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IRS Releases Private Letter Ruling Addressing Management Contract with Incentive Payments Related to Net Operating Results

Posted on November 30, 2011 in Health Law News

Published by: Hall Render

On November 10, 2011, the IRS published private letter ruling 2011-45005.  This private letter ruling came to two significant conclusions:

  1. The IRS found that an incentive payment of a fixed dollar amount, payable upon achieving, among other things, a net operating surplus/deficit level, did not give rise to private business use.  (To our knowledge, this is the first time the IRS has considered such an arrangement.)

  2. The IRS confirmed that reimbursement to a service provider for the salaries and associated expenses of a service provider’s employees, where those employees do not have an ownership interest in the service provider, does not constitute compensation to the service provider.

The contract, found by the IRS not to give rise to private business use, was for management of a municipally-owned convention center.  Compensation to the manager consisted of: 1) an annual fixed fee; 2) an incentive fee of a fixed dollar amount not in excess of the annual fixed fee, which is only paid if the service provider meets three requirements, which were: (a) achieving a baseline amount of revenues; (b) achieving a stated net operating surplus/deficit target; and (c) meeting a pre-determined customer satisfaction benchmark; and 3) reimbursement of certain expenses, including employee compensation and related expenses and employee bonuses, which bonuses are based on similar measures as the incentive payments.

The contract was outside the safe harbors of Revenue Procedure 97-13, due to its term of five years and two months and because the incentive payments took into account both revenues and expenses.  Nonetheless, the IRS found that the contract did not, based on all the facts and circumstances, give rise to private business use.  The IRS stated that “the amount of the incentive fee paid to the Manager will not vary depending on the margin of increase in revenues and/or decrease in expenses or be based on a percentage of revenue increases, a percentage of expense decreases, or some combination of both.”  It appears that the IRS was in this case comfortable that payment of a pre-determined incentive amount upon the achievement of certain net operating surplus/deficit levels did not constitute compensation based on a share of net profits from the operation of the facility.

Hospitals and health care systems are increasingly seeing their reimbursements tied to quality of outcomes and cost control.  Hospitals and health care systems are in turn incentivizing private physicians and other service providers to achieve quality and cost control benchmarks.  Incentive contracts between hospitals and non-employed doctors operating in space financed with tax-exempt bond proceeds often raise private business use concerns.  While private letter rulings may not be relied on as precedent, this private letter ruling provides some additional guidance from the IRS for how service providers, including physicians, might be incentivized to achieve certain operating results without giving rise to private use of a hospital’s bond-financed assets.

While this private letter ruling provides an example of a permitted incentive payment structure, health care providers should proceed with caution in this area.  Most service and management contracts that include incentive payments will continue to be outside the safe harbors of Revenue Procedure 97-13, and so all service and management contracts that include incentive payments for service providers (including private physicians not employed by the hospital or health care system) should be carefully crafted and thoroughly vetted by qualified bond counsel.

Action Steps for Hospitals and Health Care Systems

  • Review existing incentive payment contracts for private business use.

  • Consider what service or management contracts would benefit from incentive payment features and discuss the feasibility of such arrangements with bond counsel.

  • When considering participation in bundled payment, shared savings or other alternative payment arrangements, discuss with bond counsel how the associated service provider agreements may create private business use.

How Hall Render Can Help

  • We can assist in reviewing service agreements and management contracts for private business use.

  • We can assist in negotiating, drafting and amending service and management contracts to minimize private business use, while incentivizing quality and efficiency by service providers, including private physicians.

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