The IRS recently issued new guidance on safe harbor provisions in management contracts for publicly-owned, bond-financed properties. These safe harbor provisions affect a variety of real estate assets including hotels and other privately managed public properties.
On August 22, 2016, the IRS issued Revenue Procedure 2016-44, which provides new guidance on safe harbor provisions for management contracts for properties financed with tax-free government bonds. The new regulations loosen requirements under the previous guidance in Revenue Procedure 1997-13, as amended. These new regulations will have a large impact on publicly-financed hotels, which are commonly operated under management contracts by popular hotel brands.
Many municipalities look to finance the construction of public projects with bonds. These government bonds are tax-exempt to the bondholders because the project serves a public purpose and is owned by a qualified user (depending on the project, either a governmental entity or a 501(c)(3) organization). However, owners of these public projects usually retain private management companies to operate them under “qualified management agreements.”
Hotels are often publicly-owned and funded through bond sales to serve other nearby public facilities like airports, convention centers, and stadiums. Many hotels are operated by branded managers under management contracts. For an example of the structure of a manager-managed hotel, see Branded Hotel Management Arrangement Chart.
When a hotel is publicly-owned and financed, it must meet specific IRS requirements so that use of the property is not a private business use (including the management company profiting from the property). A private business use causes the bonds to be taxable. These IRS requirements make negotiation of the hotel management agreement more challenging. Historically, limits on the length of contracts, type of compensation structure, operations, and uses of the property have caused hotel managers to enter into arrangements that vary considerably from what is customary in the hospitality industry. Hotel managers abandoned traditional management agreement terms, such as incentive fee compensation and renewal options, in order to meet IRS guidelines.
The IRS established new safe harbor provisions to provide greater guidance on structuring management contracts to prevent a private business use or other taxable event. The provisions cover important aspects of management contracts including management fees, operating terms, and affiliate contracts.
Rev. Proc. 2016-44 Safe Harbor Provisions and Requirements
The new revenue procedure describes several conditions that, if met by the terms of a management contract, the manager’s role under the management contract is not considered a private business use of publicly-financed property:
- Degree of Control.The owner must retain a significant degree of control over the use of the managed property. This can be satisfied by the owner approving:
- annual budgets;
- capital expenditures;
- dispositions of property;
- rates charged (which can include owner’s approval of the methods for determining rates or requiring that the manager charge reasonable and customary rates); and
- the types of services provided.
- Risk of Loss.The owner must bear the risk of loss if the property is damaged or destroyed. The owner may obtain insurance to satisfy this requirement.
- Contract Term.The management contract must not exceed 30 years or 80% of the economic life of the managed property. Previous IRS safe harbors only applied to contracts for up to 15 years, restricting a manager’s ability to negotiate a longer term. The contract term limit does not include the time before a managed property is placed in service during the design or construction management phase.
- Inconsistent Tax Positions.The management company may not take a tax position inconsistent with its position as a manager. The manager may not realize tax benefits typically reserved for property owners, such as depreciation and amortization.
- Net Profits and Losses; Manager Compensation.The contract may not provide for compensation based on net profits, nor may the manager be responsible for net losses. However, the safe harbor provisions do permit incentive compensation based on performance or productivity triggers. This relaxes the stringent fixed fee arrangement requirement under previous IRS guidance, and instead allows for any reasonable compensation.
- Expense Reimbursement.Payments for eligible expense reimbursements do not lead to a private business use for actual and direct expenses paid to unrelated parties for reasonably related overhead costs.
- The safe harbor provisions limit the circumstances under which the manager and owner have common ownership or control.
- Functionally Related and Subordinate Use.Use of the property that is functionally related and subordinate to performance of services under an otherwise compliant management contract does not result in private business use. The revenue procedure gives the example of using storage areas for equipment used in performing activities under a management agreement. In the past, this might have been questioned as a lease or non-permitted use.
The new safe harbor provisions apply to management contracts entered into on or after August 22, 2016. Issuers and borrowers can elect to apply the new provisions to contracts entered into before August 22, 2016. Issuers and borrowers may also elect to apply the prior safe harbor requirements for management contracts entered into before February 18, 2017.
The new IRS safe harbor provisions are significant because they represent a relaxed posture towards the use of publicly-issued bonds to finance public projects. The new rules allow for:
- Longer term private management agreements.
- Fee arrangements more consistent with standard hotel management agreements.
- These changes may encourage both:
- The use of tax-exempt bonds as a financing method.
- More branded hotel chains managing publicly-financed hotels.
The new revenue procedure will also affect 501(c)(3) charitable organizations, hospitals, public housing, schools, public private partnerships, and various other privately managed organizations funded with government bonds.
Counsel should review, and consider modifying, all management contracts for bond-financed properties to take advantage of the new regulations.
Practical Law Real Estate offers hotel owners and developers, and their counsel, a variety of resources related to hotel property transactions:
- Practice Note, Hospitality Law: Overview.
- Practice Note, Key Issues in Hotel Sales and Acquisitions.
- Standard Document, Hotel Due Diligence and Closing Checklist.
- Standard Document, Hotel Acquisition Due Diligence Request List.
- Standard Clauses, Description of the Property and Excluded Property in a Hotel Purchase and Sale Agreement.
- Standard Clauses, Licenses and Permits (including Liquor License) Clause in a Hotel Purchase and Sale Agreement.
- Standard Clauses, Prorations and Expenses in a Hotel Purchase and Sale Agreement.
- Branded Hotel Franchise Arrangement Chart.
- Branded Hotel Management Arrangement Chart
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