By MAXWELL D. SOLET and CHRISTIE MARTIN

In August, 2016, the IRS issued Revenue Procedure 2016-44, the first comprehensive revision of its management contract safe harbors since Revenue Procedure 97-13.  Rev. Proc. 2016-44 (see our description here) built upon and amplified principles laid out in private letter rulings issued over many years and in Notice 2014-67.  Now, less than six months later, the IRS has published Revenue Procedure 2017-13, which clarifies and supersedes Rev. Proc. 2016-44 but does not materially change the safe harbors described therein.  The clarifications are in response to questions received with respect to certain types of compensation protected under earlier safe harbors, incentive compensation, timing of payments, treatment of land when determining useful life, and approval of rates.

 

 

By CHRISTIE MARTIN and MAXWELL D. SOLET

After two sets of proposed regulations, Treasury and IRS have now released final regulations on the definition of “issue price” for purposes of arbitrage investment restrictions that apply to tax-advantaged bonds (the “Final Regulations”) and it appears that the third time’s the charm. Practitioners are particularly praising the addition of a special rule for determining issue price for competitive sales and clarification on determining issue price for private placements.  The Final Regulations were published in the Federal Register on December 9, 2016 and can be found here.

Several years ago, tax regulators became concerned that the longstanding practice of allowing an issue price to be calculated based on reasonable expectations could lead to abuse in that “reasonably expected” issue prices for bonds sometimes differed from the prices at which bonds were actually being sold to retail investors. A determination by the IRS that the “issue price” has been erroneously calculated can have ramifications for the calculation of arbitrage yield that could ultimately cause loss of tax-advantaged status.  A clear and predictable definition of issue price is therefore essential for the tax-advantaged bond community.

After the first set of proposed regulations, published in the Federal Register on September 16, 2013, caused an uproar in the bond counsel community as being largely unworkable, they were withdrawn and re-proposed on June 24, 2015 (the “2015 Proposed Regulations”). The 2015 Proposed Regulations were subject to a comment period followed by a public hearing.  These Final Regulations build on the 2015 Proposed Regulations with certain changes in response to the public comments.

The Final Regulations look to actual facts as the general rule for determining issue price. Generally, the issue price of bonds is the first price at which a substantial amount (at least 10%) of the bonds is sold to the public.  For bonds issued in a private placement to a single buyer, the Final Regulations clarify that the issue price of the bonds is the price paid by that buyer.

In recognition of the need in the tax-advantaged bond community for certainty as of the sale date (particularly in the case of advance refundings), the Final Regulations offer a special rule in the event a substantial amount of bonds has not been sold to the public as of the sale date. The special rule allows reliance on the initial offering price to the public if certain conditions are satisfied including evidence that the bonds were actually offered at the initial offering price and the written agreement of each underwriter that it will not offer or sell the bonds to any person at a price higher than the initial offering price during the period starting on the sale date and ending on the earlier of (i) the close of the 5th business day after the sale date, or (ii) the date on which the underwriters have sold at least 10% of the bonds to the public at a price that is no higher than the initial offering price.

Procedures for satisfying the conditions for use of this special rule will have to be developed but it is reasonable to expect that changes will need to be made to bond purchase agreements and underwriter selling agreements to comply with these requirements.

The special rule for competitive sales provides that in a competitive sale meeting certain requirements, an issuer may treat the reasonably expected initial offering price to the public as of the sale date as the issue price if the winning bidder certifies that its winning bid was based on this reasonably expected initial offering price as of the sale date. This special issue price rule for competitive sales has been repeatedly requested by practitioners and is a welcome improvement over the prior proposed regulations which treated both negotiated sales and competitive sales in the same manner.

The Final Regulations will be effective for obligations that are sold on or after June 7, 2017 and there is no option to rely upon the Final Regulations with respect to obligations that are sold prior to that date. This delayed effective date should allow bond counsel and underwriters time to develop effective and hopefully uniform procedures and documentation to implement the new regulations.

