Physician-services contract avoids private business use

Plain-English summary

A state instrumentality issued bonds to finance facilities owned by a nonprofit medical center. A related taxable physician practice used those facilities under a services agreement with the healthcare group that owned the medical center. Although the related-party relationship kept the agreement from fitting one safe harbor in Revenue Procedure 97-13, the IRS examined the full facts and circumstances. It found that the compensation and contract term were permitted and that the physician practice could not substantially limit the healthcare group's ability to exercise its contract rights. The agreement therefore would not create private business use of the bond-financed facilities, provided the healthcare group's chief executive officer did not join the physician practice's board.

Ruling snapshot

• Question: Would the physician-services agreement create private business use of facilities financed with qualified 501(c)(3) bonds?
• Outcome: Approved, conditioned on the healthcare group's chief executive officer remaining off the physician practice's board.
• Key authorities: IRC §§ 141 and 145(a); Treas. Reg. §§ 1.141-3 and 1.150-1; Rev. Proc. 97-13.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201641002 Third Party Communication: None
Release Date: 10/7/2016 Date of Communication: Not Applicable
Index Number: 141.00-00
Person To Contact:
--------------------------------------------------------- ---------------------, ID No. -----------
--------------------------------------------------------- Telephone Number:
------------------------------- ----------------------
-------------------------------------------------------- Refer Reply To:
-------------------------------------- CC:FIP:B5
PLR-100414-16
Date:
July 05, 2016

Legend

Issuer: ------------------------------------------------------------------------------------------

Healthcare Group: ---------------

Medical Group: --------------------------

Medical Center: ------------------------------------------

Clinic: -----------------------------------

State: -----------------------

Bonds: ------------------------------------------------------------------------------------------
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PLR-100414-16

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X: --

Dear -----------------:

This responds to Issuer’s request for a ruling that the Clinic Physicians Service
Agreement (CPSA) described below does not result in private business use of the Bond
proceeds under § 145(a)(2)(B) of the Internal Revenue Code (the Code).
Facts

Issuer makes the following representations. Issuer is an instrumentality of State, that
issues bonds on behalf of State and uses the proceeds to make loans to health and
educational institutions located in State. Issuer loaned the proceeds of the Bonds to
Medical Center, to finance various healthcare facilities in State.

Healthcare Group is a nonprofit corporation formed under the laws of State to
consolidate other entities that constitute an integrated healthcare delivery system.
Healthcare Group directly or through its subsidiaries owns and operates hospitals, a
surgical center, an inpatient rehabilitation facility, home care companies, physician
services, pharmacies, mental health services, insurance companies and a charitable
foundation.
Medical Center is a nonprofit entity described in § 501(c)(3). Medical Center is wholly
owned by Healthcare Group. Medical Center currently owns or controls directly or
through certain affiliates all of the physical assets of Healthcare Group including the
assets financed with proceeds of the Bonds.
Medical Group, a newly formed nonprofit entity described in § 501(c)(3), provides
physician services at healthcare facilities owned by Medical Center. Healthcare Group
is the sole member of Medical Group and appoints the directors of Medical Group.
Following its formation, Medical Group through an intermediary taxable subsidiary
acquired all the outstanding stock of Clinic. Clinic is a taxable wholly-owned physician
practice group managed by a board of 10.
Healthcare Group is controlled by a self-perpetuating board of directors (HG Board)
consisting of 29 individuals elected by the HG Board. Currently three Clinic physicians
serve on the HG Board. Healthcare Group’s by-laws limit the number of Clinic
physician directors to 20 percent of the aggregate number of Healthcare Group

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directors. If the overall board size were to decrease, the number of Clinic physicians
would be adjusted to meet the 20 percent requirement.
A designee of the CEO of Healthcare Group, an employee of the Healthcare Group,
serves directly on the Clinic’s governing board. The designated representative receives
no compensation from Clinic, and has no special status or reserved power beyond that
of any other Clinic Board member. The CEO of Healthcare Group may serve on the
Clinic board in lieu of the designee.

