IRS EXPLAINS HOW FACILITY MANAGEMENT CONTRACTS SHOULD BE STRUCTURED.

Rev. Proc. 93-19

SECTION 1. PURPOSE

This revenue procedure sets forth conditions under which the provision by a nongovernmental person of management or other services involving facilities financed with proceeds of an issue of State or local bonds will not cause the proceeds to be treated as used in a private business use under section 141(b) of the Internal Revenue Code of 1986 (the "Code").

SEC. 2. BACKGROUND

01. PRIVATE BUSINESS USE. Under section 103(a) of the Code, gross income does not include interest on any State or local bond. Under section 103(b)(1), however, section 103(a) does not apply to a private activity bond, unless it is a qualified bond under section 141(e). Section 141(a)(1) of the Code defines "private activity bond" as any bond issued as part of an issue that meets both the private business use and the private security or payment tests. Under section 141(b)(1), an issue generally meets the private business use test if more than 10 percent of the proceeds of the issue are to be used for any private business use. Under section 141(b)(6)(A), private business use means direct or indirect use in a trade or business carried on by any person other than a governmental unit. Use as a member of the general public is disregarded. Other provisions of sections 141 through 150 also involve the application of the private business use test of section 141(b)(1).

Corresponding provisions of the Internal Revenue Code of 1954 (the "1954 Code") set forth the requirements for the exclusion from gross income of the interest on State or local bonds. For purposes of this revenue procedure, any reference to a Code provision includes a reference to the corresponding provision, if any, under the 1954 Code.

Section 1.103-7(b)(3) of the Income Tax Regulations indicates that private business use can arise by ownership, lease, or other arrangements. This principle was confirmed by the Conference Report for the Tax Reform Act of 1986, which provides as follows:

The conference agreement generally retains the present-law rules under which use by persons other than governmental units is determined for purposes of the trade or business use test. Thus, as under present law, the use of bond-financed property is treated as a use of bond proceeds. As under present law, a person may be a user of bond proceeds and bond-financed property as a result of (1) ownership or (2) actual or beneficial use of property pursuant to a lease, a management or incentive payment contract, or (3) any other arrangement such as a take-or-pay or other output-type contract.

2 H.R. Conf. Rep. No. 841, 99th Cong. 2d Sess. II-687 to -688, 1986-3 (Vol. 4) C.B. 687-88 (footnote omitted).

A management or other service contract that gives a nongovernmental service provider a proprietary interest in the operation of a facility is not the only situation in which a contract may result in private business use of the facility.

02. EXISTING ADVANCE RULING GUIDELINES AND THE DIRECTIVE IN THE TAX REFORM ACT OF 1986. Rev. Proc. 82-14, 1982-1 C.B. 459, contains advance ruling guidelines for determining whether provision of management services under a management contract is considered a trade or business use by a nongovernmental person for purposes of former section 103(b). Rev. Proc. 82-15, 1982-1 C.B. 461, contains additional guidelines for certain service contracts. In section 1301(e) of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. 572, Congress directed the Secretary of the Treasury or his delegate to liberalize these guidelines to provide as follows:

* * * that use pursuant to a management contract generally shall not be treated as trade or business use as long as --

(1) the term of the contract (including renewal options) does not exceed 5 years,

(2) the exempt owner has the option to cancel the contract at the end of any 3-year period,

(3) the manager under the contract is not compensated (in whole or in part) on the basis of a share of net profits, and

(4) at least 50 percent of the annual compensation of the manager under such contract is based on a periodic fixed fee.

SEC. 3. DEFINITIONS

01. ADJUSTED GROSS REVENUES means gross revenues of all or a portion of a facility, less allowances for bad debts and contractual and similar allowances.

02. CAPITATION FEE means a fixed periodic amount for each person for whom the service provider assumes the responsibility to provide all needed services for a specified period so long as the quantity and type of services actually provided to covered persons varies substantially. For example, a capitation fee includes a fixed dollar amount payable per month to a medical service provider for each member of a health maintenance organization plan for whom the provider agrees to provide all needed medical services for a specified period.

03. PERIODIC FIXED FEE means a stated dollar amount for services rendered for a specified period of time. For example, a stated dollar amount per month is a periodic fixed fee. The stated dollar amount may automatically increase according to a specified, objective, external standard that is not linked to the output or efficiency of a facility. For example, the Consumer Price Index and similar external indices that track increases in prices in an area or increases in revenues or costs in an industry are objective external standards. Capitation fees and per-unit fees are not periodic fixed fees.

04. PER-UNIT FEE means a fee based on a unit of service provided. For example, a stated dollar amount for each specified medical procedure performed, car parked, or passenger mile is a per- unit fee.

05. QUALIFIED USER means a State or political subdivision of a State. The term also includes a 501(c)(3) organization if the facilities are not used in the organization's unrelated trades or businesses under section 513(a).

06. RENEWAL OPTION means a provision under which a party to a contract has a legally enforceable right to renew the contract.

07. SERVICE CONTRACT means a contract 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 an entire hospital, management services for a specific department of a hospital, janitorial services at a hospital, or physician services to patients of a hospital.

08. SERVICE PROVIDER means any person other than a qualified user that provides services under a service contract to or for the benefit of a qualified user.

SEC. 4. SCOPE

This revenue procedure applies when, under a service contract, a service provider provides management or other services involving facilities financed with proceeds of an issue of State or local bonds subject to section 103 of the Code.