By LEN WEISER-VARON

The Stephen Beck, Jr., Achieving a Better Life Experience Act of 2014 (ABLE Act), one of the few recent examples of bipartisan cooperation on a new category of tax and budget expenditure, is both well-intentioned in its principles and cumbersome in its details, another example of the proposition that a camel is a horse designed by a committee.  Recent and imminent actions by regulators at the United States Treasury and Social Security Administration evidence commendable dedication to sanding off some of the rougher edges of the ABLE legislation.  Such beneficial regulatory guidance reflects, in both substance and timing,  extraordinary attention by federal regulators to concerns raised by the state instrumentalities charged with establishing and administering ABLE programs and by disability advocacy groups that have pushed and prodded to make this new form of savings and investment account for individuals with severe disabilities a reality.  Aided by this healthy cooperation among regulators, administrators and beneficiaries and the developments described below, ABLE programs should become available in various states during 2016.

  •  Treasury Issues Favorable Advance Guidance for ABLE Program Administrators

Treasury issued proposed ABLE regulations on June 29, 2015, has received comments on those regulations and is expected to publish a revised version of such regulations as final regulations when feasible taking into account the regulatory process.  It is anticipated that some ABLE programs will be launched in advance of the issuance of such final regulations.  However, the National Association of State Treasurers’ College Savings Plan Network (CSPN) (which now includes entities involved in establishing Section 529A ABLE programs as well as  entities involved with Section 529 college savings programs) had requested advance guidance from Treasury on three points which, if not resolved by Treasury prior to its issuance of final regulations, could have delayed the structuring and launching of ABLE programs.  On November 20, 2015, Treasury issued Notice 2015-81, providing such expedited advance guidance and agreeing with CSPN’s requested resolution on each of the three points.

In particular. Notice 2015-81 affirms that, notwithstanding contrary language in the proposed regulations, the final regulations under Internal Revenue Code Section 529A will provide that:

  1. An ABLE program will not be required to track or report the use of distributions from an ABLE account.  Although an ABLE program will need to report the amount of distributions and allocate distribution amounts to earnings or return of basis, it will not need to determine the amount of each distribution used by the account beneficiary for, respectively, non-housing qualified disability expenses,  housing-related qualified disability expenses, or expenses that are not qualified disability expenses.  The ABLE account beneficiary, however, will need to maintain records sufficient to allocate ABLE account distributions to qualified or non-qualified expenditures for tax purposes, and, in certain instances as discussed below, to  qualified non-housing, qualified housing or nonqualified expenditures for Supplemental Security Income (SSI) eligibility purposes.
  2. An ABLE program will not be required to request the social security number or other tax identification number (TIN) of each third party contributor to an ABLE account at the time a contribution is made, if (as will be the case for most if not all programs) the program has a system in place to identify and reject excess contributions and excess aggregate contributions before they are deposited into an ABLE account. (If, however, an excess contribution or excess aggregate contribution is deposited into an ABLE account, the qualified ABLE program will be required to request the TIN of the contributor making the excess contribution or excess aggregate contribution.)
  3. In instances where the ABLE statute conditions ABLE eligibility on the filing of a signed physician’s diagnosis of the relevant disability, an ABLE program will not be required to collect or review such physician diagnosis, but can rely on a certification under penalties of perjury that the individual (or the individual’s agent under a power of attorney or a parent or legal guardian of the individual) has the signed physician’s diagnosis, and that the signed diagnosis will be retained and provided to the ABLE program or the IRS upon request.  Notice 2015-81 indicates that the final regulations will “likely” require that such certification include the name and address of the diagnosing physician and the date of the diagnosis, and “may also provide” that the certification “may” include information provided by the physician as to the “categorization of the disability” that could determine, under the particular state’s program, the appropriate frequency of required recertification.   (The need for annual recertification is another sensitive topic from the perspective of state ABLE program administrators, but the proposed regulations suggest that the final regulations will be sufficiently flexible that states that do not wish to require annual recertification will not be obligated to do so.)  The Notice helpfully states that if the final regulations require more as to the signed physician diagnosis than the certification of its possession by the provider of the certification and that the diagnosis will be retained and provided to the ABLE program or the IRS upon request, such additional requirements will not apply to certifications obtained by an ABLE program prior to the effective date of such final regulations.

