IRS Ruling on Hotel Management Contract Shows Leniency

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WASHINGTON – The Internal Revenue Service ruled that a management contract between a bond issuer and the manager of a hotel who receives incentive fees based on gross revenue will not result in private business use that could jeopardize the tax-exempt status of the bonds.

Some bond lawyers said the recently published private letter ruling may indicate the IRS is becoming more lenient in its stance on fees paid under management contracts.

Management contracts can lead to private business use that may cause bonds to become taxable if service compensation is based on a share of the net profits.

The ruling, which did not identify the parties involved, concluded that neither the base fee nor the incentive fee would be based on net revenues, but would instead be based on gross revenues. Although a portion of the incentive fee in question in the ruling was a result of a variant of net profits, IRS counsel concluded the fee is not based on a share of the net profits.

An incentive fee differs from the base fee because it is contingent on a variant of net profits and the RevPar test, which is based solely on revenues. RevPAR is performance metric in the hotel industry, which is calculated by multiplying a hotel's average daily room rate by its occupancy rate. It may also be calculated by dividing a hotel's total guestroom revenue by the room count and the number of days in the period being measured.

IRS officials found that the amount paid as an incentive fee was a "predetermined, fixed percentage of gross revenue."

"Despite being partly triggered by a variant of net profits … the incentive fee is not structured in such a way that its amount rises in proportion to increase in the hotel's net profits or falls in proportion to decreases in the hotel's net profits," IRS officials wrote in their ruling.

Harold Bucholtz, a partner with Holland & Knight in Washington, called the letter ruling "significant," but said its impact could be only temporary. The IRS and Treasury have said over the past two years they intend to publish successor guidelines to Revenue Procedure 97-13, he said, adding that IRS officials have indicated that new management contract guidelines could be close to being published.

"As helpful as the private letter ruling is, there's a good chance it will be effectively superseded by new guidelines in the near future," Bucholtz said. "I think everyone agrees that one ruling at a time isn't the answer – something more generalized is most likely coming out."

Bucholtz said the analysis in the most recent private letter ruling may foreshadow the more "liberal" direction the IRS and Treasury are headed in terms of hotel management contracts.

"This indicates the IRS is less concerned today that some portion of the management fee is fixed than it was when it wrote 97-13," Bucholtz said.

The IRS' Revenue Procedure 97-13, released in 1997, states that management contracts of five-to-ten years require 80% of the annual compensation be paid to a manager as a fixed amount, while the other 20% can be incentive based on gross revenues. In 15-year contracts, 95% has to be a fixed fee and only 5% can be a variable amount.

Bucholtz said he believed that the bond issuer - the hotel owner - sought the most recent ruling as a way to deviate from paying a fixed fee during times when the hotel may be underperforming. A typical hotel contract, he said, is more than five years and the manager typically would like to get the maximum of 15 years under current guidelines.

In October 2014, the IRS issued new rules adding an additional safe harbor for management contracts if the contract is five years or less and payment for services is based on a stated amount or a fixed, capitation or per-unit fee.

Similar to this private letter ruling, the 2014 management contract rules determined that service compensation could also be based on a percentage of gross revenues or adjusted gross revenues, but not both revenues and expenses.

In November, the National Association of Bond Lawyers sent a letter to the IRS and Treasury recommending that existing safe harbors for management contracts of greater than five years be expanded. The group recommended additional frameworks for safe harbors not based on fixed fees.

The group also suggested that private-activity bond regulations prohibiting management contracts based on net profits "should be reconsidered" and replaced by a more flexible rule based on control relationships.

Tax-exempt bonds are often used to finance hotel development when the hotel also includes a convention or conference center, or is located at an airport or other public transportation facility. After 1986, hotels could no longer be financed with private-activity bonds.

Governmental entities that own hotels adjacent to airports or convention centers often enter into management agreements with well-known hotel chains or brands. In those cases, the hotel is essentially supporting another public facility.

Hotel owners issue bonds to support the development and improvement of hotels, and managers can receive an "incentive fee" based on hotel performance. That incentive fee must be based on gross revenue rather than on net profits to avoid private business use and jeopardizing the status of the hotel's tax-exempt bonds. Tax-exempt bonds are considered private-activity bonds if more than 10% of the proceeds are used for private business and more than 10% of debt service is payable from, or secured by, a private party.

Tom Vander Molen, a partner at Dorsey and Whitney in Minneapolis, also said that the ruling could signal a shift in how management contracts are viewed by the IRS and Treasury.

Vander Molen said the private letter ruling is another in a line of "favorable and welcome rulings" by the IRS and Treasury permitting management terms to exceed the safe harbors in Revenue Procedure 97-13. He said he would not be surprised if a revenue procedure or notice was issued by the IRS and Treasury this year, but did not anticipate a change in regulations.

"I trust this ruling is a precursor to more liberal rules to be adopted by Treasury and counsel in anticipated general guidance on management and service contracts," Vander Molen said.

The IRS always cautions that private letter rulings are supposed to pertain only to those that requested them based on the particular facts and circumstances involved. But attorneys sometimes exam or rely on them in areas where guidance is lacking.

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