The Internal Revenue Service is moving toward a more flexible approach when evaluating contacts between tax-exempt entities—such as many hospitals—and private, for-profit entities such as radiology groups.

With the release of IRS Rev. Proc. 2016-44, the IRS is replacing Rev. Proc. 97-13 with a new approach for hospital bond counsel to evaluate contacts like radiology group-hospital professional services agreements to assure they do not constitute impermissible “private activity” use of tax-exempt bond financed properties.

The current IRS regulations restricting the term of professional service agreements or management contracts between tax-exempt hospitals and hospital-based physicians have been in place for almost 20 years. In 1997, the IRS issued Revenue Procedure 97-13 on qualified tax-exempt bonds that sets precise term lengths for certain management, service, or incentive payment contracts with tax-exempt hospitals in order to safeguard against the private use of tax-exempt property. The rules mandate certain term lengths, depending on the percentage periodic fixed fee arrangement and the percentage of compensation for services on an annual basis.

Paul W. Pitts, Partner, Reed Smith, Life Sciences Health Industry Group

For purposes of the 1997 rules, separate billing arrangements between physicians and hospitals have been treated generally as per-unit fee arrangements. (A "per-unit fee" is based on a unit of service provided specifically in the contract or otherwise determined specifically by an independent third party, such as the administrator of the Medicare program.) The term of such contract, including all renewal periods, must not exceed three years, and the contract must be terminable by the hospital on reasonable notice, without penalty or cause, at the end of the second year of the contract term. Although excluded from the original three-year term, a contract could include a provision allowing automatic renewal for one-year periods absent cancellation by either party.

Under this new rule, the IRS will now permit fixed or variable compensation for services provided pursuant to a management contract with a term of up to the lesser of 30 years or 80 percent of the weighted average reasonably expected economic life of the tax exempt property.  Consequently, tax-exempt hospitals may no longer assert that hospital professional service contracts cannot exceed two or three years. And these contracts need no longer require that a three-year contract be capable of termination without penalty or cause or reasonable notice at the beginning of the third year of the three-year agreement.

Certain aspects of Rev. Proc. 97-13 remain, but these features should rarely impact radiology group-hospital contracts. For example, the radiology group must not have any role or relationship with the tax-exempt hospital that, in effect, substantially limits the hospital’s ability to exercise its rights under the contract, based on all the facts and circumstances.

Under the safe harbor, a private entity such as a radiology group will not be treated as having prohibited a role or relationship if:

1. No more than 20 percent of the voting power of the governing body of the hospital in the aggregate is vested in the directors, officers, shareholders, partners, members, and employees of the contracted group;
2. The governing body of the qualified user does not include the chief executive officer of the group or the chairperson (or equivalent executive) of the group’s governing body; and
3. The chief executive officer of the private entity like a radiology group is not the chief executive officer of the hospital or any of the hospital’s related parties.

The safe harbors in the new revenue procedure apply to any management contract that is entered into on or after August 22, 2016, and a hospital may apply the new safe harbors to any management contract that was entered into before August 22, 2016. However, the hospital may continue to apply the provisions of Rev. Proc. 97.13 if the contract is entered into before August 18, 2017 and is not materially modified or extended on or after that date.

So, bottom line: hospital bond counsel will no longer scrutinize the term and termination provisions of exclusive radiology contracts. Similarly, counsel for radiology groups will no longer have to consider whether a separate billing or contacts with reassignment and payment to the radiology group falls into a particular category that limits the duration of the contract.

Hospitals may, for business reasons, continue to resist five-year or longer exclusive contracts. But they can no longer point to IRS rules relating to private activity use as justification for relatively short-term contracts.