UNDERSTANDING PRIVATE BUSINESS USE OF TAX EXEMPT BONDS. Presented by: Caleb Lansky, BLX Group

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1 UNDERSTANDING PRIVATE BUSINESS USE OF TAX EXEMPT BONDS Presented by: Caleb Lansky, BLX Group

2 PRIVATEBUSINESS USE OVERVIEW AND EXCEPTIONS The hardest thing to understand in the world is the income tax. Albert Einstein 2

3 POST ISSUANCE COMPLIANCE OVERVIEW Post issuance tax compliance begins with the debt issuance and requires a continuing focus on investment of bond proceeds and use of bond financed property. After the Bonds Are Issued Then What? Advisory Committee on Tax Exempt and Governmental Entities

4 PRIVATE BUSINESS USE OVERVIEW 501(c)(3) Bond Requirements At least 95% of the net proceeds of the bond issue must be used in a manner related to the exempt purposes of the Section 501(c)(3) organization No more than 5% of the net proceeds of the bond issue can be used for a private business use or an unrelated trade or business use For this purpose, costs of issuance of the bonds paid with bond proceeds are treated as a private business use All bond financed property must be owned by a 501(c)(3) organization or State or local governmental unit 2% costs of issuance limit 4

5 PRIVATE BUSINESS USE OVERVIEW Governmental Bond Requirements Generally, at least 90% of the proceeds of the bond issue must be used for governmental purposes Aggregate private business use generally cannot exceed the lesser of 90%, 95% or $15 million Costs of issuance of the bonds paid with bond proceeds are not treated as a private business use 5

6 PRIVATE BUSINESS USE OVERVIEW $800 million governmental bond issue Par Amount $800 million $800 million $800 million Tax Code Limit 10% 5% $15 million Maximum PBU $80 million $40 million $15 million Need to be mindful of this lesser of concept 6

7 PRIVATE BUSINESS USE OVERVIEW Basic Tax Analysis in Governmental Bond Financings Are the bond financed assets used by members of the general public? Does a party other than a State or Local Government agency or entity have a special legal entitlement to use the bond financed assets? Private business use can arise under a management contract even if the assets serve the general public Use of bond financed assets by a charitable organization (e.g., a Section 501(c)(3) organization) will generally give rise to private business use Contracts with the federal government will generally give rise to private business use 7

8 PRIVATE BUSINESS USE OVERVIEW 501(c)(3) Bonds and Private Business Use Use of bond financed property by other than a 501(c)(3) organization or a state or local government Examples: Leases to for profit entity Certain management contracts with for profit entity Certain sponsored research contracts with for profit entity In these examples, the trade or business is provided rights to the facility (i.e., a special legal entitlement) 8

9 PRIVATE BUSINESS USE OVERVIEW Unrelated Trade or Business Use Use of bond financed property by a 501(c)(3) organization in an unrelated trade or business activity For tax exempt bonds the focus is activity Unrelated trade or business use involving bond financed property will generally constitute private business use even if it does not give rise to a tax payment for unrelated business use 9

10 PRIVATE BUSINESS USE OVERVIEW Contracts that may give rise to private business use include: Management Contracts Gift Shop / Bookstore Contracts Physician / Physician Group Contracts Food Service / Concession / Cafeteria Contracts Parking Management Contracts Research Contracts Federal Business Sponsored 10

11 PRIVATE BUSINESS USE OVERVIEW Contracts that will generally give rise to private business use: By definition, a lease will almost always create private business use. Common Examples: Cafeteria Contracts Pharmacies Physician Office Spaces Gift Shops Corporate Events Solar Panels Cell Phone Antennas 11

12 PRIVATE BUSINESS USE OVERVIEW Many so called management contracts are in fact leases If someone is paying you rent ($) or splitting profits ($) from an operation in bond financed space they are not generally treated as a manager under the tax rules 12

13 MANAGEMENT & SERVICE CONTRACTS Why do Some Management Contracts Give Rise to Private Business Use? They represent a transfer of control or economic benefit from the owner to a private party They provide a special legal entitlement to use bond financed property 13

