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IRS offers safe harbor in physician employment contracts.

State and local governments issue certain bonds, known as "qualified private activity bonds," to encourage the financing of certain projects, such as hospital facilities, that further important government purposes. The interest on qualified private activity bonds is tax-exempt as long as the bonds are used exclusively for exempt purposes. Because of their appeal to investors and the lost revenue due to their status, tax-exempt bonds are highly scrutinized by the IRS. Currently, the IRS is investigating situations involving the use of tax-exempt bonds to finance health care facilities in order to determine whether the exempt organization participant furthers private interests impermissibly.

Under section 141(b)(1) of the Internal Revenue Code (IRC), no more than 10 percent of tax-exempt bond proceeds (5 percent for tax-exempt entities) may be applied to any "private business use," which is defined to mean use (directly or indirectly) in a trade or business carried on by any private party. Service contracts may give rise to private business use because of the flow of monies between the service provider and the facility financed by tax-exempt bonds. Violation of the private business use test of the IRC will result in the loss of the bonds' tax-exempt status and taxation of the interest paid on the bonds.

Rev. Proc. 93-19, which became effective March 15, 1993, requires hospitals and other health care organizations to review and amend as necessary their service contracts to ensure continued exemption of the interest on tax-exempt bonds. This revenue procedure -- an official statement affecting the rights and duties of taxpayers under the IRC -- created four "safe harbors" for service contracts between tax-exempt organizations and nonexempt private parties. These "safe harbor" provisions have been interpreted to apply to service contracts between tax-exempt hospitals and hospital-based physicians.

Hospital Service Contracts Affected

Rev. Proc. 93-19 applies to management and other service contracts entered into by "qualified users," which includes state and local government entities as well as tax-exempt entities with bond-financed facilities. Contracts that are subject to the prohibitions of Rev. Proc. 93-19 include certain employment agreements between physicians and qualified users. At issue is whether such contracts involve a private business use that may cause the interest on any bonds to become taxable.

Pursuant to the provisions of Rev. Proc. 93-19, a "service contract" is defined as one "between a qualified user and a service provider under which the service provider provides services involving all, a portion, or any function of a facility. For example, a service contract includes a contract for the provision of management services for . . . a specific [hospitall department, [or] janitorial services at a hospital."

Management and service contracts entered into, materially modified, or extended (other than pursuant to a renewal option) after March 15, 1993, are subject to the provisions of Rev. Proc. 93-19. In addition, a bond issuer may apply the provisions of the revenue procedure to any earlier service contract involving facilities financed with proceeds of tax-exempt bonds.

Rev. Proc. 93-19 establishes a two-prong test to determine whether a management or service contract gives rise to "private business use." Specifically, in order to avoid an adverse determination, the compensation arrangement in a service or management contract must:

* Provide for reasonable compensation

for services rendered.

Compensation must

not be based upon a share of

the net profits from the operation

of the facility.

* Fall into one of four specifically

designated "safe harbor"

provisions of the

revenue procedure. The four

safe harbor provisions focus

upon the term of the contract

and the method by

which the service

is compensated.

Reasonable Compensation

To constitute reasonable compensation under Rev. Proc 93-19, a contract for services must not provide for compensation based, in whole or in part, on a share of the net profits from the operation of the facility. Compensation based on a percentage of gross revenues (or adjusted gross revenues) of a facility or a percentage of expenses from a facility (but not both) is generally not considered to be a share of the net profits. Compensation does not include reimbursement to the service provider for actual and direct expenses incurred by the service provider for goods or services obtained from unrelated third parties.

Compensation Safe Harbor Provisions

In addition to constituting reasonable compensation, under Rev. Proc 93-19 a compensation arrangement with a service provider also must satisfy the requirements of one of four safe harbor provisions. In general, the safe harbor provisions attempt to control the amount of compensation that a facility pays to a service provider. The four compensation arrangements are:

* 50 Percent Periodic Fixed Fee Arrangement:

Under this compensation arrangement, at least 50 percent

of the compensation for services for each annual

period during the term of the contract must be based on

a periodic fixed fee. In addition, the term for this fee

arrangement must be no longer than five years, including

all renewal periods, and it must be cancelable by

the facility without penalty or cause at the end of the

third year. A periodic fixed fee is a stated dollar

amount for service rendered for a specified period. For

example, the payment of a set dollar amount per week

as compensation for management fees in an agreement

constitutes a periodic fixed fee payment.

* Capitation Fee Arrangement: Under this payment

plan, all of the compensation to a service provider is

based on a capitation arrangement or on a combination

of capitation and fixed fee. A capitation fee means a

fixed periodic amount for each person for whom the service

provider assumes the responsibility to provide all

needed care for a specified period, as long as the quantity

and type of services actually provided to covered persons

varies substantially. In addition, the term for this

fee arrangement must be no longer than five years,

including all renewal periods, and it must be cancelable

by the facility without penalty or cause at the end of the

third year. Generally, service contracts with physicians

or physician groups lend themselves to capitation. Food

and custodial service agreements usually are not structured

as capitation fee payment arrangements.

