(Jake Smith also co-authored this post.)
Moby Dick is not a book about the whaling industry, The Godfather is not a movie about cannoli, and IRS Notice 2014-67 is not just about accountable care organizations (ACOs). You’re going to be inundated with coverage about this new Notice, and it’s all going to focus first on the new safe harbor from private business use of bond-financed facilities that the Notice provides for certain ACOs.
But like a kid eating a cinnamon roll, if you stop there, you’re going to miss the best part.
Notice 2014-67 also amplifies IRS Revenue Procedure 97-13 to provide a generous, new safe harbor from private business use for management contracts, and it’s available immediately for any governmental use or qualified 501(c)(3) bond issue, regardless of whether the bond issue has anything to do with ACOs (or whether anyone using the bond-financed facilities even knows or cares what an ACO is).
Notice 2014-67 creates a new 5-year safe harbor with no “termination right” requirement
The new safe harbor allows a management contract that covers bond-financed facilities to have a 5-year term, with no more fussing over termination rights, if the compensation under the agreement is based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee, a percentage of either (but not both) gross revenues or expenses, or any combination of these types of compensation. That covers almost all of the different types of compensation that were allowed by the existing Rev. Proc. 97-13 safe harbors.
One very nice feature of the new safe harbor from private business use is that it does not require the issuer or conduit borrower to have an early termination right that can be exercised without cause or penalty. Each of the other Rev. Proc. 97-13 safe harbors from private business use that apply to a management contract that has a stated term that does not exceed five years requires the issuer or conduit borrower to have the right to terminate the contract, without cause or penalty, prior to the expiration of contract’s stated term. Rev. Proc. 97-13 treats as a penalty the accelerated repayment of an embedded loan that arises if the issuer or conduit borrower exercises its early termination right before the embedded loan is fully amortized.
An embedded loan in a management contract often takes the form of a capital investment made in the bond-financed facilities by the manager, the cost of which is amortized over a stated recovery period. These embedded loan arrangements are fairly common, and their accelerated repayment upon early termination of a management contract can wreak havoc in trying to fit the contract within a Rev. Proc. 97-13 safe harbor from private business use, as those safe harbors existed before Notice 2014-67. The new 5-year safe harbor does not require the existence of an early termination right, so, with one exception, it avoids the complications created by the accelerated repayment of embedded loans.
It can be very difficult in life to avoid completely something that is unpleasant. So it is with the adverse effect an embedded loan can have on compliance with certain Rev. Proc. 97-13 safe harbors from private business use, even with our new 5-year safe harbor. The penalty treatment under Rev. Proc. 97-13 that results from the accelerated repayment of an embedded loan upon the early termination of a management contract can be a concern under the new safe harbor where the embedded loan amortizes over a period longer than five years.
Here’s an illustration. Assume a 501(c)(3) hospital enters into a food service management contract with a for-profit entity. The contract has a 5-year term with five consecutive one-year evergreen renewals. The compensation under the contract consists of a per-unit fee (a charge per every meal served) and incentive compensation based on the satisfaction of certain qualitative criteria (more on Notice 2014-67’s treatment of incentive compensation below). Further assume that the contract provides that the for-profit entity will make $2,000,000 of improvements to the hospital’s food service operations, and the cost of these improvements will amortize over a 10-year period on a straight-line basis. If the contract is terminated prior to the end of this amortization period, the 501(c)(3) hospital must immediately pay back the unamortized balance of the embedded loan. In this example, the acceleration of the embedded loan upon the early termination of the contract would be treated as a penalty under Rev. Proc. 97-13 that would result in the contract having a term beyond the 5-year term permitted by the new safe harbor. It’s questionable, of course, whether the accelerated payment of the embedded loan is truly a penalty. The IRS has solicited comments on Notice 2014-67; this could be an item on which to comment.
Notice 2014-67 provides that incentive compensation for achieving qualitative standards won’t cause a contract to fall outside the new safe harbor from private business use
Notice 2014-67 also amplifies Rev. Proc. 97-13 to state that a productivity reward for services will not cause compensation under a management contract to be based on a share of the net profits of the bond-financed facility (and thus give rise to private business use) if (1) the productivity award is based on the quality of the services provided (for example, the achievement of Medicare Shared Savings Program quality performance) rather than increases in revenue or decreases in expenses, and (2) the amount of the reward 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. Importantly, the Notice also says that this type of productivity reward will be treated as a type of compensation that is eligible for the new five-year safe harbor.
This amplification of Rev. Proc. 97-13 ratifies the result in PLR 200926005 and brings the facts of that private letter ruling, which involve a very common arrangement in physician contracts, within the 97-13 safe harbors. In PLR 200926005, the IRS held under a facts and circumstances analysis that a management contract with a physician group did not cause private business use of a bond-financed hospital where the compensation under the contract consisted of direct billing of patients by the physician group (which is a per-unit fee under 97-13) and incentive compensation based on the achievement of certain qualitative criteria. The incentive compensation was not based on quantitative measures, such as the attainment of revenue thresholds or cost reduction targets. This contract did not satisfy any private business use safe harbor set forth in Rev. Proc. 97-13 as it existed at the time. The amplification of Rev. Proc. 97-13 by Notice 2014-67 is a welcome change because it provides issuers and conduit borrowers with similar contracts the certainty of a Rev. Proc. 97-13 safe harbor.
It’s unfortunate that Notice 2014-67 does not expand Rev. Proc. 97-13 to include within the safe harbors incentive compensation measured by achieving cost reduction targets. These types of arrangements are also becoming an increasingly common form of incentive compensation. The IRS held under a facts and circumstances analysis in PLR 201338026 that this type of incentive compensation did not result in private business use of a tax-exempt bond-financed facility. Although this PLR is helpful, expansion of the safe harbors to include the result of this PLR would be preferable because it would provide much greater certainty over the facts and circumstances analysis and would also provide guidance that can actually be relied on (as opposed to a private letter ruling). This type of incentive compensation can fit within the Rev. Proc. 97-13 safe harbors applicable to contracts with at least 50% of annual compensation in the form of a periodic fixed fee. These safe harbors do not, however, have the same flexibility of financial arrangements as the new safe harbor added by Notice 2014-67, and hospitals often don’t want to commit to paying at least 50% of the annual compensation to service providers as a periodic fixed fee. This could also be an item on which to comment.
We’re going to be posting much more about Notice 2014-67 in the future, including a look at the ACO parts of the Notice. But in the meantime, the new safe harbor from private business use and the new guidance about adding qualitative productivity rewards are great news, because they’re broadly applicable and immediately available.