Appreciation is due to Catherine Hughes at Treasury and to Terri Harris and Sean Barnett at IRS for their attentiveness and responsiveness to the request for such advance guidance.

  •  Social Security Administration Expected to Issue Favorable Guidance for ABLE Beneficiaries

For SSI benefit recipients, the beneficial treatment of ABLE account balances and distributions for SSI eligibility purposes is at least as important as their beneficial tax treatment.  Although the Social Security Administration has yet to issue formal guidance clarifying that treatment, it is expected to do so through an update to its Program Operations Manual System (POMS) before the end of 2015.  Based on informal communications with and by SSA officials, the treatment is expected to facilitate the use of ABLE accounts without adverse impact on SSI benefits.

Broadly speaking, SSI benefits eligibility is reduced and may be eliminated to the extent the applicable beneficiary has countable assets or countable income in excess of extremely modest amounts.  However, the ABLE Act provides that ABLE account balances are disregarded for SSI purposes except to the extent they exceed $100,000, and that ABLE account distributions for qualified disability expenses also are disregarded except in the case of distributions for housing expenses.

The statutory exclusions leave some ambiguity as to the timing and methodology of determinations that particular ABLE account distributions are excluded from SSI benefits determinations.  The treatment expected to be described in the POMS update is as follows:  Distributions of ABLE account balances of $100,000 or less will not constitute countable income, as such amounts already are owned by the SSI beneficiary at the time of the distribution. Distributions from ABLE accounts will not constitute countable assets if expended within the same month as the distribution is received by the beneficiary from the account, irrespective of the nature of the expenditure.  Distributions from ABLE accounts that are not expended within the same month as the distribution is received by the beneficiary will not be counted as a countable asset if ultimately expended on a qualified disability expense that is not a housing expense.  An ABLE account distribution expended on a housing expense or non-qualified expense in a later month than the month in which the distribution is received may be treated retroactively as a countable asset in all months between distribution and expenditure, potentially requiring the beneficiary to refund SSI benefits received during that period.

Bottom line:  An SSI recipient should not experience any adverse impact from the existence of an ABLE account as long as the account balance is kept at or below $100,000 (probably measured as of each month end), and, subject to confirmation when the relevant POMS update is published by SSA, as long as distributions from the ABLE account are expended in the month of receipt.  Expending ABLE account distributions in a month subsequent to the month of receipt will not produce an adverse result if the expenditure is a qualified disability expense that is not a housing expense, but may create some risk to SSI benefits if the documentation of the expenditure is inadequate or the classification of the expenditure is debatable.

By MAXWELL D. SOLET

On November 13, the IRS issued Notice 2015-78, providing favorable guidance on topics of interest to providers of “supplemental” or “alternative” student loans financed with tax-exempt bonds and to underwriters of such student loan bonds. Such guidance confirms that loans financeable under such programs include (i) parent loans as well as student loans and (ii) loans that refinance or consolidate prior loans that were or could have been financed on a tax-exempt basis.

Tax-exempt bonds used to finance student loans, so-called “qualified student loan bonds,” come in two flavors under the Internal Revenue Code, those issued to finance federally-guaranteed loans made under the Federal Family Education Loan Program (“FFELP”) and those issued to finance certain loans issued under programs created by the states, generally known as “supplemental” or “alternative” loan programs. While the FFELP program, historically much larger, terminated in 2010, tax-exempt financing for new loans under state supplemental programs has continued in approximately fifteen states.

