PLR 1338026: IRS finds a hospital management contract will not create private business use

Plain-English summary

An issuer planned to use tax-exempt bond proceeds to finance clinical facilities operated by a tax-exempt hospital, which would pay a medical group under a management contract. The contract included base compensation, incentive compensation, expense reimbursements, and compensation for certain officers and employees. The IRS concluded that the contract did not meet the requirements of the safe harbor in Rev. Proc. 97-13, but the surrounding facts and circumstances still showed that it would not create private business use under § 141. The conclusion relied in part on compensation being at fair market value, incentive metrics not being based on net profits, and the medical group not having a relationship that substantially limited the hospital's rights.

Ruling snapshot

• Question: Will the hospital's management contract create private business use of the bond-financed clinical facilities?
• Outcome: Approved, the contract will not result in private business use.
• Key authorities: IRC §§ 103, 141, and 145; Treas. Reg. §§ 1.141-3 and 1.145-2; Rev. Proc. 97-13.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201338026 Third Party Communication: None
Release Date: 9/20/2013 Date of Communication: Not Applicable
Index Number: 141.07-00, 141.07-01
Person To Contact:
------------------------- --------------------------------, ID No. ----------
------------------------------------------------------------ ------------------
------------- Telephone Number:
------------------------------------- ----------------------
-------------------------------------- Refer Reply To:
CC:FIP:05
PLR-124654-12
Date:
May 13, 2013

Legend

Management Contract = ------------------------------------------------------------------------
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Bonds = ------------------------------------------------------------------------
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Issuer = ---------------------------------------------------------------

State = -------------------------

Hospital = ---------------------------------------------------

Medical Group = ------------------------------------------------------------------------
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University = -----------------------------------------------

Date 1 = -----------------

Specialty = ------------

Patient = ---------------
PLR-124654-12 2

a = ----

b = ------

c = --------

d = ----

e percent = --------------

f = ----

g = ----

h = ----

i = ----

j = ----

Date 2 = -----------------------

Date 3 = ------------------

Dear ----------------:

This letter is in response to your request for a ruling that the Management Contract will
not result in private business use under section 1.141-3(b)(4)(i) of the Income Tax
Regulations of the property financed by the Bonds.

Facts and Representations

You make the following factual representations. The Issuer, an instrumentality of the
State, is authorized under State law to issue revenue bonds for the purpose of financing
the acquisition or renovation of health facilities operated by participating health
institutions. The Hospital intends to use a portion of the proceeds of the Bonds and
other bonds to be issued in the future by the Issuer to finance the acquisition or
renovation of facilities to be owned or leased by the Hospital for the purpose of
providing clinical medical services (the “Clinical Facilities”). Pursuant to the
Management Contract, the Medical Group will provide physician services to the Hospital
at the Clinical Facilities in exchange for the payments and reimbursements described
below.

The Hospital is an organization described in section 501(c)(3) of the Internal Revenue
Code (the “Code”) and exempt from federal income tax under section 501(a). It is the
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principal Specialty teaching hospital of the University, a State public university, which
controls one-third of the Hospital’s board of trustees.

The Medical Group is a State professional corporation owned by certain physicians who
practice through the Medical Group. It is governed by a board of directors consisting of
certain physicians, who are both shareholders of the Medical Group and University
faculty members, and of certain officials of the University and Hospital. The individual
employed by the University as Dean of Patient Clinical Services also serves as the
president of the Medical Group and executive director of the division of the Hospital that
uses the Clinical Facilities (the “President”). Not more than --- percent of the voting
power of the governing board of the Hospital is vested in the Medical Group or its
directors, officers, shareholders, or employees. Neither the chief executive officer nor
the chair of the governing board of the Hospital serves as a voting member of the
Medical Group’s board of directors, and neither the chief executive officer nor the chair
of the board of directors of the Medical Group serves as a voting member of the
Hospital’s governing board.

