Revenue Procedure 97-13 and New Management Contract Rules

Governmental entities and certain non-profits, like hospitals or universities, use tax-exempt bonds to build facilities. Because the interest paid to bondholders is free from federal income tax, these organizations can borrow money at lower rates. To maintain this benefit, financed facilities must serve a public purpose. The Internal Revenue Service (IRS) provides “safe harbor” guidelines for management contracts with private companies to avoid being classified as improper “private business use,” which could jeopardize a bond’s tax-exempt status. For two decades, Revenue Procedure 97-13 set these rules, but today Revenue Procedure 2017-13 provides the primary guidance.

Understanding Private Business Use

State and local governments issue tax-exempt bonds to fund public projects like schools and hospitals at a reduced borrowing cost. This tax advantage is a federal subsidy for public works, and the core principle is that facilities built with it should be used for public benefit. The IRS becomes concerned when these facilities are used by a private, for-profit entity in its trade or business, an activity defined as “private business use.”

Under Section 141 of the Internal Revenue Code, limits are placed on this activity. Generally, if more than 10% of the bond proceeds are used by a private business, and more than 10% of the debt service is paid from property used in that business, the bonds are reclassified as “private activity bonds.” Unless these bonds meet further qualifications, the interest they pay becomes taxable, eliminating the issuer’s borrowing advantage. This can have significant financial consequences for the public entity.

For example, a city that issues tax-exempt bonds to build a new convention center cannot structure a management contract in a way that the private manager shares in the net profits and operational control. If it does, the IRS may view this as private business use, as the public facility would be functioning more like a private enterprise. The rules are designed to prevent such scenarios.

The regulations scrutinize any arrangement that gives a private entity special legal entitlements to use the financed property that are not available to the general public. This includes not only management contracts but also leases and other service agreements. The focus is on the substance of the arrangement, not just its label.

Permissible Management Contracts Under Revenue Procedure 97-13

Revenue Procedure 97-13 established structured safe harbors for management contracts to avoid being classified as private business use. The guidance created a direct link between the type of compensation paid to a private manager and the maximum allowable length of the contract. This framework was designed to prevent the service provider from having an economic interest that resembled ownership, such as sharing in the facility’s net profits or bearing the risk of its net losses. A formula based on net profits was strictly forbidden.

Compensation and Contract Term Limits

The rules created several distinct categories of permissible arrangements. For contracts with a term of up to five years, compensation had to be structured as a periodic fixed fee or a capitation fee, where the manager received a fixed amount per person served, a common model in healthcare settings. A third option was a per-unit fee, where compensation was tied to a unit of service, like a fee per car parked, but this was limited to a three-year contract term.

The procedure allowed for limited arrangements where compensation was tied to the facility’s financial performance, but these had even shorter contract durations. A contract with a term of up to three years was permitted if at least 80% of the manager’s annual compensation was based on a fixed fee. For contracts lasting only up to two years, the fixed-fee requirement dropped to 50%. In these arrangements, the variable portion of the compensation could be based on a percentage of the facility’s gross revenues or a percentage of its expenses, but not a combination of both. The procedure did allow for certain productivity rewards, such as a stated dollar amount for increasing gross revenues or reducing expenses, but not for achieving both in the same period.

Control and Termination

Beyond compensation, Revenue Procedure 97-13 mandated that the public entity retain a significant degree of control over the managed facility. This included the right to approve the annual budget, capital expenditures, and the rates charged to the public. The contract also had to give the qualified user the right to terminate the agreement without penalty at the end of a specified period, typically after three years for a five-year contract. These formulaic requirements provided a clear but narrow path for compliance, often failing to accommodate more complex partnership models.

The Modern Framework of Revenue Procedure 2017-13

Recognizing the limitations of its predecessor, the IRS issued Revenue Procedure 2017-13, which now provides the primary safe harbor guidance for management contracts. This framework supersedes the formula-based rules of 97-13, replacing them with a more flexible, principles-based approach. The shift reflects that modern management arrangements often involve more nuanced risk-sharing and performance incentives.

A significant change is the elimination of the specific compensation formulas tied to contract length. Under the new guidance, the core requirement is that the private manager receives only “reasonable compensation” for the services rendered. The contract must not provide the service provider with a share of the net profits from the operation of the facility, nor can it impose the burden of bearing any net losses.

This updated procedure extends the potential length of a management contract. The maximum allowable term is now the lesser of 30 years or 80% of the reasonably expected useful economic life of the managed property. This allows for long-term, stable partnerships, which are often necessary for large-scale infrastructure projects.

The new rules also clarify what does not constitute a share of net profits. Arrangements based on a percentage of gross revenues or incentive fees based on meeting quality or performance standards are permissible. The service provider must agree in the contract not to take any tax position inconsistent with its role as a service provider, such as claiming depreciation on the managed property.