WASHINGTON -- A recent ruling shows that while the Internal Revenue Service has not updated guidance on management contracts to reflect 1986 tax law changes, it is using the changes to determine whether such contracts result in too much private use of bond-financed projects.

In the private letter ruling, which did not identify the parties involved, the IRS concluded that proposed contractual arrangements would not prevent a nonprofit corporation from borrowing tax-exempt 501(c)(3) bonds to finance a large, mixed-use commercial project in an economically distressed area.

The IRS ruled that the contractual arrangements that the nonprofit corporation has with the developer, an affiliated company to the developer, and the managers of the project would not constitute private use of the project under provisions of the Tax Reform Act of 1986.

Under the tax law, no more than 5% of the proceeds of a tax-exempt 501(c)(3) bond issue can be used by anyone other than the governmental unit issuing the bonds or the nonprofit organization borrowing them. Also, any project financed with 501(c)(3) bonds must be owned by a nonprofit organization or a governmental unit.

The tax reform act included more liberal requirements for management contracts with private parties so that such contracts are not deemed to constitute private use of a project if certain conditions outlined in the 1986 act are met. One of the conditions is that the contract is for a team of not more than five years including renewal options.

"One thing a little unusual about this was that there were separate contracts with the developer and with entities related to the developer. For purposes of the ruling, we viewed all of those separate contracts together," said an IRS official.

The IRS also concluded that the 23,000 square feet of the project to be used for commercial purposes would not create too much private use of the project. The borrower had told the IRS that the bond proceeds to be spent on the leased portions of that part of the project would not exceed 3% of the bond issue.

The project, which was to be financed with two separate bond issues, included the commercial space, an apartment complex, a parking garage, and a hotel.

The borrower proposed to enter into an agreement with a company to develop the project. Under the agreement, the borrower would pay the company a fixed fee of about 7% of the costs of each of three phases of construction of the project. To secure its commitment, the borrower would give a second mortgage to the company.

The borrower also proposed to enter into contracts with two companies to manage the projects. The hotel and commercial facilities would be managed by a company not related to any other party in the transaction. The apartment complex and garage would be operated by a corporation affiliated with the developer.

Each of the management contracts would not exceed five years and would not have an automatic renewal option. The borrower would have the right to cancel either of the contracts at the end of a three-year period with or without cause.

The annual compensation for each of the managers would not be based on the net profits of the portion of the project they managed. None of the borrower's board members would be owners, directors, or board members of the project.

The IRS said the letter ruling is directed only at the hospital that requested it and is not to be cited as precedent. But bond lawyers have said that in areas of the tax law where there is no other guidance, the bond community will use letter rulings for help in interpreting the tax law.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.