Notice 2015-78 appears to have been prompted by recent efforts by governmental issuers to provide refinancing of student loan debt through non-federally guaranteed “consolidation loans”, which presented questions on which the IRS had not previously provided guidance.  The IRS also used the notice as an opportunity to address selected other issues applicable to all tax-exempt financed supplemental loans, not just refinancing loans. The Notice clarifies the following:

  • Eligible Borrowers.  Notwithstanding the widespread practice of making higher education loans to parents, a practice provided for by statute under FFELP through the Parent Loan to Undergraduate Students (PLUS) program, the IRS had expressed concerns in the context of ruling request discussions about whether loans to parents were bond-financeable student loans.  Notice 2015-78 clarifies that the student, the parent, or both can be an eligible borrower of a bond-financed “student loan.”  The Notice attempts to provide a similar rule for refinancing loans, stating, “An eligible borrower of a refinancing loan … is the student or parent borrower of the original loan.”  In the refinancing loan context the Notice’s particular wording leaves unclear whether if the sole borrower on the original loan was the parent, the sole borrower on the refinancing loan can be the proud young graduate who wishes to take on the debt through a consolidation loan.  Such a fact pattern clearly satisfies the policy underlying this otherwise expansively drafted notice.
  • Nexus to State.  The Internal Revenue Code requires the student to be a resident of the state which provides the “volume cap” allocation for the bonds or enrolled at an educational institution in that state.  In the case of a refinancing or consolidation loan, there has been some question whether such “nexus” is required to be established at the time the original loan was made or at the time the refinancing loan is made.  The Notice provides the broadest rule, stating that a “refinancing loan,” including a loan which allows the borrower to consolidate prior debt, complies with the statutory nexus requirement either if that requirement was satisfied at the time of the original loan or if it is satisfied at the time of the refinancing loan.  If reliance is placed on nexus at the time the original loan is made,  in the case of a consolidation loan care may need to be exercised to establish nexus for all underlying loans.
  • Loan Size.  The Code limits supplemental loans to “the difference between the total cost of attendance and other forms of student assistance … for which the student borrower may be eligible.”  The “may be eligible” language has resulted in troublesome challenges in IRS audits, where IRS agents have suggested that issuers might be responsible for documenting that students actually had applied for all other potentially available student assistance, or obligated to downsize loans by the amount of other student assistance that was hypothetically available but not received by the student.  The Notice confirms that tax-exempt bond issuers may rely on certifications from the student’s school as to total cost of attendance and as to other student assistance.  Further, the school may rely on definitions provided under the Higher Education Act, including a definition of “estimated financed assistance” which looks only to assistance the student “will receive.”
  • Type of Loans Eligible for Refinancing.  The Notice states that supplemental student loan bonds can be used to refinance not only original loans which were themselves supplemental loans but also other loans, “for example, a FFELP loan or a student loan made by a private lender, provided that the refinancing loan meets all of the requirements for a State Supplemental Loan.”   Although not addressed by the Notice, it should be noted that tax-exempt bonds issued to refinance prior loans, including consolidation of prior loans, generally will require an allocation of state volume cap, which in some states is a scarce commodity.  The need for volume cap may be avoided to the extent the refinancing loans made with proceeds of a bond issue refinance loans financed with other tax-exempt bonds issued by the same issuer or a related issuer and the payoffs on the refinanced loans are applied to redeem such other tax-exempt bonds in a manner that qualifies for the volume cap exception for current refunding bonds.

As a general proposition, the national student loan market is growing and dynamic.  Notice 2015-78 will assist governmental issuers in fulfilling their intended role.

By LEONARD WEISER-VARON

The IRS’s recently-published proposed regulations for Section 529A qualified ABLE programs have taken some wind out of the sails of state program administrators and potential program managers who had hoped for regulations that hewed closer to the requirements in effect for qualified tuition programs under Section 529, on which Section 529A was based.  Some state officials and would-be program managers are evaluating whether cost-effective ABLE programs can be launched given what, at first blush, appear to be substantially greater administrative burdens imposed on state programs by the proposed ABLE regulations.

The hesitation provoked by the proposed regulations is understandable when one compares the IRS’s proposed administrative requirements to those applicable to Section 529 programs. Section 529 programs are not required to check whether an account owner is eligible to open an account, are not required to check on an annual basis whether the account owner’s status has changed, and are not required to inquire into or track the use of account withdrawals.  (As originally enacted, Section 529 did make programs responsible for determining whether distributions were qualified or unqualified, a requirement so unworkable that Congress amended Section 529 to eliminate it and make the recipient responsible for documenting the use of the distribution upon inquiry by the IRS.)