14 MANAGEMENT & SERVICE CONTRACTS Management Contract Guidelines Rev. Proc and IRS Notice Safe harbor contractual requirements that if met, the contract does not cause private business use Sharing or splitting of net profits is never permitted under the management contract guidelines 14

15 MANAGEMENT & SERVICE CONTRACTS Management Contract Guidelines Rev. Proc and IRS Notice Types of Compensation Arrangements addressed: fixed fee capitation fee per unit fee percentage of revenue or variable rate various combinations thereof Duration of contract Long term agreements are required to have larger portion of fixed compensation 15

16 MANAGEMENT & SERVICE CONTRACTS Contracts for a Term of 5 Years or Less IRS significantly relaxed rules for management contracts with a term of 5 years or less Compensation based on stated amount, periodic fixed fee, capitation fee, per unit fee, percentage of gross revenues, adjusted gross revenues, or expenses (or any combination of the foregoing) are permitted The contract need not be terminable by the governmental unit/501(c)(3) entity prior to the end of the term 16

17 MANAGEMENT ANDSERVICE CONTRACTS SAFEHARBORS Compensation to Service Provider Maximum Term* under Rev. Proc Maximum Term* under Notice At least 95% periodic fixed fee (e.g., $95 per year fixed fee, with possibility of up to $5 variable additional comp) 15 years No change At least 80% periodic fixed fee (e.g., $80 per year fixed fee, with possibility of up to $20 variable additional comp) 10 years No change At least 50% periodic fixed fee (e.g., $50 per year fixed fee, with possibility of up to $50 variable additional comp) Capitation fee (e.g., per patient fee for medical services) or mix of fixed fee and capitation fee 5 years and cancellable without cause no later than end of 3rd year No change Per unit fee (e.g., $x for each service provided) or a mix of per unit fee and periodic fixed fee (e.g., $y for each service provided, plus $x per year) % of gross revenues, % of adjusted gross revenues, or % of expenses 3 years and cancellable without cause no later than end of 2nd year 2 years and cancellable without cause no later than end of first year 5 years, no cancellation requirement Compensation based on a stated amount;** periodic fixed fee; a capitation fee; a per unit fee; or a combination of the preceding. Compensation may also include a % of gross revenues, adjusted gross revenues, or expenses of the facility (but not both revenues and expenses). Not a Safe Harbor under Rev. Proc years, no cancellation requirement *The maximum term of the contract also cannot exceed 80% of the useful life of the assets. **Includes a productivity award if (a) eligibility for the productivity award is based on quality of services rather than increases or decreases in revenue in expenses of the facility; and (b) 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 level of performance achieved with respect to the applicable measure. 17

18 PRIVATE BUSINESS USE EXCEPTIONS Incidental Contracts or Arrangements Janitorial services Equipment repair Billing activities or similar services Landscaping 18

19 PRIVATE BUSINESS USE EXCEPTIONS Short Term Use 50 Day Exception for Leases Term of use pursuant to the contract, including renewal options, is not longer than 50 days Note, focus is on total use days not term of contract The contract is a negotiated arm s length arrangement and compensation is at fair market rule The property is not financed for a principal purpose of providing that property for use by that party *Short term use exceptions do not apply to unrelated activities of the 501(c)(3) organization 19

20 SPONSORED RESEARCH CONTRACTS Under Tax Rules, Sponsored Research Contracts May Give Rise To Private Use of Bond Financed Property Trend in governmental and non profit organizations to undertake more research activities The sponsor of the research can vary: NIH Other federal government Private biotech company Pharmaceutical company 501(c)(3) State or local government 20

21 SPONSORED RESEARCH CONTRACTS Research Contract Guidelines Rev. Proc Permits certain types of sponsored research to be conducted within bond financed space without research being treated as private business use Applies only to basic research any original investigation for the advancement of science not having a commercial objective 21

22 SPONSORED RESEARCH CONTRACTS Safe Harbor 1 The sponsor may have exclusive use and ownership of the license or resulting technology The price paid by the sponsor must be determined at the time the license or other resulting technology is available for use (must pay fair market value) 22

