IRS Issues Favorable Private Letter Ruling Interpreting the Management Contract Rules

In a recent private letter ruling (PLR 201622003) the IRS approved a transaction and, in doing so, provided some helpful insight regarding the “management contract” provisions of Section 141 of the Internal Revenue Code. In the ruling, a government entity financed the construction of a hotel project with the proceeds of bonds the interest on which it intended to be exempt from federal income tax under Section 103. However, the government entity hired a private management company to manage the hotel, raising the question of whether the contract created prohibited “private use” of the hotel by the manager. The basic terms of the contract were:

• (1) The manager would manage the operations of the hotel for a period of years (the number of years was not given, but the ruling explains it was more than five years); and
• (2) As compensation, the manager would receive (i) a base fee calculated as a certain percentage of gross revenues of the hotel each year, and (ii) an incentive fee calculated as a different percentage of gross revenues, if certain targets were met.

The ruling is significant because the incentive fee was dependent, in part, upon a concept called “adjusted revenue,” which the ruling describes as a “variant” of net profit. Generally, any compensation pursuant to a management contract based upon net profit is prohibited and results in private use. But, the IRS held in the ruling that the incentive fee did not violate this prohibition for two reasons: (i) the fee did not fluctuate proportionately with net profit (i.e., an increase in net profit did not create a proportionate increase in the incentive fee), and (ii) earning the incentive fee required the manager to satisfy multiple criteria, only one of which involved net profit. While only a private letter ruling (and therefore not precedential), this latest guidance offers some comfort to issuers and managers who wish to tie compensation, in some respect, to bottom line performance. Calfee lawyers have counseled bond issuers, developers and managers on the management contract rules. We have also successfully guided clients through the private letter ruling process with the IRS National Office.  

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For additional information and discussion on this topic, please get in touch with your regular Calfee contact or one of the attorneys listed below:   Virginia D. Benjamin 216.622.8367 vbenjamin@calfee.com Michael K. Gall 216.622.8460 mgall@calfee.com 

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