Facilities owned by nonprofits and government entities are frequently financed with tax-exempt bonds and managed by for-profit management companies. To avoid tainting the tax-exempt status of the interest payable on those bonds, due to excessive "private business use" of the financed facility, the terms of the management contracts are drafted to comply with IRS safe harbor guidelines (IRS Revenue Procedure 2017–13, or the "Guidelines"). A private letter ruling from the IRS (PLR 202229022; the "2022 Ruling") released on July 22, 2022, provides new insights on the permissible terms for such management contracts under the Guidelines.
The Guidelines provide a safe harbor pursuant to which a management contract will not be considered to result in private business use of the managed facility by the for-profit manager. The Guidelines include a list of requirements regarding compensation, term, termination, and related party status. This alert focuses only on the compensation requirements and specifically on what the newest IRS ruling seems to permit and what the ruling leaves unanswered.
The IRS Safe Harbor Guidelines
The Guidelines generally require that payments to a manager be reasonable compensation for services rendered during the term of the contract. The Guidelines further state that a management contract must not provide for the manager to share in the net profits from the operation of the managed facility. Thus, no element of the manager's compensation may take into account or be contingent upon either the managed facility's net profits or both the managed facility's revenues and expenses (other than any reimbursements of direct and actual expenses paid by the service provider to unrelated third parties) for any fiscal period.
Incentive compensation will not be treated as providing a share of net profits if the eligibility for the incentive compensation is determined by the service provider's performance in meeting one or more standards that measure quality of services, performance, or productivity, and the amount and timing of the payment of the compensation meet other requirements of the Guidelines. In addition, the contract also must not, in substance, impose upon the manager the burden of bearing any share of net losses from the operation of the managed facility.
Compensation at Issue in the 2022 Ruling
The 2022 Ruling considers whether a management contract for the management of a government-owned hotel gives rise to private use when it does not meet all the requirements of the Guidelines. The compensation terms of the contract provide for the manager to be compensated with three distinct components:
(1) A monthly hotel services fee based on a tiered percentage of gross revenue from the hotel operations each fiscal year. The 2022 Ruling does not disclose the specifics of the tiered percentages.
(2) Reimbursement from gross revenue for operating expenses with respect to hotel operation and management, including the for-profit manager's personnel costs, such as: employee salaries, fringe benefits, incentive compensation, bonuses, employee performance and service awards, and other operating expenses.
(3) Reimbursement from gross revenue for the hotel's allocable share of costs of various system services that the manager provides, including promotion, marketing, centralized reservations, guest incentive programs, and tech services.
What Are Net Profits?
Inherent in the analysis undertaken in the 2022 Ruling, but not addressed extensively enough to be of great assistance, are several issues that have long plagued an interpretation of the Guidelines. For one, is a compensation structure that includes both a percentage of gross receipts in combination with a reimbursement of the manager's incurred costs, for managing the facility, a prohibited combination of revenue and expense based compensation? Another, when, if ever, are employees of the manager "related" to the manager, such that reimbursement of their compensation is not a permitted reimbursement under the Guidelines? In particular, is there a difference between employees compensated on an hourly basis and salaried management personnel when determining "related" status?
One common fee structure is for the manager to be paid a percentage of gross revenues, and cover the costs of senior management and its own administrative costs, while the non-management employees, working on site at the facility, remain employees of the non-profit with their compensation, paid by the non-profit. This structure generally seems compliant with the Guidelines. But the analysis becomes less clear when the for-profit manager is compensated on a percentage of gross revenues and is also reimbursed for funding the various costs of managing and/or operating the facility
The facts of the 2022 Ruling address, in general, a fee structure which: (1) includes payment to the manager of a percentage of gross receipts; and (2) reimburses certain operating expenses of the manager, including compensation of hourly employees plus salaried senior management. In addition, reimbursed compensation to some of the manager's personnel is based on factors related to the financial performance of the managed facility.
The Guidelines preclude a manager's compensation from being based on a combination of both revenues and expenses, other than reimbursements of direct and actual expenses paid by the service provider to unrelated third parties. But the Guidelines seem to implicitly allow for a manager to be compensated based on a share of gross revenues while also bearing the operating costs of the facility for which it may be reimbursed. The Guidelines preclude the manager being reimbursed for expenses paid to related parties and seemingly preclude the manager from bearing and being reimbursed for all costs of a facility's management and operation (as this would, in substance, result in the manager being paid on a net profits basis). But they do not explicitly address this situation in which the manager bears all, or substantially all, of the costs of the facility's management and operations. Similarly, with the right mix of numbers, if a manager is paid based on a share of gross receipts and bears the costs of operating the facility, the net compensation to the manager could also roughly approximate the net profits of the facility.
An analogous prohibition on basing payments on net income or profits appears in the unrelated business taxable income rules in Section 512(b)(3) of the Internal Revenue Code and the rules for Real Estate Investment Trusts in Section 856 of the Internal Revenue Code. The Treasury Regulations, thereunder, provide that a payment for the use of leased property does not qualify as "rent" if the purported rent payment depends, in whole, or, in part, on the net income or profits the lessor derives from the leased property. The IRS has issued numerous private letter rulings approving rental formulas based on gross receipts, less certain defined deductions. In those private letter rulings, the IRS appears to construe the term "net income or profits" narrowly.
Take-Aways From the 2022 Ruling
The Guidelines preclude a manager's compensation from being based on a combination of both revenues and expenses, other than reimbursements of direct and actual expenses, paid by the manager to unrelated third parties. This is where the 2022 Ruling seems to provide some liberalization of the Guidelines as it permitted the manager to be paid a share of gross revenues while being reimbursed for its own personnel expenses. Thus, the 2022 Ruling does not treat employees of the manager, including senior management employees of the manager, as being "related parties" to the manager such that reimbursement of their compensation would be precluded under the Guidelines.
Further, the 2022 Ruling permits employee-incentive compensation to be based on several factors, including the "financial performance" of the facility. The 2022 Ruling does not provide any specifics regarding this factor. At face value, a "financial performance" factor could result in the manager's compensation being indirectly based on net profits from operating the facility. However, given the absence of detailed facts, it is unclear as to both how the financial performance factor related to the facility's net profits and how it impacted the compensation arrangement. In any event, the fact that incentive compensation was payable to senior management appears to have led the IRS to conclude that the contract did not satisfy the safe harbor in the Guidelines.
The lack of detail as to many of the key facts in the 2022 Ruling makes it difficult to ascertain how much reliance can be placed on its conclusions, and leaves many questions unanswered as to what economic arrangements, other than a pure profit-sharing arrangement, could result in a prohibited sharing of "net profits" from the operating of a bond-financed facility. But the 2022 Ruling does indicate that the IRS is willing to acknowledge that certain compensation arrangements that do not fall within the Guidelines, because they involve both a revenue sharing payment and reimbursement of the manager's expenses, do not result in private business use.