23 SPONSORED RESEARCH CONTRACTS Safe Harbor 2 Title to any product produced by research lies exclusively with the 501(c)(3) organization Sponsor(s) gets only a non exclusive, royalty free license to use product of that research Generally covers NIH/Bayh Dole Act research the rights of the federal government, including march in rights, mandated by the such act will not in and of themselves cause a research agreement to fail the safe harbor 23

24 PRIVATE BUSINESS USE OVERVIEW What you need to know to determine private business use Who is using the facilities employees, students, outside groups, research agreements, management contracts, short term use How contracts relating to use are structured safe harbor compliant? Any leases of space? Has any portion of the bond financed property been sold Specifically, how bond proceeds were expended buildings/facilities/equipment 24

25 PRIVATE BUSINESS USE OVERVIEW Bond Proceeds Expenditures Bond requisitions often don t categorize expenditures in a manner conducive to calculating private business use. A specific, perhaps more deliberate accounting may be necessary How much bond proceeds went to project/building A? B? C? How much in other sources went to the same projects/buildings? 25

26 HOW TO MEASURE PRIVATE BUSINESS USE Fundamentals Identify each bond issue that financed or refinanced property For Schedule K purposes, only consider bonds that were issued after 12/31/02 Identify other funds that financed property Identify any allocations of bond proceeds and equity to specific portion of financed property Is such allocation supported by a timely written allocation Who uses space within that property? How much space are they using and for how long? Is that use private business use or unrelated trade or business use? 26

27 HOW TO MEASURE PRIVATE BUSINESS USE Annual Reporting Requirements v. General Tax Principles Schedule K private business use activities measured over a 12 month reporting period (annual snap-shot) Federal Tax Principles private business use activities measured over the entire life of the bonds, plus any refunding bonds Observation A bond issue could have a high level of private business use for Schedule K purposes while at the same time remaining in compliance under general federal tax law principles 27

28 HOW TO MEASURE PRIVATE BUSINESS USE Annual Reporting Requirements v. General Tax Principles 28

29 HOW TO MEASURE PRIVATE BUSINESS USE Under the applicable tax regulations, the measurement of private business use must be reasonable Determining what method is most appropriate requires professional judgment Square footage Time of use Time/space analysis Revenues 29

30 PRIVATE BUSINESS USE OVERVIEW How to Avoid Trouble in Your Bond Financing Review management contracts annually Adopt uniform contract if possible Seek outside tax help as required Create a research intake protocol Categorize agreements as either qualified or non qualified Seek outside tax help as required Work with outside provider to assist with annual measuring private business use/unrelated trade or business use and Schedule K preparation Update and review written post issuance policies 30

31 IDENTIFICATION AND CORRECTION OF TAX VIOLATIONS Violations identified through: Annual review of management/service/research contracts Annual private use analysis Annual arbitrage rebate analysis Annual Schedule K review and analysis 31

32 IDENTIFICATION AND CORRECTION Various self help remedies are available in the event of violations relating to: Excess private business use limits on bond financed property Sale of bond financed property OF TAX VIOLATIONS 32

33 IDENTIFICATION AND CORRECTION OF TAX VIOLATIONS Self help actions include: Defeasance of a portion of the bonds Bonds retired within 90 days of deliberate action; or Defeasance escrow established within 90 days of the deliberate action In all cash sale, using the sale proceeds of the bond financed asset for another qualified purpose within 2 years of the date of the sale IRS Voluntary Closing Agreement Program When self help is not available 33

34 FINAL THOUGHTS With private business use and bond compliance in general, preparation and maintenance is key Understand what is required, what must be monitored Develop processes Delegate Build your team Seek outside help when necessary via Tax Counsel, 3 rd party, etc. Execute 34

AHLA: Tax Issues for Healthcare Organizations. Tax-Exempt Bonds, Schedule K and Preparing for IRS Private Business Use Examinations

AHLA: Tax Issues for Healthcare Organizations Tax-Exempt Bonds, Schedule K and Preparing for IRS Private Business Use Examinations October 15-16, 2012 Now, tell me exactly how you got these Schedule K