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Davis Brown Tax Law Blog

Certain Management Contracts Can Cause Trouble for Tax-Exempt Bonds - January 10, 2012

The Internal Revenue Service has recently become more proactive regarding its efforts to conduct audits on tax-exempt bond financings and has indicated that issuers and borrowers should maintain and follow post-compliance policies and procedures in order to make sure that the interest on the bonds continues to remain tax-exempt.


One such example where bonds can lose their tax-exempt status is when a 501(c)(3) borrower or a governmental issuer enters into an arrangement with a private party which is a management or incentive payment contract on property that is financed with proceeds of tax-exempt bonds because this may result in private business use.  If the contract is considered a management contract under Regulation ยง 1.141-3 and does not pass the tests under Rev. Proc. 97-13 which make it a qualified management contract, then the contract may cause the bonds to lose their tax-exempt status.


One of the warning signs that a contract may not be a qualified management contract is when a contract provides compensation based in whole or in part on a share of either net profits, gross revenues or gross expenses. Management contracts where compensation is based in whole or in part on a share of net profits are not allowed and there are limitations on the amount of compensation that can be based on a percentage of gross revenues or expenses and on the term of the contract.


If your organization has either entered into or is planning on entering into management or incentive payment contracts on property that is financed with proceeds of tax-exempt bonds, it would be a good idea to review the contract against the Internal Revenue Service rules for qualified management contracts to make sure that such contracts don't trigger the loss of tax exemption on your bonds.