In marked contrast, the proposed ABLE regulations would require that ABLE programs do all of the above.

The resulting cost issue for ABLE programs and their potential customers is obvious. Due to statutory restrictions under Section 529A, annual contributions to ABLE accounts cannot exceed an inflation-indexed $14,000; Section 529 accounts have no such limit. Moreover, each state’s 529A program is limited to that state’s residents, unless another state elects to have its residents use the other state’s program instead of establishing its own program.  Section 529 programs, on the other hand, can gather assets from the entire nation.  If one adds to the substantially smaller projected amount of a particular ABLE program’s assets under management the expenses associated with the increased staff and systems programming necessitated by the additional verification and recordkeeping requirements imposed by the proposed regulations, the math is simple: greater expenses divided into fewer assets equals substantially higher program expenses to be recovered from program participants, and therefore reduced investment returns for the future expenses of disabled individuals.

A fair reading of the ABLE Act is that Congress intended the IRS, not the state programs, to be the watchdog that would ensure that ABLE programs are used by the disabled and for qualified disability expenses, and intended the Social Security Administration to determine whether ABLE account distributions are used for housing or unqualified expenses (in which case they are factored into the disabled individual’s eligibility for SSI benefits, whereas ABLE account distributions for non-housing qualified disability expenses are disregarded.)  But in an era where federal agency resources, particularly the IRS’s, are stretched, the proposed regulations have been drafted to effectively shift that responsibility, and the attendant costs, to the state programs.

The question the state programs and their potential contractors are struggling with is what exactly these unexpected and unwelcome responsibilities entail, and how much expense has been shifted from the federal government to the disabled community.  If the well-intentioned and long-sought ABLE Act is to achieve its objective, it will be in the interest of Congress, the IRS and the disability community, not just the state programs, to ensure that the administrative burden is reduced to the minimum necessary to make these programs function as intended.

The proposed regulations are not technically binding before they are finalized, and it is possible that, following the current 90 day comment period, the IRS will issue final regulations that lighten some of the proposed burden on ABLE program administrators.  But whether and when any more program-friendly final regulations will be issued is unknown, and the disability community deserves to have access to ABLE programs sooner than the indefinite future.  Unless and until the IRS, by advance notice or other clarification, provides better answers, individual states that wish to go forward with ABLE programs in advance of final regulations will need to reach a comfort level that they can comply with the IRS’s unexpected views on what a state must do to maintain its ABLE program’s beneficial tax status without making the pass-through costs of operating an ABLE program so expensive as to potentially outweigh the tax benefit.

A consensus on what practices are sufficient to comply with the proposed regulations without saddling ABLE programs with impracticable and expensive procedures will take some time to evolve.  Here is an initial perspective:

1)       Account–opening:

The proposed regulations state that “[a] qualified ABLE program must specify the documentation that an individual must provide, both at the time an ABLE account is established for that individual and thereafter, in order to ensure that the designated beneficiary of the ABLE account is, and continues to be, an eligible individual.”

For those account owners who are ABLE-eligible because they are eligible for SSI or SSDI disability benefits, the preamble to the proposed regulations suggests that “[f] or example, a qualified ABLE program could require the individual to provide a copy of a benefit verification letter from the Social Security Administration and allow the individual to certify, under penalties of perjury, that the blindness or disability occurred before the date on which the individual attained age 26.”  This suggestion may be workable if the Social Security Administration will provide such benefit verification letters with respect to the then-current tax year in short order upon request by an individual wishing to open an ABLE account.  Otherwise, if an individual can only provide a prior year benefit verification letter to the state program, states will need to decide whether, in connection with an account opening, they can rely upon the account owner’s certification, under penalties of perjury, that such eligibility status has not changed since the year in which the benefit verification letter submitted to the program was issued by the Social Security Administration.