SEC. 5. OPERATING GUIDELINES FOR MANAGEMENT CONTRACTS AND OTHER SERVICE CONTRACTS

01. IN GENERAL. If the requirements of this section are satisfied, the provision of the services under a service or management contract does not cause the facilities to be treated as used in a private business use under section 141(b) of the Code. In the case of an incidental use (as defined in paragraph (b)(2) of Notice 87-69, 1987-2 C.B. 378) of a facility, the provisions of Notice 87-69 may be applied as an alternative to these operating guidelines.

02. COMPENSATION ARRANGEMENTS. The compensation arrangement under the service contract must satisfy both sections 5.02(1) and 5.02(2).

(1) IN GENERAL -- REASONABLE COMPENSATION NOT BASED ON NET PROFITS. The contract must provide for reasonable compensation for services rendered. The contract must not provide for any compensation for services based, in whole or in part, on a share of net profits from the operation of the facility. Compensation based on a capitation fee or a per-unit fee is generally not considered to be based on a share of net profits. 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 based on a share of net profits. Reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated parties is not by itself treated as compensation.

(2) PERMITTED COMPENSATION ARRANGEMENTS. The compensation arrangement under the service contract must satisfy any one of section 5.02(2)(a), (b), (c), or (d).

(a) 50 PERCENT PERIODIC FIXED FEE ARRANGEMENTS. At least 50 percent of the compensation for services for each annual period during the term of the service contract is based on a periodic fixed fee.

(b) CAPITATION FEE ARRANGEMENTS. All of the compensation for services is based on a capitation fee or a combination of a capitation fee and a periodic fixed fee.

(c) PER-UNIT FEE ARRANGEMENTS IN CERTAIN 3-YEAR CONTRACTS. All of the compensation for services is based on a per-unit fee or a combination of a per-unit fee and a periodic fixed fee. The contract has a term, including renewal options, that is not longer than 3 years. The contract must be cancellable by the qualified user on reasonable notice, without penalty or cause, at the end of the second year of the contract term. The amount of the per-unit fee must be specified in the service contract or otherwise specifically limited by the qualified user or an independent third party, such as the administrator of the Medicare program.

(d) PERCENTAGE OF REVENUE OR EXPENSE FEE ARRANGEMENTS IN CERTAIN 2-YEAR CONTRACTS. All 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 expenses of a facility. The service contract must have a term, including renewal options, that is not longer than 2 years. The contract must be cancellable by the qualified user on reasonable notice, without penalty or cause, at the end of the first year of the contract term. This section 5.02(2)(d) applies only to (i) service contracts under which the service provider primarily provides services to third parties (e.g., radiology services), or (ii) service contracts involving a facility during an initial start-up period for which there have been insufficient operations to establish a reasonable estimate of the amount of the annual gross revenues and expenses (e.g., a service contract for general management services for the first year of operations).

03. CONTRACT TERM. The term of the service contract must not exceed five years, including all renewal options, or the shorter period, if applicable, provided in sections 5.02(2)(c) and (d) for certain compensation arrangements.

04. CANCELLATION WITHOUT PENALTY OR CAUSE. The service contract must be cancellable by the qualified user upon reasonable notice at the end of the third year of the contract term, without penalty or cause, or at the earlier time provided in sections 5.02(2)(c) and (d) for certain compensation arrangements. Contract termination penalties include: a limitation on the qualified user's right to compete with the service provider; a requirement that the qualified user purchase equipment, goods, or services from the service provider; and a requirement that the qualified user pay liquidated damages for cancellation of the service contract. In contrast, a requirement effective on cancellation that the qualified user reimburse the service provider for ordinary and necessary expenses or a restriction on the qualified user against hiring key personnel of the service provider is generally not a contract termination penalty.

05. NO RELATED PARTIES OR COMMON CONTROL. In general, the service provider must not have any role or relationship with the qualified user that, in effect, substantially limits the qualified user's ability to exercise its rights, including cancellation rights, under the service contract. Not more than 20 percent of the voting power of the governing body of the qualified user in the aggregate may be vested in the service provider and its directors, officers, shareholders, and employees. Not more than 20 percent of the voting power of the governing body of the service provider in the aggregate may be vested in the qualified user and its directors, officers, shareholders, and employees. Furthermore, the overlapping board members must not include the chief executive officers of the service provider and the qualified user, or their respective governing bodies. The qualified user and the service provider under the service contract must not be members of the same controlled group, as defined in section 1.150-1(f) of the regulations, or related persons, as defined in section 144(a)(3) of the Code.

SEC. 6. EFFECT ON OTHER DOCUMENTS

Rev. Proc. 82-14, 1982-1 C.B. 459, and Rev. Proc. 82-15, 1982-1 C.B. 461, are made obsolete.

SEC. 7. EFFECTIVE DATE

This revenue procedure is effective for any service contract entered into, materially modified, or extended (other than pursuant to a renewal option) after March 15, 1993. In addition, an issuer may apply this revenue procedure to any earlier service contract involving facilities financed with proceeds of an issue to which section 1301(e) of the Tax Reform Act of 1986 applies.

SEC. 8. DRAFTING INFORMATION

The principal author of this revenue procedure is David White of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue procedure contact David White at (202) 622-3980 (not a toll-free call).