The Management Contract provides that the Hospital will pay the Medical Group base
compensation and incentive compensation. The base compensation is generally
computed by multiplying the number of work relative value units (“WRVUs”) produced
by a division of the Medical Group (divisions are generally organized by medical
specialty) over a specified period by an agreed upon fee for that division. For a minority
of the divisions, however, base compensation is calculated differently. For certain
divisions, base compensation is computed, as above, based on WRVUs, except that it
cannot be less than a stated amount. In one case, base compensation is calculated as
a fixed charge per patient visit.

The Medical Group’s incentive compensation is based on the achievement of
benchmarks in various performance categories. The Medical Group will receive
incentive compensation for each benchmark it meets, but for most performance
categories must return compensation to the Hospital if it falls short of a benchmark. At
the beginning of each fiscal year, the parties will agree on the performance categories
to be used in that year. You represent that, in the fiscal years beginning on or after
Date 1, no performance category will be based on gross revenues or adjusted gross
revenues. The performance categories for the fiscal year beginning on Date 1 will
include cost management, patient access, emergency medicine patient satisfaction,
emergency medicine throughput, and neonatal intensive care unit interaction
satisfaction.

For the cost management category, the Medical Group will receive a percent of the
amount by which the Hospital’s expenses for salaries and wages, agency labor,
supplies, and purchased services are less than b percent of the amount budgeted.
Conversely, the Medical Group will return an amount of compensation equal to a
percent of the amount by which those expenses exceed c percent of the amount
budgeted. You represent that the total amount earned or returned in each year under
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the incentive compensation provisions is capped and will not exceed d percent of the
base compensation expected to be paid in that year.

Every third year, the base compensation and incentive compensation are renegotiated
by the parties to ensure that they remain within fair market value, as determined by
reference to industry group compensation surveys and a third-party valuation opinion.

The Management Contract also provides that the Hospital will pay or reimburse the
Medical Group for the following miscellaneous expenses: (1) expenses not in excess of
$------- for travel, meetings, and professional dues incurred by each Medical Group
physician; (2) administrative expenses up to a budgeted amount, including accounting
expenses, meeting expenses, supply expenses, and management services expenses;
and (3) reasonable professional liability tail insurance for certain resigned or terminated
physicians.

In addition, the Hospital will pay or reimburse the Medical Group for all or a portion of
the Medical Group’s expenses for compensation of the following employees and officers
of the Medical Group: (1) certain newly recruited physicians during their first year of
employment, (2) fellows in certain medical specialties, (3) legal counsel, (4) an
administrator, (5) the Vice President, Surgery, (6) the Vice President, Medicine, (7) the
Compliance Officer, and (8) the President. Except in the case of the President (as
further described below), the amount of the compensation paid to each of these
individuals and reimbursed to the Medical Group under the Management Contract will
be a stated amount or a stated amount increasing periodically by a stated percentage
and will be determined without reference to gross revenues or expenses of the Clinical
Facilities. The Hospital will also pay or reimburse the Medical Group for the cost of
employee benefits furnished to the physicians providing medical services through the
Medical Group and fellows in certain medical specialties. You represent that these
employee benefits will not be determined by reference to either gross revenue or
expenses from the Clinical Facilities.

The Management Contract further provides that the Hospital will, on behalf of the
Medical Group, pay the University e percent of the compensation of the President. The
full amount of the President’s compensation and other terms of his employment are set
under an employment agreement between the University and the President. Of this
compensation, f percent will be base compensation and g percent will be the total
incentive compensation for which the President is eligible (the “Total Incentive
Compensation”). The base compensation will be a stated amount. The Total Incentive
Compensation will also be a stated amount, but payment will depend on satisfactory
achievement with respect to certain metrics that will be redetermined from year to year.