As to those account owners who are ABLE-eligible under Section 529A because they file an eligibility certification and a physician diagnosis with the Secretary of Treasury, the preamble to the proposed regulations states that “[w]hile evidence of an individual’s eligibility based on entitlement to Social Security benefits should be objectively verifiable, the sufficiency of a disability certification that an individual is an eligible individual for purposes of section 529A might not be as easy to establish.”  The proposed regulations state that “a disability certification will be deemed to be filed with the Secretary [of Treasury] once the qualified ABLE program has received the disability certification”, which “deemed” filing, according to the preamble, is designed  “to facilitate an eligible individual’s ability to establish an ABLE account without undue delay.”

Taking the IRS at its word that the shifting of the certification filing from the Treasury, as specified in the statute, to the states, as specified in  the proposed regulations, is designed to “facilitate” account-opening “without delay,” it seems sensible to interpret the regulations as requiring a state to confirm no more than that a certification facially stating what the proposed regulations require has been signed or e-signed by the account owner (or his or her agent, parent or guardian), and is accompanied by a physician’s signed or e-signed letter facially providing the diagnosis on which the account owner’s certification relies.

Based on the proposed regulations, it appears that the certification filed with the ABLE program by or on behalf of the account owner must be signed or e-signed under pains and penalties of perjury and should state something along the following lines:

“(i)(A) I have the following medically determinable physical or mental impairment: _____________________________.  This impairment results in marked and severe functional limitations (as defined below), and—

(1) Can be expected to result in death; or

(2) Has lasted or can be expected to last for a continuous period of not less than 12 months; or

(B) I am blind (within the meaning of section 1614(a)(2) of the Social Security Act);

(ii) Such blindness or disability occurred before the date of my 26th birthday.

For purposes of this certification, “marked and severe functional limitations” means  the standard of disability in the Social Security Act for children claiming Supplemental Security Income for the Aged, Blind, and Disabled (SSI) benefits based on disability (see 20 CFR 416.906). Specifically, this is a level of severity that meets, medically equals, or functionally equals the severity of any listing in appendix 1 of subpart P of 20 CFR part 404, but without regard to age. (See 20 CFR 416.906, 416.924 and 416.926a.) Such phrase also includes any impairment or standard of disability identified in future guidance published in the Internal Revenue Bulletin. Consistent with the regulations of the Social Security Administration, the level of severity is determined by taking into account the effect of the individual’s prescribed treatment. (See 20 CFR 416.930.)  Conditions listed in the “List of Compassionate Allowances Conditions” maintained by the Social Security Administration (at www.socialsecurity.gov/compassionateallowances/conditions.htm) are deemed to meet the requirements of clause (i) of this certification.”

Based on the proposed regulations, it appears that the physician’s diagnosis accompanying the account owner’s certification must be signed or e-signed by the physician and should state:

“I hereby certify that I am a physician meeting the criteria of section 1861(r)(1) of the Social Security Act (42 U.S.C. 1395x(r)).  I further certify that I have examined ____________ and that, based on my examination, I have determined that s/he has the following physical or mental impairment: ________________________.”

The ABLE program administrator would need to determine that the account owner’s certification has been signed or e-signed in the name of the account owner or by someone who has certified that he or she is the account owner’s agent, parent or guardian, and that the diagnosis inserted in the blank of such certification matches the diagnosis in the blank of the physician’s diagnosis, and that the physician’s diagnosis is signed or e-signed.

It should be noted that draft tax instructions for Form 5498-QA released by the IRS require a program to report to the IRS annually, for each account and by code number, “the type of disability for which the designated beneficiary is receiving ABLE qualifying benefits.” The code menu on the draft IRS instructions is:

Code 1-  Developmental Disorders: Autistic Spectrum Disorder, Asperger’s Disorder, Developmental Delays and Learning Disabilities

Code 2 – Intellectual Disability: “may be reported as mild, moderate or severe intellectual disability”

Code 3 – Psychiatric Disorders: Schizophrenia, Major depressive disorder, Post-traumatic stress disorder (PTSD), Anorexia nervosa, Attention deficit/hyperactivity disorder (AD/HD), Bipolar disorder

Code 4 – Nervous Disorders: Blindness; Deafness; Cerebral Palsy, Muscular Dystrophy, Spina Bifida, Juvenile-onset Huntington’s disease, Multiple sclerosis, Severe sensoneural hearing loss, Congenital cataracts

