IRS Rules that Hotel Management Contract Does Not Constitute Private Business Use
Private Activity Bonds
Under IRC §141(a) a private activity bond is any bond issued as part of an issue which meets the private business use test of IRC §141(b)(1) and the private security or payment test of IRC §141(b)(2). Under IRC §141(b)(1), a bond issuance generally meets the private business use test if more than 10% of the proceeds of the issue are to be used for any private business use. IRC §141(b)(6) defines private business use as use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit.
Under IRS Treasury Regulation §1.141-3(b)(1), a nongovernmental person is generally 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. The regulation also provides that a management contract related to the financed property may constitute private business use if the contract provides for compensation based, in whole or in part, on a share of net profits from the operation of the facility.
IRS Publication 4078 includes tests for determining whether or not a bond is a private activity bond. As outlined in the Publication, interest on a private activity bond is taxable unless the bond is a qualified private activity bond and meets various other requirements including private business use.
Additionally, IRC §147(g) limits the amount of proceeds of the private activity bond that may be used to finance issuance costs. Under IRC §147(g), a private activity bond is not a qualified bond if the issuance costs financed by the issue exceed 2% of the total proceeds of the issue. Issuance costs are defined in IRS regulations as costs incurred in connection with and allocable to, the issuance of the bond. Examples of issuance costs include, but are not limited to, accounting fees, financial advisory fees, trustee fees and counsel fees.
Revenue Procedure 97-13
Revenue Procedure 97-13 outlines three sets of conditions under IRC §141(b) which, if met by a management contract, mean that the contract does not result in private business use.
The first set of conditions, General Compensation Requirements, provides that 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.
Secondly, Permissible Arrangements, requires that the contract fit into one of seven specific types of arrangements including (1) compensation for services under the contract must be based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee or a combination of any of these; (2) compensation for services under the contract may include a percentage of gross revenue, adjusted gross revenue or expenses of the financed facility; and (3) the term on the contract (including renewals) is five years or less.
Under the third set of conditions, a service provider generally must not have any role or relationship with the state or local government that substantially limits the state or local government’s ability to exercise its rights, including cancellation rights, based on all the facts and circumstances.
Private Letter Ruling 201622003
Facts
In Private Letter Ruling 201622003 a state agency issued bonds for which the proceeds were to be used to provide permanent financing for a hotel. Pursuant to an executed contract, the Manager of the hotel was contracted for a period exceeding five years.
As outlined in the contract, the Manager received a base fee equal to a percentage of the gross revenue of the hotel in each year plus an incentive fee equal to a percentage of the gross revenue of the hotel in any year in which certain tests were met. The first test would be satisfied if in any year in which the revenue per available room for the hotel exceeded a percentage of the average revenue per available room for a pre-determined group of hotels that are comparable to the hotel. The second test would be satisfied if in any year in which the adjusted revenue margin for the hotel met or exceeded a certain percentage.
Ruling
After taking into account all the relevant facts and circumstances outlined above, the IRS concluded that the contract met the facts and circumstances requirement in Treasury Regulation §1.141-3(b)(4)(i) and does not constitute private business use. The IRS determined that the management contract did not meet all of the requirements outlined in Revenue Procedure 97-13 in that the term of the contract exceeded five years.
Additionally, based on its analysis of the facts and circumstances, the IRS concluded that the incentive fee was not based on a share of net profits and should be treated as a share of gross revenue.
Lastly, the IRS noted that none of the voting power of the governing body of the state agency issuing the bonds was vested in the Manager or its directors, officers, shareholders, or employees including no overlap of board members between the state agency and the Manager. Furthermore, the IRS concluded that the state agency and the Manager were not related parties as defined in Treasury Regulation §1.150-1(b). Accordingly, the IRS concluded that the Manager has no role or relationship with the state agency that would substantially limit the state agency’s ability to exercise its rights under the contract.
Applicability to Tax-Exempt Organizations
IRS Publication 4077 states that interest on a private activity bond is generally taxable; however, the interest may be excludable from tax if the issuer meets additional requirements that apply to private activity bonds, making the bonds qualified private activity bonds. A qualified IRC §501(c)(3) bond is a type of qualified private activity bond. Qualified IRC §501(c)(3) bonds are considered private activity bonds subject to the general rules applicable to all tax-exempt bonds. However, IRS Publication 4077 provides for modified private business use tests for these types of bonds.
Under the modified private business use tests, if an IRC §501(c)(3) organization is using the bond-financed property in furtherance of its tax-exempt purposes, the property will be treated as though it were used by a governmental unit. However, the financed property must be tested for private business use purposes. If a person other than the IRC §501(c)(3) organization is utilizing a portion of the space financed by the bonds, the use generally constitutes unrelated business income of the IRC §501(c)(3) organization and must be tested to determine the amount of private business use associated with the bond-financed property; if any. Similar to private activity bonds for a non IRC §501(c)(3) organization, issuance costs financed with bond proceeds are treated as private business use when applying the modified private business use test.
Under IRC §145(a)(2) the private business use tests are modified:
- To apply to the net proceeds of the bonds (the proceeds of a bond issue reduced by amounts allocated to a reasonably required reserve or replacement fund); and
- So that no more than 5% of private business use and no more than 5% of private security or payments are permitted (as opposed to 10% for a private activity bond of a non IRC §501(c)(3) organization outlined above).
Under IRC §145(a)(2), an IRC §501(c)(3) organization is not treated as a governmental unit with respect to its activities that constitute unrelated trade or business activities. Thus, such activities continue to be treated as private business use activities.
Accordingly, if the total private business use exceeds 5% of the net proceeds of the bonds and the total private payments exceeds 5% of the net proceeds, the bonds meet the modified private business use tests and therefore are not qualified bonds under IRC §501(c)(3).
Form 990, Schedule K
Certain IRC §501(c)(3) organizations are required to prepare and file a Schedule K, Supplemental Information on Tax-Exempt Bonds, with the annual filing of their Form 990, Return of Organization Exempt from Income Tax. If an IRC §501(c)(3) has an outstanding tax-exempt bond issue with a principal amount in excess of $100,000 as of the last day of its tax year which was issued after December 31, 2002, Schedule K is required to be completed and filed as part of the organization’s Form 990.
Part III of Schedule K is dedicated to reporting information with respect to the private business use activities associated with tax-exempt bond issuances. Part III addresses areas that could give rise to private business use such as whether or not:
1. The filing organization is a partner in a partnership or a member in a limited liability company that owns property that is financed by the tax-exempt bond proceeds;
2. There are any lease arrangements that may result in private business use of the property financed by the tax-exempt bonds;
3. There are any management or service contracts that may result in private business use of the property financed by the tax-exempt bonds; or
4. There are any research agreements that may result in private business use of the property financed by the tax-exempt bonds.
Conclusion
If a bond issuance fails the private business activity rules it will not be a qualified private activity bond and interest associated with the bond issuance will be subject to applicable taxes. In addition to monitoring the use of bond proceeds at the issuance date it is extremely important to continue to monitor the use of tax-exempt bond proceeds subsequent to issuance to ensure post-issuance compliance.
A copy of Private Letter Ruling 201622003 can be accessed below.
Private Letter Ruling 20162200
Ask Our Experts
Please contact a member of Withum’s Healthcare Services Group at [email protected] for further questions or assistance.
The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your individual facts and circumstances.
