Magazine article The CPA Journal

Management Service Agreements Involving Bond-Financed Space

Magazine article The CPA Journal

Management Service Agreements Involving Bond-Financed Space

Article excerpt

Earlier this year, the IRS issued two documents that will be of interest to hospitals with outstanding tax-exempt bonds. They provide additional guidance and flexibility in the permissible terms of certain management service agreements entered into with for-profit entities that involve bond-financed facilities.

Private Left Ruling 200123057

Released on June 8, 2001, Private Letter Ruling (PLR) 200123057 will be of interest to exempt hospitals with outstanding bond issues participating in joint ventures with their medical staff or other for-profit entities that provide management services to the hospital. In essence, the ruling reiterated that the safe harbor requirements for management agreements set forth in Revenue Procedure 97-13, 1997-1 C.B. 632, are just that; deviations from the safe harbors can occur without jeopardizing the bonds' interest exemption.

In PIR 200123057, a hospital used the proceeds of an exempt bond issue to finance its hospital facility and medical clinics. The hospital corporation was also the sole corporate member of a nonprofit, but taxable, subsidiary that employed physicians. The subsidiary entered into a professional services agreement with the hospital to provide professional services to the hospital and its clinics. The hospital appointed a majority of the subsidiary's directors; moreover, the hospital's CEO served on the subsidiary's board.

Revenue Procedure 97-13 defines certain characteristics of management service agreements that do not create a "private business use" if a non-exempt entity provides management services to an exempt entity involving bond-financed property. Under applicable IRS requirements, too much private business use of facilities financed with exempt bonds will destroy the exemption, making interest on the bonds taxable and potentially causing a default on the bonds and acceleration of their principal. Key principles of Revenue Procedure 97-13 include requirements governing the contract term and compensation methodologies that service agreements should incorporate.

Another key provision of Revenue Procedure 97-13, and the one at issue in PLR 200123057, is found in section 5.04(1); it addresses the required governance relationship between the exempt entity (qualified user) and the management entity (service provider). As a general rule, the service provider "must not have any role or relationship with the qualified user that ... substantially limits the qualified user's ability to exercise its rights ... under the contract." The logic is that if the service provider has control over the qualified user, the service agreement could be used primarily to benefit the service provider rather than the exempt facility. Revenue Procedure 97-13 provides various governance safe harbors that, if met, will satisfy this lack-of-control test. These include a requirement that not more that 20% of the board members of the exempt institution are board members, officers, shareholders, or employees of the service provider; that the CEOs of both the hospital and service provider not sit on each other's boards; and that the parties not be "related parties" within the meaning of various Treasury Regulations that define certain control relationships.

As applied to hospital-physician joint ventures that provide management services to hospitals with outstanding bond issues, these requirements often disqualify the hospital CEO from the board of the joint venture, an outcome that both limits board overlap and minimizes hospital control over the venture. …

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