Revenue Procedure 2017-13: Compensation, Control, and Term Limits

Revenue Procedure 2017-13 lets a state or local government (or a 501(c)(3) borrower) hire a private company to run a bond-financed facility without triggering private business use, as long as the management contract clears five conditions: compensation is reasonable and carries no share of net profits or net losses; the governmental or nonprofit owner keeps meaningful control over the property; the term stays within the lesser of 30 years or 80% of the property’s expected economic life; the manager and owner deal at arm’s length, with the manager’s people holding no more than 20% of the owner’s governing board; and the manager agrees not to take any federal tax position inconsistent with being a service provider. Meet every condition and the IRS deems the arrangement not to be private business use. Miss one and the safe harbor is gone.

Why the Safe Harbor Matters

Interest on state and local bonds is excluded from federal gross income under Section 103 of the Internal Revenue Code.¹ That exclusion disappears if the issue trips the two-part private activity bond test in Section 141: more than 10% of the proceeds used for a private business use, and more than 10% of the debt service secured by or derived from payments tied to that use.²

A management contract can count as private business use even though the government still owns the building. Revenue Procedure 2017-13 carves out a safe zone. Contracts inside it are deemed not to create private business use. Contracts outside it get analyzed under the general facts-and-circumstances rules in Treasury Regulation 1.141-3, which is the uncertainty most bond counsel work hard to avoid.³

What Contracts and Parties Are Covered

The safe harbors reach any arrangement where a private party performs services involving property financed with proceeds of state or local bonds described in Section 103. That includes standard governmental bonds and qualified 501(c)(3) bonds. The label on the paper does not decide the question. Management contracts, operating agreements, and incentive-based service deals all fall within scope, and so do significant modifications of existing agreements. Typical fact patterns: running a municipal hospital, operating a university research facility, managing a public parking garage, handling day-to-day operations at a convention center.

The revenue procedure uses specific labels. The qualified user is the governmental or 501(c)(3) entity that benefits from the tax-exempt financing. The service provider is the private party hired to operate the facility. The managed property is the bond-financed facility, or the portion of it, covered by the contract. Compensation means every payment or financial benefit flowing to the service provider.

One boundary worth noting: an “eligible expense reimbursement arrangement,” where the only payment to the manager is reimbursement of actual direct expenses paid to unrelated third parties plus reasonable overhead, is not treated as private business use at all. Those contracts do not need to run the safe harbor gauntlet.³

Compensation: No Net Profits, No Net Losses

How the manager is paid is the most heavily scrutinized part of any contract. Two overarching rules apply. Every dollar of compensation must be reasonable for the services actually delivered. And the contract cannot give the service provider any share of the facility’s net profits or make the service provider bear any share of its net losses.³ That bright line is what separates a service arrangement from something the IRS would treat more like a partnership or a lease.

Fee structures that fit inside the rule include:

Periodic fixed fees, meaning a stated dollar amount for a stated period (monthly, quarterly, annually).
Capitation fees, a fixed dollar amount per person served during each period.
Per-unit fees tied to each unit of service delivered, such as a stated amount per medical procedure, per car parked, or per passenger mile. The unit has to be specified in the contract or set by an independent third party like Medicare.
A percentage of gross revenues, adjusted gross revenues, or expenses, as long as no single element of compensation uses both revenues and expenses in the same fiscal period. A revenue-based fee alone is fine. An expense-based fee alone is fine. Combining them so the math effectively tracks net profit is not.
Incentive compensation tied to quality, efficiency, or performance standards, such as hitting patient-satisfaction benchmarks or beating an energy-cost target. The eligibility, amount, and timing of the incentive cannot be linked to net income.

A per-unit fee does not lose safe harbor treatment just because it automatically adjusts with an external index like the Consumer Price Index, so long as the index is not tied to the output or efficiency of the managed property itself.³

How Expense Reimbursements Are Counted

Reimbursements of actual expenses that the service provider pays to unrelated third parties get special treatment. When the IRS looks at whether a fee arrangement effectively shares net profits, it excludes those third-party reimbursements from the calculation. In practice, a contract can reimburse the manager for outside vendor invoices, utility bills, and similar direct costs without those payments contaminating an otherwise compliant fee structure.³

