Management contracts for public facilities

October 01, 2016 | By Keith Martin in Washington, DC

Municipalities have greater flexibility to negotiate terms with private companies to operate and maintain municipal facilities after new guidelines the IRS issued in late August.

Municipalities that issue tax-exempt bonds to finance schools, roads, hospitals and other public facilities must be careful not to allow more than 10 percent “private business use” of the facilities or the bondholders could end up having to pay taxes on the interest they receive on the bonds.

Hiring a private company to operate and maintain a public facility can be private business use, depending on the terms of the management contract.

This is potentially an issue for any facility owned by a municipality. However, it is not an issue for facilities that are financed with “private activity bonds.” Such facilities are already considered to have too much private business use, so the content of a management contract with a private party is irrelevant.

The new guidelines are in Revenue Procedure 2016-44.

A management contract with a private party will not be considered “private business use” of a public facility if the contract is purely for incidental services, like janitorial services, office equipment repair, billing, payroll or similar tasks.

It is also not private business use for a private party to manage utility-type property if the private party is merely reimbursed for its direct expenses plus reasonable administrative overhead.

In all other cases, the management contract must comply with the following guidelines to avoid being labeled a form of private business use.

The compensation paid to the private party must be reasonable in amount. Thus, the municipality should not pay more than other parties are charging for the same services. The amount does not have to be the lowest bid.

The contract cannot tie the contractor’s compensation to profits or losses. Thus, the contractor cannot share in profits. It cannot be paid less or have its compensation deferred if there are losses. However, a penalty for failure to keep expenses below specified targets is okay. The dollar amount of penalty should be set in advance in the contract. It can be a range of dollar amounts and expense targets.

The contract cannot have a term longer than 80 percent of the expected economic life of the facility or 30 years, whichever is shorter.

The municipality must retain a “significant degree of control” over use of the facility. It must approve annual budgets and capital expenditures, dispositions of any parts of the facility, and the rates charged for the electricity, steam or other output.

The municipality must bear the risk of loss to the facility from a casualty or other event outside the control of the contractor.

The contractor cannot have a role in the project company—for example, director positions that give it more than 20 percent of the vote or a board role for the contractor’s CEO or board chairman—that might undermine the ability of the municipality to enforce the management contract.