IRS Revises Safe Harbor for Private Business Use of Tax-Exempt Bond Financed Property

By Mike Vecchioni, J.D., LL.M., Detroit, and Kendall Schnurpel, J.D., New York City

Editor: Michael Dell, CPA

In Rev. Proc. 2016-44, the IRS issued new safe-harbor procedures under which a management contract does not result in private business use of property financed with governmental tax-exempt bonds under Sec. 141(b) or cause the modified private business use test under Sec. 145(a)(2)(B) to be met for property financed with qualified 501(c)(3) bonds.

Private Business Use of Tax-Exempt Bonds

Under Sec. 103(a), gross income does not include interest on any state or local bond. Sec. 103(b)(1) provides, however, that Sec. 103(a) does not apply to any private activity bond that is not a "qualified bond" under Sec. 141.

Sec. 141(a) generally defines "private activity bond" as any bond issued as part of an issue that (1) meets the private business use test of Sec. 141(b)(1) and the private security or payment test of Sec. 141(b)(2); or (2) meets the private loan financing test of Sec. 141(c). Under Sec. 141(b)(1), an issue generally meets the private business use test if more than 10% of its proceeds are to be used for any private business use. Sec. 141(b)(6) defines "private business use" for purposes of Sec. 141(b) as used (directly or indirectly) in a trade or business carried on by any person other than a governmental unit.

Under Regs. Sec. 1.141-3(b)(4)(i), 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.

Sec. 141(e) provides that a "qualified bond" includes qualified 501(c)(3) bonds meeting certain requirements. Sec. 145(a) defines a "qualified 501(c)(3) bond" as any private activity bond issued 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 bond would not be a private activity bond if—

(A) 501(c)(3) organizations were treated as governmental units with respect to their activities which do not constitute unrelated trades or businesses, determined by applying [Sec.] 513(a), and

(B) [Secs. 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.

Previous Guidance on Management Contracts and Private Business Use

Rev. Proc. 97-13, as amended by Rev. Proc. 2001-39 and amplified by Notice 2014-67, provides conditions under which a management contract does not result in private business use under Sec. 141(b). This previous IRS guidance also applies in determining whether a management contract causes the test in Sec. 145(a)(2)(B) to be met for qualified 501(c)(3) bonds.

Rev. Proc. 97-13: The requirements for a management contract to not be treated as resulting in private business use were originally set forth in Section 5 of Rev. Proc. 97-13. Specifically, Section 5.02(1) says 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." Section 5.02(2) specifies certain types of compensation that are not considered to be based on a share of net profits. Section 5.02(3) clarifies that certain productivity rewards will generally not cause management contract compensation to be based on a share of net profits. Section 5.03 sets forth six permissible arrangements (Sections 5.03(1)-(6)) that satisfy the requirements of Section 5 of the revenue procedure and therefore do not cause a management contract to result in private business use.

Notice 2014-67: In Notice 2014-67, the IRS issued interim guidance on whether governmental entities or 501(c)(3) organizations will be considered to have private business use of their tax-exempt bond financed facilities due to their participation in accountable care organizations in connection with the Patient Protection and Affordable Care Act, P.L. 111-148, as well as guidance on management contracts that will not result in private business use. Notice 2014-67 added a new safe harbor, which, effectively consolidating the existing safe harbors from Rev. Proc. 97-13, allowed compensation for services to be based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee, or a combination of these and required no more than a five-year term (with no early termination requirement). It also retained the requirements of (1) reasonable compensation, not based on net profits, and (2) no circumstances that would substantially limit the qualified user's (e.g., the exempt borrower's) ability to exercise its rights under the contracts.

New Safe Harbor

Rev. Proc. 2016-44 modifies and supersedes the previous guidance on management contracts and private business use contained in Rev. Procs. 97-13 and 2001-39 and Section 3.02 of Notice 2014-67 (all other sections of Notice 2014-67 remain in effect). The new safe harbor retains the previous constraints on (1) net profits arrangements and (2) the relationship between the parties entering into management contracts (as described in previous IRS guidance)—but aims to apply a more "principles-based approach."

Management contracts that meet all conditions specified in the new safe harbor will not result in private business use under Sec. 141(b) or Sec. 145(a)(2)(B). These conditions include:

  • General financial requirements. In general, the compensation paid to the "service provider" (i.e., the person providing services under the management contract) under the contract must be reasonable. In addition, the contract must neither provide the service provider a share of net profits from the operation of the managed property nor impose on the service provider the burden of any share of net losses from the property's operation.
  • Term of the contract and revisions. The term of the contract, including renewal options, must be no greater than the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property.
  • Control over use of the managed property. The "qualified user" of the managed property (generally, the applicable governmental person or 501(c)(3) organization) must exercise a significant degree of control over the use of the managed property (e.g., by exercising approval over the managed property's annual budget, capital expenditures, dispositions of property, rates charged for its use, etc.).
  • Risk of loss of the managed property. The qualified user must bear the risk of loss upon damage or destruction of the managed property.
  • No inconsistent tax position. The service provider must agree that it is not entitled to and will not take any tax position that is inconsistent with being a service provider to the qualified user with respect to the managed property.
  • No circumstances substantially limiting exercise of rights. In general, the service provider must not have any role or relationship with the qualified user that, in effect, substantially limits the qualified user's ability to exercise its rights under the contract, based on all the facts and circumstances.

In addition, Section 5.08 of Rev. Proc. 2016-44 reiterates the principle from Rev. Proc. 97-13 that a service provider's use of a project that is functionally related and subordinate to performance of its services under a management contract that meets the requirements listed above does not result in private business use. Similarly, as under Rev. Proc. 97-13, a management contract that constitutes an "eligible expense reimbursement arrangement" does not result in private business use. An eligible expense reimbursement arrangement is generally defined in Rev. Proc. 2016-44 as a management contract where the only compensation provided to the service provider consists of reimbursements of the service provider's actual and direct expenses paid to unrelated parties and its reasonable related administrative overhead expenses.

Effective Date

The new safe harbor applies to management contracts that are entered into on or after Aug. 22, 2016. Issuers may also apply the new safe harbor to management contracts entered into before Aug. 22, 2016. In addition, issuers may apply the safe harbors in Rev. Proc. 97-13, as modified by Rev. Proc. 2001-39 and amplified by Notice 2014-67, to a management contract that is entered into before Aug. 18, 2017, and that is not materially modified or extended on or after Aug. 18, 2017 (other than pursuant to a renewal option as defined in Regs. Sec. 1.141-1(b)).


Through Rev. Proc. 2016-44, the IRS has provided a significantly more favorable framework for the issuers of governmental tax-exempt bonds and qualified 501(c)(3) bonds seeking to comply with the private business use tests outlined in Secs. 141(b) and 145(a)(2)(B). In sum, Rev. Proc. 2016-44 provides an easier pathway to enter into management contracts in connection with tax-exempt bond financed property.

The language of Rev. Proc. 2016-44 makes clear that management contract arrangements will not be treated as giving rise to private business use if they provide for reasonable fixed or variable compensation that is not tied to net profits for the services provided under the contract, provided qualified users that are parties to the contract are primarily in control of the tax-exempt bond financed projects. Governmental persons and 501(c)(3) organizations that are (or are seeking to become) parties to management contracts in connection with tax-exempt bond financed property should take the principles of Rev. Proc. 2016-44 into account when reviewing existing management contracts or structuring future ones.


Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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