The Net Losses Side

The mirror image of the net-profits ban is a prohibition on making the service provider absorb net losses. A contract fails if the manager’s pay contracts based on the facility’s overall losses, because that economic exposure looks like ownership. A contract can, however, dock the manager’s fee by a stated dollar amount when a specific expense target is missed. The line runs between accountability for defined performance metrics, which is fine, and general downside risk tied to the facility’s bottom line, which is not.³

Control the Qualified User Must Retain

The qualified user has to exercise meaningful control over how the bond-financed property is used. The contract must require the qualified user to approve five things:³

The annual operating budget for the managed property.
Capital expenditures. Approval can come as a budget organized by functional purpose with maximum amounts, rather than line-by-line sign-off on each purchase.
Dispositions of property that are part of the managed property.
Rates charged for use of the property. The qualified user can approve specific rates, approve a general methodology, or require the manager to charge rates that are reasonable and customary as determined by an independent third party such as a medical insurance company.
The general nature and type of use of the managed property. A hospital stays a hospital; a parking garage stays a parking garage.

The relationship also has to look arm’s length in fact, not just on paper. The service provider’s directors, officers, shareholders, partners, members, and employees cannot make up more than 20% of the voting members of the qualified user’s governing board. The rule closes an obvious loophole: a manager with enough board seats could approve its own budget and its own fee, which is exactly the separation the safe harbor depends on.³

Maximum Term, Including Renewals

The contract term, counting every renewal option, cannot exceed the lesser of 30 years or 80% of the weighted average reasonably expected economic life of the managed property. Economic life is measured at the start of the contract term using the same method as Section 147(b) of the Internal Revenue Code.³

Land has its own rule. If 25% or more of the net bond proceeds are used to finance land costs, that land is treated as having a 30-year economic life. For a facility built on bond-financed land, this can cap the weighted average life and, with it, the maximum contract term.

Renewal options are the trap. The IRS counts every renewal period toward the maximum. A 20-year contract with two 10-year renewal options is a 40-year contract for safe harbor purposes, and 40 exceeds 30. Read every optional extension in the draft and add them up before signing.

The Manager’s Tax-Position Promise

The service provider must agree not to take any federal tax position inconsistent with being a service provider. In practice, that means no claiming depreciation or amortization on the managed property, no investment tax credits related to it, and no deducting any payments as rent.³ Those tax benefits belong to owners. A manager who tried to claim them would be telling the IRS the deal is really a lease.

If You Miss the Safe Harbor

Falling outside the safe harbor does not automatically make the bonds taxable. It means the issuer loses the bright line and has to defend the contract under the facts-and-circumstances test in Treasury Regulation 1.141-3. If that analysis shows the bonds have actually crossed into private activity bond territory, two correction paths exist.

Treasury Regulation 1.141-12 provides remedial actions for violations caused by deliberate actions. The main options are redemption or defeasance of the nonqualified bonds within 90 days; alternative use of disposition proceeds within two years if the property is sold for cash; and redirecting the facility itself to a qualifying use, such as shifting operations from a private manager to a 501(c)(3). Done properly and on time, these actions preserve tax-exempt status for the remaining bonds.⁴

When the regulatory remedies do not fully solve the problem, issuers can approach the IRS through the Voluntary Closing Agreement Program. VCAP lets the issuer negotiate a settlement and preserve tax-exempt status going forward. The IRS generally requires that any nonqualified bonds be redeemed before it will execute the agreement, and the settlement payment reflects the federal tax revenue lost during the violation period.⁵

Effective Date and the Retroactive Election

Revenue Procedure 2017-13 applies to any management contract entered into on or after January 17, 2017. Issuers may also elect to apply it retroactively to contracts signed before that date.³ The retroactive option matters for older deals that were built around the compensation-and-term matrix in Revenue Procedure 97-13. If the older contract already satisfies the 2017-13 conditions, the issuer can rely on the newer safe harbor going forward without renegotiating the agreement. Records that support the position, including the contract itself and documentation of how the property has been used, should be kept for as long as the bonds are outstanding and for three years after final redemption.⁶

1
Office of the Law Revision Counsel. 26 USC 103 – Interest on State and Local Bonds
2
Office of the Law Revision Counsel. 26 USC 141 – Private Activity Bond; Qualified Bond
3
Internal Revenue Service. Revenue Procedure 2017-13
4
eCFR. 26 CFR 1.141-12 – Remedial Actions
5
Internal Revenue Service. Model Closing Agreements for VCAP and Examinations
6
Internal Revenue Service. Tax Exempt Bond FAQs Regarding Record Retention Requirements