Participate in an ACO? Are Your Hospital's Bonds Still Tax Exempt?           


If a Code Section 501(c)(3) organization (501(c)(3)) or State or local government (collectively Exempt Entity) hospital or other facility financed with tax-exempt bonds has “too much” private business use of such facility, the bonds will lose their exempt status. Various arrangements, including partnerships or management agreements with non-exempt persons can constitute private business use. There has been a concern that an Exempt Entity hospital or other healthcare organization with exempt bond financing participating in an accountable care organization (ACO) could represent an arrangement that constitutes a private business use and disqualify the exempt status of the bonds. The IRS has now confirmed this concern and provided a useful but limited path to avoid the private business use in the context of ACOs and management contracts.

On October 24, 2014, the Internal Revenue Service (“IRS”) released Notice 2014-67 (the Notice) which implicitly affirms that an Exempt Entity’s participation in an ACO with non-exempt persons may constitute a private business use unless the ACO and the Exempt Entity’s participation is carefully structured and meets the safe-harbor requirements set forth therein. While failure to comply with Rev. Proc. 97-13’s safe-harbors does not, as a matter of law, automatically mean the arrangement disqualifies the exempt bonds, it will be a rare organization that will want to test the waters outside of the arrangements approved by the Notice.

The Notice provides the first interim guidance for determining the circumstances under which healthcare tax-exempt bond financed facilities will or will not be considered to have private business use in the context of ACOs. The Notice also provides guidance as to whether a tiered productivity award such as for the achievement of quality performance standards resulting in participation in the Medicare Shared Savings Program contemplated under the Affordable Care Act (“Shared Savings Program”) will be considered a permitted form of compensation under Rev. Proc. 97-13. As the reader is aware, Rev. Proc. 97-13 is the IRS’s primary pronouncement for determining the types of compensation arrangements under management contracts between Exempt Entities and service providers which are permitted under the tax-exempt bond rules and do not result in private business use. Management contracts are broadly defined in the Treasury Regulations as a management, service, or incentive payment contract between an Exempt Entity and a service provider (for example, physicians and other healthcare practitioners) under which the service provider provides services involving all, a portion, or any function of a facility. The Notice solicits public comments with respect to the interim guidance as well as further guidance needed to facilitate participation in the Shared Savings Program.

Under the Internal Revenue Code, governmental bonds or bonds issued for the benefit of 501(c)(3)s may be issued on a tax-exempt basis as long as, among other requirements, the bond financed facilities do not have too much “private business use.” In the case of governmental bonds, too much private use consists of more than 10% of the proceeds being used in a trade or business of a private person at the facility in question. In the case of a 501(c)(3), too much private business use consists of more than 5% of the net proceeds. Private business use generally can be found if the private user has special legal entitlements to use the tax-exempt bond financed property, whether through ownership, lease, management contract or other arrangements.

Private business use is use other than as a member of the general public by a non-governmental person or by a 501(c)(3) whose activities at the bond financed facility in question consists of unrelated trade or business. In the context of an ACO operating at a tax-exempt bond financed facility, various participants could be eligible to receive payments under the Shared Savings Program if the ACO meets certain performance standards and achieves savings benchmarks established by Centers for Medicare and Medicaid Services (CMS) against expected average per capita Medicare fee for services expenditures. Consequently, participation in an ACO might be deemed some “other arrangement” that could trigger adverse findings of private business use.

In the Notice, the IRS determined that participation by an Exempt Entity user in the Shared Savings Program through an ACO itself will not result in private business use at the facility in question if the ACO satisfied all of the following conditions:

  1. The term of the user’s participation in the Shared Savings Program are set forth in advance in a written agreement negotiated at arm’s length;
  2. CMS has accepted the ACO and has not terminated the ACO from its Shared Savings Program;
  3. The user’s share of economic benefit derived from the ACO is proportional to the benefits or contributions the user provides the ACO, the ownership interest is proportional and equal in value to its capital contributions to the ACO, and all ACO return of capital, allocations and distributions are made in proportion to such ownership interest;
  4. The user’s share of ACO losses does not exceed the share of ACO economic benefits to which the user is entitled;
  5. All contracts entered into by the user with the ACO and its participants and any other parties are at fair market value; and
  6. The user does not contribute or transfer the financed property to the ACO unless the ACO itself is an Exempt Entity.

