IRS issues guidance on tax-exempt bond requirements

Healthcare Financial Management, July, 1998 by Laura Kalick

Integrated delivery systems (IDSs) need to be aware of important tax issues associated with arrangements such as management contracts, research agreements, and leases involving facilities financed with tax-exempt bonds. Such arrangements can result in a level of private business use of the bond-financed facility that exceeds the allowable threshold amount, thereby jeopardizing the bonds' tax-exempt status. Private business use refers to the use of a bond-financed facility in the trade or business activities of a private party. Use for 501(c)(3) or governmental purposes is considered qualified use.

Although bond counsel may not have noted any tax concerns regarding private business use when the bond was issued, the healthcare organization is responsible for monitoring the use of tax-exempt-bond-financed facilities and ensuring compliance with tax law. Because compliance problems are widespread, IRS revenue agents are using regulations issued January 10, 1997, to conduct targeted examinations.(a) In addition, enforcing tax-exempt bond compliance is a priority under the IRS's comprehensive audit initiative, the Coordinated Examination Program.

The January 10, 1997, regulations clarify the effect of the Tax Reform Act of 1986 on private-business-use tests. Essentially, the regulations provide that in most instances where the tax-exempt bonds are not secured by the full faith, credit, and taxing authority of the issuing political subdivision, any private business use exceeding the threshold amount - ie, 5 percent for 501(c)(3) bonds and 10 percent for government bonds - will nullify the bonds' tax-exempt status. Even if the threshold is not exceeded, any private business use of a 501(c)(3) facility financed with tax-exempt bonds will result in unrelated business income without a corresponding deduction for interest expense.(b)

This situation even applies to rental income, which ordinarily would not be taxed as unrelated business income. For example, income from leasing clinic space in a bond-financed facility for use by a taxable physician corporation would constitute unrelated business income, even if the taxable corporation is affiliated with the tax-exempt organization.

Management Contracts

One way an IDS can run afoul of the bond-use rules is by hiring a private company or group to manage a department of its tax-exempt-bond-financed facilities. To help organizations with compliance in such arrangements, recent guidelines issued by the IRS state the conditions under which a management contract will not result in private business use and will be considered qualified use.(c)

Compensation for the management services may not be based on a share of net profits from the operation of the facility. In general, compensation based on a percentage of a facility's gross revenues, a percentage of a facility's expenses (but not both revenue and expenses), a capitation fee, or a fee based on a unit of service provided is not considered to be based on net profits.

The IRS guidelines describe permissible compensation arrangements that involve periodic fixed fees for services rendered during specific time periods. For example, an arrangement in which at least 95 percent of the compensation for services is based on a periodic fixed fee would be acceptable, as long as the term of the contract does not exceed the lesser of either 80 percent of the reasonably expected useful life of the financed property or 15 years.

Contracts for services that are merely incidental to the governmental or tax-exempt function of the bond-financed facility (eg, janitorial services, office equipment repair, and hospital billing) do not constitute private business use.

Research Agreements

The IRS also has issued guidance on when research agreements, another potential problem area, will not result in private business use of a facility financed through tax-exempt bonds.(d) The IRS guidance provides a safe harbor for corporate-sponsored basic research. The revenue procedure defines "basic research" as "any original investigation to advance scientific knowledge not having a specific commercial objective."

With some restrictions, corporate-sponsored basic research arrangements may qualify for the safe harbor. Corporate-sponsored drug testing, however, probably would not be considered basic research and, therefore, would fall outside of the safe harbor.

Leases

Leases constitute per se private business use, but they sometimes are disguised as management contracts in which rent is based on business revenue. As a general rule, if patients of a facility financed by tax-exempt bonds become patients of the management company, the facility's lease probably will be seen as serving the private business use of the management company.

Similarly, if an IDS leases space in a tax-exempt-bond-financed facility to a taxable physician services company for use as a walk-in clinic, the use of the property will be viewed as private business use, even if the physician services company is a taxable subsidiary of the hospital.