In each fiscal year beginning on or after Date 1, you expect that the President’s
incentive compensation will be based at least on the following three metrics: (a) not
more than h percent of the Total Incentive Compensation will be awarded at the
discretion of the governing board of the Hospital, (b) not more than i percent will be
PLR-124654-12 5

awarded if the Clinical Facilities achieve their budgeted WRVUs, and (c) not more than j
percent will be awarded if the Clinical Facilities both reduce expenses and achieve a
stated number of WRVUs. You have provided historical financial data showing that
gross revenue of the Clinical Facilities does not increase or decrease in concert with the
number of WRVUs generated in the Clinical Facilities. You also represent that the
governing board of the Hospital will not award the portion of the President’s incentive
pay dependent on its discretion based on the Clinical Facilities’ net profits.

You represent that, excluding the three metrics described in (a), (b), and (c) above,
none of the metrics used in the fiscal years beginning on or after Date 1 to award
incentive compensation will be determined by reference to revenues, expenses, or net
profits of the Clinical Facilities. You also represent that, with the exception of the fiscal
year beginning on Date 1, the amount of the Total Incentive Compensation, the
elements of each metric, and the percentages awarded for achieving each metric in a
given fiscal year will be determined by the end of the first quarter of that fiscal year.

The term of the Management Contract ends on Date 2 and either party can terminate
without cause or penalty on Date 3, a date which is approximately three and a half
years prior to Date 2.

Law

Under section 103(a), gross income does not include interest on any state or local bond.
Section 103(b) provides, however, that section 103(a) shall not apply to any private
activity bond which is not a qualified bond (within the meaning of section 141).

Section 141(a) provides that the term “private activity bond” means any bond issued as
part of an issue which: (1) meets the private business use test of section 141(b)(1) and
the private security or payment test of section 141(b)(2); or (2) meets the private loan
financing test of section 141(c). Section 141(b)(1) provides, in general, that an issue
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.

Section 141(b)(6) provides that the term “private business use” for purposes of section
141(b), means use (directly or indirectly) in a trade or business carried on by any person
other than a governmental unit. For this purpose, any activity carried on by a person
other than a natural person is treated as a trade or business.

Section 141(e)(1)(G) provides that the term “qualified bond” includes any private activity
bond if such bond is a qualified 501(c)(3) bond and meets other specified requirements.

Section 145(a) provides that a “qualified 501(c)(3) bond” means any private activity
bond issued as part of an issue if (1) all property which is to be provided by the net
proceeds of the issue is to be owned by a 501(c)(3) organization or a governmental unit,
and (2) such bonds would not be a private activity bond if (A) 501(c)(3) organizations
PLR-124654-12 6

were treated as governmental units with respect to their activities which do not
constitute unrelated trades or businesses, determined by applying section 513(a), and
(B) sections 141(b)(1) and (2) were applied by substituting “5 percent” for “10 percent”
each place it appears and by substituting “net proceeds” for “proceeds” each place it
appears.

Section 1.145-2(a) provides generally that sections 1.141-0 through 1.141-15 apply to
section 145(a). Section 1.145-2(b) provides, in part, that in applying sections 1.141-0
through 1.141-15 to section 145(a), (1) references to governmental persons include
501(c)(3) organizations with respect to their activities that do not constitute unrelated
trades or businesses under section 513(a); and (2) references to “10 percent” and
“proceeds” in the context of the private business use test and the private security or
payment test mean “5 percent” and “net proceeds”.

Section 1.141-3(a)(1) provides that the private business use test relates to the use of
the proceeds of an issue. The 10 percent private business use test of section 141(b)(1)
is met if more than 10 percent of the proceeds of an issue is used in a trade or business
of a nongovernmental person. For this purpose, the use of financed property is treated
as the direct use of proceeds. Any activity carried on by a person other than a natural
person is treated as a trade or business.

Section 1.141-3(b)(1) provides that both actual and beneficial use by a
nongovernmental person may be treated as private business use. In most cases, the
private business use test is met only if a nongovernmental person has special legal
entitlements to use the financed property under an arrangement with the issuer. In
general, a nongovernmental person is treated as a private business user of proceeds
and financed property as a result of ownership; actual or beneficial use of property
pursuant to a lease, or a management or incentive payment contract; or certain other
arrangements such as a take or pay or other output-type contract.