The Notice contemplates that Exempt Entities may enter into management contracts (as broadly defined) with nongovernmental persons to provide healthcare services at the Exempt Entities’ tax-exempt bond financed facilities. The Notice contemplates such contracts will take into account the quality performance and Medicare fee-for-service expenditures relevant to participation in the Shared Savings Programs. Similarly, in evaluating whether a management contract (as broadly defined) entered into with an ACO will give rise to private business use, the Notice amplifies Rev. Proc. 97-13. The Notice provides that participation in a productivity reward for services does not cause the compensation to be deemed to be based on a share of the net profits of the financed facility if certain conditions are met. Generally speaking, management contracts which provide for the service provider to share in the facility’s net profits are prohibited. Nevertheless, under the Notice, participation in a productivity reward for services will not be deemed to be a sharing in the net profits of the enterprise in question as long as:

  1. The eligibility for the productivity award is based on the quality of the services provided under the management contract (for example, achievement of the Medicare Shared Savings Program quality performance standards or meeting the data reporting requirements); and
  2. The amount of the productivity award is a stated dollar amount, a periodic fixed fee or a tiered system of stated dollar amounts or periodic fixed fees based solely on the level of performance achieved with respect to the applicable measure. Percentage productivity awards as opposed to fixed amounts are not blessed by the Notice! A fixed amount grid may be required rather than a percentage mechanism.

Rev. Proc. 97-13 requires that management contracts with Exempt Entities must be described in specific subsections of section 5.03 of Rev. Proc. 97-13 to be a contract that does not give rise to private business use. The Notice amplifies Rev. Proc. 97-13 by adding a new section 5.03(7) which permits a contract with a term of five years or less (including all renewal options) to have compensation based on a stated amount; periodic fixed fee; a capitation fee; a per unit fee; or a combination of the preceding. The compensation for services also may include a percentage of gross revenues, adjusted gross revenues, or expenses of the facility (but not both revenues and expenses). For this contract, a tiered productivity award meeting the requirements discussed above, will be treated as a stated amount or a periodic fixed fee as appropriate. Such a contract is not required to be able to be terminable by the Exempt Entity prior to the end of the term.

The Notice thus provides useful guidance that should allow Exempt Entity healthcare providers and other participants to join an ACO’s Shared Savings Program with assurance that no adverse tax-exempt bond consequences will be encountered as long as the conditions set forth in the Notice are satisfied. In addition, the amplification of Rev. Proc. 97-13 permitting tiered productivity awards and the management agreement described in new section 5.03(7) therein may also present more compensation flexibility in the ACO context and in some non-ACO circumstances as the guidance by its terms is not limited to ACO application.

Basically, participation in a Shared Savings Program is permitted as long as the allocation of the savings are made in proportion to the parties’ capital accounts, and no disproportionate allocations are permitted and no losses in excess of the user’s economic benefit in the ACO are permitted. For facilities with management contracts, it is likely that the amplifications to Rev. Proc. 97-13 made by the Notice will be particularly useful as it provides greater flexibility in structuring service provider compensation arrangements by explicitly permitting the use of a tiered system of fixed dollar compensation. Importantly, the use of tiered fixed percentage compensation is not permitted. The ability to use a sliding scale or grid system based on achievement of the Shared Savings Program quality performance standards or meeting data reporting requirements should provide significantly greater flexibility in determining how service provider compensation can be structured without running afoul of the private activity bond rules.

The Notice applies to exempt bonds sold on or after January 22, 2015 and contracts entered into, materially modified, or extended (other than pursuant to a renewal option) on or after January 22, 2015. The Notice cryptically states that the operative provisions may be applied to bonds sold or contracts entered into before January 22, 2015. Presumably this “before” language means that taxpayers may rely on this guidance for protection for bonds sold before or contracts entered into before January 22, 2015 which meet the requirements. It should not mean that bonds sold or contracts entered into before January 22, 2015 that do not meet the Notice’s requirements are automatically to be challenged by the IRS on the basis that the requirements were not met.

At a time when many Treasury Regulations are trending toward restricting opportunities, the welcomed addition of the tiering structure should prove useful in developing acceptable compensation packages.

For additional information, please contact Alex Buchanan, Leigh Griffith or Don Stuart at 800.487.6380.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.