The IRS has over the past three years issued significant guidance on the safe harbors from private business use for management contracts, and we’ve been dutifully reporting on this guidance (here, here, here, and here). This guidance has generally been well received, but some issues remain. In addition to questions raised by Bob Eidnier in his post a few weeks ago (link above), the recent spate of IRS guidance raises a concern that is the subject of this post. By correlating the permitted length of management contracts with the economic lives of the managed property, some management contracts that are materially modified after August 18, 2017 might not fit within the New Safe Harbors (defined below) even if the term of the modified contract is unchanged from the prior iteration!! (Tax lawyers use exclamation points to try and keep people awake).
Management contracts qualify for the safe harbors to avoid private business use established under Revenue Procedure 97-13 (the “Old Safe Harbors”) based primarily on the term of the contract and the compensation provided for under the contract. With a some notable exceptions among the Old Safe Harbors (and aside from management contracts that are in substance leases of bond-financed property or that otherwise convey an ownership interest in such property), qualifying for the majority of the Old Safe Harbors occurs without regard to the economic lives of the assets financed with tax-exempt bond proceeds. Especially for management contracts for the provision of services in space financed with proceeds of qualified 501(c)(3) bonds, it is very common for parties prohibited from entering into a long-term contract to instead enter into short-term contracts (within the timeframe permitted by the Old Safe Harbors) with evergreen provisions.[1]
The term permitted for a contract to qualify for the safe harbors to avoid private business use as established by Rev. Proc. 2016-44, as modified, amplified, and superseded by Rev. Proc. 2017-13 (the “New Safe Harbor”) cannot be greater than the lesser of 30 years (rarely a problem outside of the public-private partnership context) or 80% of the weighted average reasonably expected economic life of the managed property (as defined in Rev. Proc. 2017-13). The New Safe Harbors apply to all management contracts entered into, or materially modified, after August 18, 2017. Therefore, a management contract that previously qualified for the Old Safe Harbor applicable to 5-year contracts would not, if materially modified subsequent to August 18. 2017, qualify for the New Safe Harbors if the weighted average reasonably expected economic life of the managed property is less than 4-years.
Of course, as is often the case, when the managed property consists primarily of core and shell improvements with a very long economic life, qualifying for the New Safe Harbor will rarely be a concern. However, in those rare instances when the managed property consists primarily of assets with shorter lives (e.g., equipment, etc.), following a material modification, qualifying for the New Safe Harbor could be problematic.
In various informal contexts, the IRS has acknowledged that correlating the term of the management contract with the term permitted under the New Safe Harbor does raise certain concerns. However, to date, the IRS hasn’t offered any guidance (formal or otherwise) to alleviate some of these concerns. One reason for this could be that this concern has always existed in determining whether a management contract is instead for federal tax purposes a conveyance of some ownership interest in the bond-financed property. This is akin to the concern that lease agreements entered into in the latter portions of the economic lives of bond-financed property could transfer tax ownership to the lessee of that property.[2]
[1] Hopefully, the evergreen provisions were written in such a way that they did not constitute “renewal options” as defined in Rev. Proc. 97-13. For purposes of qualifying for the Old Safe Harbors (and the New Safe Harbors for that matter), renewal options are added to the stated term of the contract.
[2] Determining the tax owner of bond-financed property is a significant concern for qualified 501(c)(3) bonds which are subject to the unforgiving requirement that 100% of the property financed with such bonds be owned by a 501(c)(3) organization.
