Few prospects are more terrifying than either an audit by the Internal Revenue Service or anything involving prison.  Put the two together, and you not only have a nightmare worthy of Stephen King, you begin to appreciate how some issuers of tax-exempt bonds have been feeling recently. As reported in the press ($), several issuers have been forced to settle with the IRS and redeem bonds because  those issuers have violated the tax-exempt bond requirements for their bond-financed  prison facilities. The problems discovered by the IRS or by the issuers themselves have involved excess private business use and excess private payments, which would cause the bonds to become taxable private activity bonds.

Private business use in these cases has resulted from one or both of two sources – a non-qualifying management contract or a contract with the federal government to house federal prisoners.  Some of the prisons were managed by private companies under management contracts that did not satisfy Rev. Proc. 97-13 or did not otherwise avoid private business use by the manager.  Of course, we can now also rely on IRS Notice 2014-67, previously reported on this blog, for more lenient management contract standards.  Unfortunately, but as generally dictated by the regulations, even under the new Notice a manager’s compensation cannot be based to any extent on a share of net profits of the facility.  This prohibition, which strikes so many issuers as counterintuitive, defeats issuers’ common purpose of incentivizing the manager by allowing the manager to share in the upside and downside of the facility’s financial results.

A bad prison management contract will not by itself cause the bonds that financed the prison to become taxable private activity bonds because a prison that houses only the issuer’s prisoners generally will not be producing any private payments.  However, private payments will arise if the prison with the bad management contract houses other prisoners (such as those of a neighboring jurisdiction) for a fee.  While the portion of operating and maintenance expenses allocable to the prisoners for which the issuer receives fees can be used to offset the fees, if the fees provide any contribution toward overhead or financing cost, then the issuer will realize net private payments that count against the private payment limit.

This brings us to the second common source of private business use in the case of prison financings – contracts with the federal government to house federal prisoners. To the surprise of many issuers, the federal government is treated as a private person under the provisions of the tax law applicable to tax-exempt bonds.  Thus, if the contract with the federal government does not satisfy an exception from private business use, the right of the federal government to house prisoners in the financed prison will result in private business use.  Moreover, private business use occurs regardless of whether the federal government actually exercises its right to house its prisoners in the prison – the mere contractual right of the federal government to house its prisoners in the issuer’s prison generally creates private business use.

One of the exceptions from private business use, which is contained in the regulations (as opposed to Rev. Proc. 97-13), seems to be targeted at prisons. This exception requires (1) that the contract have a term (including legally enforceable rights to require the renewal of the contract) not longer than 100 days, (2) that the contract would be treated as public use if the facility were available to the public (this requirement seems to be aimed at a small group of facility types, and particularly prisons), (3) that the property was not financed for a principal purpose of providing the facility for use by the federal government, and (4) that the contract does not result in tax ownership of the prison by the federal government.

The two key requirements of this exception – and those that might present a challenge to satisfy – are the 100-day limit and the no principal purpose requirement.  A helpful example in the regulations applying this exception to a prison financing clarifies that these two requirements are not violated merely because the governmental entity that owns the prison reasonably expects the contract to renew indefinitely (because neither party to the contract is expected to terminate the contract rather than let it renew automatically) and it is reasonably expected that during the term of the bonds more than 10 percent of the prisoners at the prison will be federal prisoners.  If the exception is satisfied, the federal government will not be a private business user of the prison.  In that case, fees paid by the federal government will be private payments only if the prison is subject to some other form of private business use, such as that resulting from a bad management contract.

If an issuer finds itself in the position of having entered into either or both a private business use management contract and/or federal prisoner contract, and if both the private business use and private payments exceed the applicable limit, generally 10% in this case, a remedial action under the regulations, such as redeeming the “nonqualified bonds,” if taken early enough can solve the problem.   If the remedial actions are not available because, for example, too much time has passed since the tax violation occurred, a closing agreement under the IRS’s Voluntary Closing Agreement Program (VCAP) would likely be advisable.  While a closing agreement would probably require the issuer to make some payment to the IRS, the policy of the IRS is to require a lower payment — potentially significantly lower — under VCAP than if the violation is discovered upon an audit of the bonds.

In summary, a management contract for any prison generating substantial revenues – whether from the federal government or from another state or local government – must be structured to avoid private business use.  Further, all prisoner contracts with the federal government must be reviewed for private business use because those contracts will also produce revenues, thus potentially causing the bonds to exceed both the private business use and private payment limits. Otherwise, issuers may end up sympathizing with Andy Dufresne’s escape from prison in The Shawshank Redemption before their problems are over.