Pursuant to the CPSA, Clinic physicians provide medical services at the facilities of
Healthcare Group, and in turn Healthcare Group provides space, equipment and
supplies necessary for the physicians to serve patients. The stated term of the CPSA is
three years, subject to one-year automatic renewals absent cancelation; either party
may terminate the CPSA by giving 30 days written notice. During the three-year term of
the CPSA, Healthcare Group may not amend or terminate the compensation
arrangement with Clinic physicians without approval by a majority of the Clinic Board of
Directors.

Healthcare Group compensates Clinic for Clinic salaries other than physicians, Clinic’s
third party expenses (including employee benefits) and Clinic physician compensation.
The compensation for Clinic physicians is based on a monthly aggregate of physician
patient billings for that month, adjusted to reflect actual collections, for physician
services at Healthcare Group facilities. Clinic earns no additional fees.

Physician compensation is an aggregate of fixed physician fees, where physicians in
certain practice groups are paid a predetermined amount, and a production model,
under which physician fees are set based on the amount of services provided and the
unit value of those services, as established by the Centers for Medicaid and Medicare
Services (CMS). The CPSA imposes two reasonability tests on physician
compensation to ensure that it is at fair market value. These tests focus on the
physician’s production and collection ratios. If the initially determined compensation
fails either of these two tests, it is adjusted accordingly. Issuer represents that
physician compensation is reasonable. Physicians may also qualify for an annual
bonus if certain quality benchmarks are met. Examples of such benchmarks include:
attendance; good behavior; and favorable patient satisfaction surveys. Physician
bonuses are paid from a bonus pool that is funded by, up to X percent, of the physician
compensation remitted to Clinic.

LAW

Section 103(a) provides that, except as provided in subsection (b), gross income does
not include interest on any State or local bond. Section 103(b) provides that subsection
(a) shall not apply to any private activity bond which is not a qualified bond, within the
meaning of § 141.

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Section 141(a) provides, in part, that the term “private activity bond” means any bond
issued as part of an issue which meets the private business test of § 141(b)(1) and the
private security or payments test of § 141(b)(2); or meets the private loan financing test
of § 141(c). Section 141(b)(1) generally provides that, except as otherwise provided in
this subsection, an issue meets the test of this paragraph if more than 10 percent of the
proceeds of the issue are to be used for any private business use.

Section 141(b)(6)(A) provides, in part, that for the purposes of this subsection, the term
“private business use” means use (directly or indirectly) in a trade or business carried
on by any person other than a governmental unit. Section 141(b)(6)(B) states that for
the purposes of the first sentence of § 141(b)(6)(A), any activity carried on by a person
other than a natural person shall be treated as a trade or business.

Section 141 (e) provides, in part, that a qualified bond means a private activity bond if
the bond is a qualified 501(c)(3) bond.

Section 145(a) provides that for purposes of this part, except as otherwise provided in
this section, the term “qualified 501(c)(3) bond” means any private activity bond issued
as part of an issue if: 1) all property which is to be provided by the net proceeds of the
issue is to be owned by a 501(c)(3) organization or a governmental unit, and; 2) such
bond would not be a private activity bond if; A) 501(c)(3) organizations were treated as
governmental units with respect to their activities which do not constitute unrelated
trades or businesses, determined by applying § 513(a); and B) paragraphs (1) and (2)
of § 141(b) were applied by substituting “5 percent” for “10 percent” each place it
appears and by substituting “net proceeds” for “proceeds” each place it appears.

Section 1.145-2 of the Income Tax Regulations provides that, except as provided in this
section, §§ 1.141-0 through 1.141-15 apply to § 145(a).