* Per-Unit Fee Arrangements in Certain Three-Year

Contracts: This arrangement compensates the

service provider on a per-unit basis or a combination of

a per-unit fee and a periodic fixed fee. A per-unit fee is

based on a unit of service provided. The term for this

fee arrangement must be no longer than three years,

including all renewal periods, and it must be cancelable

by the facility without penalty or cause at the end of

the second year. The amount of the per-unit fee must

be specified in the contract or limited by the facility or

an independent third party.

* Percentage of Revenue or Expense Fee

Arrangements in Certain Two-Year Contracts:

Under this compensation arrangement, all of the compensation

for services is based on a percentage of fees

charged. During the start-up period, however, compensation

may be based on a percentage of either gross

revenues, adjusted gross revenues, or the expenses of a

facility. In addition, the term for this fee arrangement

must be no longer than two years, including all renewal

periods, and it must be cancelable by the facility without

penalty or cause at the end of the first year. This

arrangement applies to service contracts under which

the provider serves third parties or to those that

involve a facility during an initial start-up period for

which operations have been insufficient to establish a

reasonable estimate of the annual gross revenues and

expenses. Included in this classification, according to

the IRS, are contractual arrangements where the service

provider begins to provide services for the facility

for the first time.

The service provider also must not have other relationships with the qualified user (e.g., the hospital) that limit the qualified user's ability to exercise its rights under the contract. In this regard, Rev. Proc. 93-19 provides that not more than 20 percent of the voting power of the qualified user's governing body may be vested in the service provider and its officers, directors, shareholders, or employees. Similarly, the revenue procedure prohibits the service provider from having more than 20 percent of the voting power of its governing board vested in the qualified user. Moreover, overlapping board members may not include the chief executive officers of the service provider or the qualified user or members of their respective governing bodies. Finally, the qualified user and the service provider must not be members of the same "controlled group" as defined in section 144(a)(3) of the Internal Revenue Code -- the 50 percent threshold test.

Consequently, Rev. Proc. 93-19 is concerned primarily with whether the qualified user pays a service provider reasonable compensation for services and whether the compensation arrangement between the parties conforms to one of the safe harbor provision compensation arrangements. In addition, Rev. Proc. 93-19 takes steps to ensure that the qualified user is not under any compulsion to enter into the service contract with the service provider by prohibiting relationships between the two parties that would encourage such abuse.

Implications for Hospitals

Qualified users, such as hospitals, may discover that the provisions of Rev. Proc. 93-19 apply to activities that are intended to enhance health care delivery. Integrated delivery systems, for example, raise special concerns for tax-exempt bond holders. When a hospital acquires a physician practice in order to integrate health care delivery, tax-exempt financing is an option. If the integrated system then contracts with a physician group to provide services, the provisions of Rev. Proc. 93-19 would require that those physicians constitute no more than 20 percent of the integrated system's governing board. The recently issued Friendly Hills and Facey Medical Center determination rulings created a safe harbor consistent with the 20 percent limitation.

Additionally, hospitals that enter into employment contracts with physicians will need to ensure that their agreements comply with Rev. Proc. 93-19. For example, a contract that compensates a physician on the basis of a percentage of revenue must be limited to a two-year term, and existing contracts that contain automatic renewal provisions may violate the five-year contract term limitation.

Cafeteria and janitorial service contracts present difficult planning issues for hospitals under Rev. Proc. 93-19. Such contracts typically compensate the service provider for management or other services on a periodic basis for a fixed fee amount and also compensate the service provider for the services of employees who perform under the contract. Typically, the portion of these contracts dedicated to employee salaries tends to constitute more than 50 percent of the overall compensation under the contract, thus falling outside of the safe harbor protection of Rev. Proc. 93-19. The IRS has indicated that the salary component of these types of contracts constitutes compensation to the service provider, although an argument exists that such salary amounts constitute reimbursement to the service provider for direct costs that it incurs. One way to remedy this issue may be for the hospital to pay the service provider for its management fees and directly employ individuals to provide the service. Alternatively, the service provider may calculate its management fee so as to encompass employee compensation. The latter solution places the risk for overstaffing on the service provider.

Hospitals and other health care entities that have financed facilities and services with tax-exempt bonds should review their contracts with service providers to determine whether they fall within the safe harbors allowed in Rev. Proc. 93-19. Failure to adhere to those provisions will not automatically violate the "private business use" test and give rise to a tax on bond proceeds, because the facts and circumstances of each case must be examined, but carefull planning may avert problems down the road.

Cynthia F. Reaves is an attorney in the Washington, D.C., offices of Epstein Becker & Green.
COPYRIGHT 1994 American College of Physician Executives
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Article Details
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Author:Reaves, Cynthia F.
Publication:Physician Executive
Date:Mar 1, 1994
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