Facilities owned by nonprofits and government entities are often funded by tax-exempt bonds and managed by for-profit management companies. To avoid tainting the tax-exempt status of interest payable on these bonds, due to excessive “private commercial use” of the financed facility, the terms of the management contracts are drafted to comply with the guidelines of the IRS Safe Harbor (IRS Revenue Procedure 2017–13, or the “Guidelines”). A private IRS ruling letter (PLR 202229022; the “2022 Regulations”) issued on July 22, 2022, provides new information about the permitted terms for such management contracts under the Guidelines.
The guidelines provide a safe harbor under which a management contract will not be considered to result in private commercial use of the facility managed by the for-profit manager. The guidelines include a list of requirements regarding remuneration, duration, termination and related party status. This alert focuses only on compensation requirements and specifically what the latest IRS ruling appears to allow and what the ruling leaves unanswered.
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 specify that a management contract should not provide that the manager shares the net profits from the operation of the managed facility. Thus, no element of the manager’s remuneration can take into account or depend either on the net profits of the managed establishment, or on both the income and the expenses of the managed establishment (other than any reimbursement of direct and actual costs paid by the service provider to unrelated third parties) for any fiscal year.
Incentive compensation will not be considered to provide a share of net profits if eligibility for incentive compensation is determined by the service provider’s performance in meeting one or more standards that measure service quality, performance or productivity, and the amount and timing of compensation payment meet the other requirements of the Guidelines. Furthermore, the contract must also not, in substance, impose on the manager the burden of bearing any part of the net losses of the operation of the managed installation.
Compensation at issue in 2022 decision
The Ruling 2022 examines whether a management contract for the management of a state-owned hotel gives rise to private use when it does not meet all the requirements of the Guidelines. The compensation conditions of the contract provide that the executive is compensated according to three distinct elements:
(1) A monthly hotel service fee based on a staggered percentage of gross revenue from hotel operations for each fiscal year. The 2022 decision does not disclose details of the tiered percentages.
(2) Reimbursement of gross revenue for operating expenses related to the operation and management of the hotel, including for-profit manager personnel costs, such as: employee salaries, benefits , incentive compensation, bonuses, employee performance and service awards and other operating expenses.
(3) Reimbursement from gross revenue of the hotel’s share of the costs of various system services provided by the manager, including promotion, marketing, centralized reservations, guest incentive programs and technical services .
What are net profits?
Inherent in the analysis undertaken in the 2022 decision, but not sufficiently addressed to be of much assistance, several issues have long hampered the interpretation of the Guidelines. On the one hand, is a remuneration structure which includes both a percentage of gross receipts in combination with a reimbursement of costs incurred by the operator, for the management of the installation, a prohibited combination of remuneration based on the income and expenses? Another, when, if at all, are the manager’s employees “tied” to the manager such that reimbursement of their remuneration is not an authorized reimbursement under the Guidelines? In particular, is there a difference between hourly paid employees and salaried supervisors when determining “related” status?
A common fee structure is for the manager to receive a percentage of gross revenue and cover senior management costs and his own administrative costs, while non-managerial employees, working at the facility site, remain employees. non-executives. profit with their remuneration, paid by the association. This structure appears to be generally consistent with the Guidelines. But the analysis becomes less clear when the for-profit manager is remunerated on a percentage of gross revenues and is also reimbursed for financing the various costs of managing and/or operating the establishment.
The facts of the 2022 ruling discuss, in general, a fee structure that: (1) includes paying the manager a percentage of gross receipts; and (2) reimburses certain operating expenses of the Manager, including compensation for hourly employees plus salaried executives. In addition, the remuneration reimbursed to part of the manager’s staff is based on factors related to the financial performance of the managed establishment.
The Guidelines prevent a manager’s compensation from being based on a combination of income and expenses, other than reimbursements of direct and actual expenses paid by the service provider to unrelated third parties. But the Guidelines appear to implicitly allow a manager to be remunerated on the basis of a share of gross revenue while also bearing the costs of running the facility for which they may be reimbursed. The Guidelines prevent the Manager from being reimbursed for expenses paid to related parties and appear to prevent the Manager from assuming and being reimbursed for all costs of managing and operating an establishment (as this would, in essence, to the effect that the manager is paid on a net profit basis). But they do not explicitly address this situation in which the manager bears all or almost all of the costs of managing and operating the installation. Similarly, with the right combination of numbers, if a manager is paid based on a share of gross revenue and bears the costs of running the facility, the manager’s net compensation could also approximate net profits. of the installation.
A similar prohibition against basing payments on net income or profits appears in the taxable income rules for businesses unrelated to Section 512(b)(3) of the IRS and the rules for real estate investment trusts. in Article 856 of the Tax Code. The Treasury Regulations, under it, state that a payment for the use of leased property is not considered “rent” if the payment of the supposed rent depends, in whole or in part, on the net income or profits that the lessor derives from the leased property. property. The IRS has issued many private letter rulings approving rental formulas based on gross receipts less certain defined deductions. In these private letter rulings, the IRS appears to interpret the term “net income or profits” restrictively.
Takeaways from the 2022 decision
The Guidelines prevent a manager’s compensation from being based on a combination of income and expenses, other than reimbursements of direct and actual expenses, paid by the manager to unrelated third parties. This is where the 2022 ruling appears to bring some liberalization of the guidelines as it allowed the manager to receive a share of gross revenue while being reimbursed for their own staff costs. Thus, the 2022 Rule does not treat the Manager’s employees, including the Manager’s senior officers, as being “related parties” to the Manager, such that reimbursement of their compensation would be excluded under the Guidelines.
Additionally, the 2022 ruling allows employee incentive compensation to be based on multiple factors, including the “financial performance” of the facility. The 2022 decision does not provide any details regarding this factor. At first glance, a “financial performance” factor could result in the manager’s compensation being indirectly based on the net profits from the operation of the facility. However, given the lack of detailed facts, it is unclear both how the financial performance factor related to the facility’s bottom line and how it impacted the compensation agreement. In any event, the fact that the incentive compensation was payable to senior management appears to have led the IRS to conclude that the contract did not satisfy the guidelines’ exempt rule.
The lack of detail on many of the key facts of the 2022 decision makes it difficult to determine the extent to which its conclusions can be trusted and leaves many unanswered questions about the economic arrangements, other than a pure profit-sharing arrangement, could result in prohibited sharing of “net profits” from the operation of a bond-funded facility. But the 2022 ruling indicates that the IRS is willing to recognize that certain compensation arrangements that fall outside the guidelines, because they involve both a revenue-sharing payment and the reimbursement of manager expenses, do not result in not for private commercial use.