Section 1.141-3(b)(4)(ii) provides that for the purposes of this section, a management
contract is a management, service, or incentive payment contract between a
governmental person and a service provider under which the service provider provides
services involving all, a portion of, or any function of, a facility. For example, a contract
for the provision of management services for an entire hospital, a contract for
management services for a specific department of a hospital, and an incentive payment
contract for physician services to patients of a hospital are treated as a management
contract.

Rev. Proc. 97-13, 1997-1 C.B. 632, as modified by Rev. Proc. 2001-39, 2001-2 C.B. 38,
and amplified by Notice 2014-67, 2014-46 I.R.B. 822 (Rev. Proc. 97-13), sets forth
conditions under which a management contract generally will not result in private
business use under § 141(b). Under section 5.02(1) of Rev. Proc. 97-13, the
management contract must provide for reasonable compensation for services rendered
with no compensation based, in whole or in part, on a share of net profits for the
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operation of the facility. Reimbursement of the service provider for actual and direct
expenses paid by the service provider to unrelated parties is not by itself treated as
compensation.

Section 5.02(2) of Rev. Proc. 97-13, states that compensation generally is not treated
as based on a share of net profits if compensation is based on: 1) a percentage of gross
revenues (or adjusted gross revenues) of a facility or a percentage of expenses from a
facility, but not both; 2) a capitation fee; or 3) a per unit fee.

Section 5.02(3) of Rev. Proc. 97-13, states that for purposes of § 1.141.-3(b)(4)(i) and
the revenue procedure, a productivity reward equal to a stated dollar amount based on
increases or decreases in gross revenue (or adjusted gross revenues), or reductions in
total expenses (but not both increases in gross revenues (or adjusted gross revenues)
and reductions in total expenses) in any annual period during the term of the contract,
generally does not cause the compensation to be based on a share of net profits. A
productivity reward for services in any annual period during the terms of the contract
generally also does not cause the compensation to be based on a share of net profits of
the financed facility if: 1) the eligibility for the productivity award is based on the quality
of the services provided under the management contract (for example, the achievement
of Medicare Shared Savings Program quality performance standards or meeting data
reporting requirements), rather than increases in revenue or decreases in expenses of
facility; and 2) the amount of the productivity award is stated dollar amount, a periodic
fixed fee, or tiered system of stated dollar amounts or periodic fixed fees based solely
on the level of performance achieved with respect to the applicable measure.

Section 5.03 of Rev. Proc. 97-13 requires that the compensation and contract term be
limited to one of several permissible arrangements. Section 5.03(7) permits an
arrangement under which all of the compensation for services is based on a stated
amount, a periodic fixed fee, a capitation fee, a per-unit fee, or a combination of the
preceding. The compensation for services also may include a percentage of gross
revenues, adjusted gross revenues, or expenses of the facility (but not both revenues
and expenses). The term of the contract, including all renewal options, may not exceed
five years. Such contract need not be terminable by the qualified user prior to the end
of the term. A tiered productivity award of stated dollars amounts or periodic fixed fee is
treated as a stated amount or a periodic fixed fee, as appropriate.

Section 3.06 of Rev. Proc. 97-13 defines a “per-unit fee” as a fee based on a unit of
service provided specified in the contract or otherwise specifically determined by an
independent third party, such as the administrator of the Medicare program or a
governmental entity or a 501(c)(3) organization.

Section 3.08 of Rev. Proc. 97-13 defines “renewal option” as a provision under which
the service provider has a legally enforceable right to renew the contract. Thus, for
example, a provision under which a contract is automatically renewed for one year
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periods absent cancellation by either party is not a renewal option (even if it is expected
to be renewed).