Section 1.141-3(b)(4)(i) provides that, except as provided in section 141-3(d), a
management contract with respect to financed property may result in private business
use of that property, based on all of the facts and circumstances. A management
contract generally results in private business use of that property if the contract provides
for compensation for services rendered with compensation based, in whole or in part,
on a share of net profits from the operation of the facility.

Section 1.141-3(b)(4)(ii) defines a management contract as a management, service, or
incentive payment contract between a governmental person and a service provider
under which the service provider provides services involving all, a portion of, or any
function of, a facility. For example, a contract for the provision of management services
for an entire hospital, a contract for management services for a specific department of a
hospital, and an incentive payment contract for physician services to patients of a
hospital are each treated as a management contract.
PLR-124654-12 7

Revenue Procedure 97-13, 1997-1 C.B. 632, as modified by Revenue Procedure 2001-
39, 2001-2 C.B. 38 (“Rev. Proc. 97-13”), sets forth conditions under which a
management contract does not result in private business use under section 141(b)..
Under section 5.02(1), the management contract must provide for reasonable
compensation for services rendered with no compensation based, in whole or in part, on
a share of net profits from the operation of the facility. 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. Under section 5.02(2), for purposes of section
1.141-3(b)(4)(i) and Rev. Proc. 97-13, compensation that is based on (a) a percentage
of gross revenues (or adjusted gross revenues) of a facility or a percentage of expenses
from a facility, but not both, (b) a capitation fee, or (c) a per-unit fee, is generally not
considered to be based on a share of net profits. Under section 5.02(3), for purposes of
section 1.141-3(b)(4)(i) and Rev. Proc. 97-13, a productivity reward equal to a stated
dollar amount based on increases or decreases in gross revenues (or adjusted gross
revenues), or reductions in total expenses (but not both increases in gross revenues (or
adjusted gross revenues) and reductions in total expenses) in any annual period during
the term of the contract, generally does not cause the compensation to be based on a
share of net profits.

Section 3.01 defines “adjusted gross revenue” as gross revenues of all or a portion of a
facility, less allowances for bad debts and contractual and similar allowances.

Section 3.05 defines a “periodic fixed fee” as 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.

Section 3.06 of Rev. Proc. 97-13 defines a “per-unit fee” as a fee based on a unit of
service provided specified in the contract or otherwise specifically determined by an
independent third party, such as the administrator of the Medicare program, or the
qualified user. For example, a stated dollar amount for each specified medical
procedure performed, car parked, or passenger mile is a per-unit fee. Separate billing
arrangements between physicians and hospitals generally are treated as per-unit fee
arrangements.

Section 3.08 of Rev. Proc. 97-13 provides that a renewal option means a provision
under which the service provider has a legally enforceable right to renew the contract.
Thus, for example, a provision under which a contract is automatically renewed for one
year periods absent cancellation by either party is not a renewal option (even if it is
expected to be renewed).
PLR-124654-12 8

Section 5.03 of Rev. Proc. 97-13 sets forth six permissible arrangements that satisfy the
requirements of section 5. Under section 5.03(5), a permissible arrangement is one
under which 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 term of the contract, including
all renewal options, must not exceed 3 years. The contract must be terminable by the
qualified user on reasonable notice, without penalty or cause, at the end of the second
year of the contract term.

Section 5.04(1) of Rev. Proc. 97-13 provides in general that a 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, including cancellation rights, based on all the facts
and circumstances. Under section 5.04(2), the qualified user's rights are not
substantially limited if the following requirements are satisfied: (1) not more than 20
percent of the voting power of the governing body of the qualified user in the aggregate
is vested in the service provider and its directors, officers, shareholders, and
employees; (2) overlapping board members do not include the chief executive officers
of the service provider or its governing body or the qualified user or its governing body;
and (3) the qualified user and the service provider under the contract are not related
parties, as defined in section 1.150-1(b).

