical procedure such as a chest X-ray.)

A five-year contract term (including renewal options), is permitted if the manager's compensation is based at least 50% on a fixed fee or wholly based on a combination of fixed fees and per capita fees. (Fixed fees may be adjusted by a specified, objective, external standard like the Consumer Price Index.) The five-year term is reduced to three years for per-unit arrangements, and to two years for arrangements based on a percentage of revenues or expenses. in the case of five-year contracts, the owner must be able to cancel the contract without penalty after three years.

The "related-party" rule is intended to prevent the service provider from exercising undue influence over the facility's owner in its decision to extend or cancel a contract. Generally, neither the owner nor the service provider may have more than 20% control of the other organization.
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Author:Dillon, Randy
Publication:The Tax Adviser
Date:Jun 1, 1993
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