The IRS recently updated its guidance for not-for-profit organizations benefiting from tax-exempt bonds. IRS Notice 2014-67 loosens up requirements related to private business use of 501(c)(3) bond financed facilities. The changes are somewhat directed to address healthcare Accountable Care Organizations (ACOs) participating in the Medicare Shared Savings Program. However the expanded safe harbor has broader applicability within the not-for-profit sector.
Certain Not-for-profit organizations are eligible to use 501(c)(3) bonds to help finance capital improvement projects. Many hospitals, educational institutions and other not-for-profit organizations take advantage of such bonds because of the lower interest costs associated with this type of borrowing.
The tax law places limits on the use of the bond-financed facilities, which is where the bond financing can get complicated. So-called “private-use”, which includes conduct of an unrelated trade or business in the space by the not-for-profit or use of the space by an organization other than a governmental organization or a not-for-profit is limited. Specifically, private use is generally limited to 5% of the net proceeds of the bond issue. (Exceeding the 5% private use threshold may cause the bonds to be disqualified and the interest to be taxable to the bond holder).
Expanded Safe Harbor for Management Contracts
Use of bond-financed space by a private party under a management contract may constitute private use. For example, a management contract between a 501(c)(3) university and a private food services vendor under which the food services company operates a university dining hall may constitute private use. Specifically, private business use results if the management contract provides for the compensation under the management contract (to the food services vendor, for example) to be based “in whole or in part” on the net profits from the operation of the facility.
Other types of compensation arrangements do not ordinarily trigger private business use. Compensation under a management contract can generally be based on:
- percentage of gross revenues or adjusted gross revenues of a facility;
- percentage of expenses of a facility (but not both expenses and revenues);
- capitation fees; or
- per-unit fees.
Productivity or Incentive Pay Contracts- Under the new guidance, the IRS will not consider productivity or incentive pay in a management contract to be based on the building’s profits (i.e., private business use), if:
- the productivity award is based on the quality of services provided under the management contract, rather than increases in revenues or decreases in expenses of the facility, and
- the amount of the productivity award 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.
Five-Year Management Contracts- Under the new guidance, contracts that including their renewal options do not exceed five years are eligible for a private business use safe harbor. Compensation in management contracts must be based on a stated amount, but again, the stated amount can take many forms including a periodic fixed fee, capitation fee, per-unit fee, or combination of these. Compensation for services may also include a percentage of gross revenues, adjusted gross revenues, or expenses of the facility (but not both revenues and expenses)
The IRS also eliminated the requirement that the issuer or borrower have a penalty-free early termination right within the management contract.
The above changes apply to management contracts entered into, materially modified, or extended (other than pursuant to a renewal option) on or after January 22, 2015. Not-for-profit organizations have the option to apply the changes retrospectively as well. For more information about how these changes could affect your not-for-profit organization, please contact us here.
Craig Klein is a Managing Director in the Tax Group at CBIZ Tofias. Craig can be reached at firstname.lastname@example.org or 617.761.0509.