Analysis

The Management Contract does not meet the requirements of section 5 of Rev. Proc.
97-13. Therefore, whether the Management Contract results in private business use of
the Clinical Facilities under section 1.141-3(b)(4) depends on all of the facts and
circumstances. In determining whether the facts and circumstances relating to a
management contract indicate private business use, the factors set forth in Rev. Proc.
97-13 are useful reference points. For the reasons described below, we conclude that
the Management Contract does not result in private business use of the Clinical
Facilities.

Setting aside the incentive pay of the President, neither the Hospital’s payment or
reimbursement of the Medical Group’s miscellaneous expenses nor its payment or
reimbursement of the Medical Group’s compensation expenses, as each such expense
is described above, supports a conclusion that the Management Contract causes
private business use of the Clinical Facilities because neither the miscellaneous
expenses nor the compensation expenses are calculated based on net profits.

Likewise, the facts and circumstances of the President’s incentive pay do not support a
conclusion that the Management Contract causes private business use of the Clinical
Facilities. The metric based on the Clinical Facilities’ achievement of their budgeted
WRVUs does not support a conclusion of private business use because a per-unit fee is
generally not considered to be based on a share of net profits. The metric based on the
discretion of the governing board of the Hospital does not support a conclusion of
private business use because you represent that it will not be based on net profits. The
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metric based on a combination of expense reduction and achievement of a WRVU
target does not support a conclusion of private business use because, based on the
historical financial data provided, WRVUs are not a proxy for gross revenue such that,
in combination with expense reduction, they track net profits.

Based in part on the periodic renegotiation to ensure that base compensation and
incentive compensation remain within fair market value, as determined by an external
standard, the Management Contract provides for reasonable compensation for the
services provided by the Medical Group. The base compensation paid by the Hospital
to the Medical Group under the Management Contract does not support a conclusion
that there is private business use under these facts and circumstances. The base
compensation closely resembles the arrangement in section 5.03(5) of Rev. Proc. 97-
13, although the term of the Management Contract exceeds the permissible term under
section 5.03(5). Additionally, the Medical Group’s incentive compensation does not
support a conclusion that there is private business use. It is not based on a share of net
profits because, although based in part on reductions in expenses, it is not, and will not
be, based on gross revenues or adjusted gross revenues.

Finally, the Medical Group does not have any role or relationship with the Hospital that
substantially limits the Hospital’s ability to exercise its rights under the Management
Contract, including its termination right. No more than --- percent of the voting power of
the governing board of the Hospital is vested in the Medical Group or its directors,
officers, shareholders, or employees. The chief executive officers and the chairs of the
governing board of the Hospital and the Medical Group do not vote on the governing
board of the other. Also, the Medical Group and the Hospital are not related within the
meaning of section 1.150-1(b).

Conclusion

We conclude that the Management Contract will not result in private business use of the
Clinical Facilities under section 1.141-3(b)(4)(i).

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. The representations relied upon include but are not limited to
your representations that metrics used in the future to measure performance will not be
based in whole or in part on the net profits of the Clinical Facilities. We have taken the
term “net profits” as used in your representations throughout this ruling to mean net
profits as the term is used in section 1.141-3(b)(4)(i). In addition, the continued
application of this ruling is conditioned upon the continued existence of the facts you
provided, including but not limited to the continuation of the lack of a close relationship
evidenced in the historical financial data you provided between the number of WRVUs
and the gross revenue of the Clinical Facilities. While this office has not verified any of
the material submitted in support of the request for rulings, it is subject to verification on
examination.
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Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                   Sincerely,


                                   Associate Chief Counsel
                                   (Financial Institutions and Products)

                                                      /S/
                                By:______________________________
                                   Timothy L. Jones
                                   Senior Counsel
                                   (Financial Institutions & Products)