Section 5.04 of Rev. Proc. 97-13 provides that the arrangement between the service
provider and the governmental person or 501(c)(3) organization must by such that the
service provider does not have any role or relationship with the qualified user that, in
effect, substantially limits the qualified user’s ability to exercise its rights, including
cancelation rights, under the contract, based on all the facts and circumstances.
Rev. Proc. 97-13 provides a safe harbor for this requirement if: 1) not more than 20
percent of the voting power of the governing body of the qualified user in the aggregate
is vested in the service provider and its directors, officers, shareholders and employee;
2) overlapping board members do not include the chief executive officers of the service
provider or its governing body or the qualified user or its governing body; and 3) the
qualified user and the service provider under the contract are not related parties, as
defined in §1.150-1(b).

Section 1.150-1(b) defines related party to mean, in reference to a governmental unit or
501(c)(3) organization, any member of the same controlled group and, in reference to
any person that is not a governmental unit or 501(c)(3) organization, a related person as
defined in § 144(a)(3).

Section 1.150-1(e) defines controlled group as a group of entities controlled directly or
indirectly by the same entity or group of entities. The determination of direct control is
made on the basis of all the relevant facts and circumstances. One entity or group of
entities (the controlling entity) generally controls another entity or group of entities (the
controlled entity) for purposes of this paragraph if the controlled entity possesses either
of the following rights or powers and the rights or powers are discretionary and non-
ministerial: 1) the right or power both to approve and remove without cause a controlling
portion of the governing body of the controlled entity; or 2) the right or power to require
the use of funds or assets of the controlled entity for any purpose of the controlling
entity. If a controlling entity controls a controlled entity then the controlling entity also
controls all entities controlled, directly or indirectly, by the controlled entity or entities.

Analysis

The CPSA has an initial term of three years, and will automatically renew for successive
terms of one year each, unless either party terminates. As provided in section 3.08 of
Rev. Proc. 97-13, a provision under which a contract is automatically renewed for one
year periods absent cancelation by either party is not a renewal option. The three year
term with automatic renewals absent a cancelation, is within section 5.03(7) of Rev.
Proc. 97-13.

The compensation arrangement of Clinic consists of reimbursement of direct expenses
for non-physician salaries, employee benefits, and a direct distribution of physician
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compensation. Other than physician bonuses, physicians are compensated based on
either a per-unit or a capitation basis both of which Rev. Proc. 97-13 permits. Physician
bonuses, triggered by factors other than net profits and based on a share of gross
revenues from physician billings, are also permitted under Rev. Proc. 97-13. Finally,
the issuer represents that physician compensation is reasonable and the CPSA requires
that physician compensation be no greater than its fair market value.

However, the CPSA does not meet the requirements of section 5.04(2) of Rev. Proc.
97-13, because Healthcare Group and Clinic are related parties. Therefore, whether
the CPSA causes private business use of the facilities financed with the Bonds depends
on the facts and circumstances. Because the other elements of Rev. Proc. 97-13 are
satisfied, the only question is whether the parties’ relationship will substantially limit the
Healthcare Group’s ability to exercise its rights under the CPSA.

Although Healthcare Group and Clinic are related parties under § 1.150-1(b),
Healthcare Group is effectively the sole shareholder of Clinic, giving Healthcare Group
ultimate control in the relationship between these two parties. Further, only up to 20
percent of the Clinic physicians may be members of the HG Board. The designee of the
CEO who serves on the Clinic board has no special status or special powers and
represents less than 10 percent of the Clinic board. Consequently, we believe that,
Clinic cannot control Healthcare Group and cannot prevent Healthcare Group from
terminating the CPSA.

Conclusion

Based on all of the facts and circumstances, we conclude that the CPSA meets the
requirements of section 5.04 of Rev. Proc. 97-13, and will not result in private business
use of the Bond proceeds under § 145(a)(2)(B). We expressly condition this
conclusion on the CEO of Healthcare Group continuing not to be a member of the Clinic
Board.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of provides
that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

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The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                        Sincerely,


                                        Associate Chief Counsel
                                        (Financial Institutions & Products)

                                                                         /S/
                                        By:
                                              Timothy L. Jones
                                              Senior Counsel, Branch 5




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