Code 5 – Congenital anomalies: Chromosomal abnormalities, including Down Syndrome, Osteogenesis imperfecta, Xeroderma pigmentosum, Spinal muscular atrophy, Fragile X syndrome, Edwards syndrome

Code 6 – Respiratory disorders: Cystic Fibrosis

Code 7 – Other: includes Tetralogy of Fallot, Hypoplastic left heart syndrome, End-stage liver disease, Juvenile-onset rheumatoid arthritis, Sickle cell disease, Hemophilia, and any other disability not listed under Codes 1-6.

The tax instructions state that “the … information will only be used for aggregate reporting purposes as required by law.”

The notion that a state ABLE program established to provide investment accounts should have any role in determining which of the above panoply of medical conditions, if any, an account applicant suffers from sends off all sorts of alarm bells for many of those involved in structuring such programs. This proposed requirement can only be met by the relevant state program, if it can be met at all, by coding into the Form 5498 whatever condition the applicant and the physician have filled in on the forms submitted when the account is established. Even that will require coding additional fields into the ABLE programs’ operating system and may require staff to translate the conditions specified in the application materials into the appropriate code. And in the case of applicants who establish ABLE eligibility via eligibility for SSI or SSDI benefits, the diagnosis may not be apparent from the benefits letter submitted as proof. This is an unwarranted level of complexity and expense for the questionable benefit of then adding up all the painstakingly gathered disability codes into an aggregate report that has nothing to do with the ABLE program’s operations. But unless and until the IRS signals relief from this proposed requirement, ABLE programs that wish to go forward will need to design systems capable of generating such coding, at the expense of ABLE program participants.

2)           Annual recertification:

As noted above, the proposed regulations require that programs specify the documentation that must be provided after an account is opened to establish the account owner’s continued disabled status.  According to the proposed regulations,  “a qualified ABLE program may choose different methods of ensuring a designated beneficiary’s status as an eligible individual and may impose different periodic recertification requirements for different types of impairments.”  The proposed regulations include several impractical suggestions on compliance that presume that the state program has expertise on the likely length of particular disabilities (see the above list) and the likelihood of a cure being found for particular disabilities.  However, the proposed regulations also state: “If the qualified ABLE program imposes an enforceable obligation on the designated beneficiary or other person with signature authority over the ABLE account to promptly report changes in the designated beneficiary’s condition that would result in the designated beneficiary’s failing to satisfy the definition of eligible individual, the program also may provide that a certification is valid until the end of the taxable year in which the change in the designated beneficiary’s condition occurred.”

It seems likely that most states will follow this suggestion and include a requirement of such notice of change in disability status in the participation agreement or similar agreement executed or adopted by an account owner when the account is opened.  There is no reason to think that such a covenant by the account owner is any less “enforceable” than any other contractual agreement by the account owner, but as the proposed regulations are unclear on what the IRS means by “enforceable”, it may be prudent to state that the IRS is a third-party beneficiary of that particular covenant, so that the IRS can enforce it as it sees fit in the event it is breached by the account owner.

3) Tracking distributions:

The most perplexing provision in the proposed regulations states that “[a] qualified ABLE program must establish safeguards to distinguish between distributions used for the payment of qualified disability expenses and other distributions, and to permit the identification of the amounts distributed for housing expenses as that term is defined for purposes of the Supplemental Security Income program of the Social Security Administration.”

The proposed regulations also provide that “[i]f the total amount distributed from an ABLE account to or for the benefit of the designated beneficiary of that ABLE account during his or her taxable year does not exceed the qualified disability expenses of the designated beneficiary for that year, no amount distributed is includible in the gross income of the designated beneficiary for that year.”  Accordingly, for tax purposes, particular distributions are not made for qualified or unqualified purposes, or for housing purposes; instead, distributions may be requested at any point in the year, and then are simply compared in the aggregate to the account owner’s aggregate qualified disability expenses for the applicable tax year.

Because the account owner is not required for tax purposes to link a particular withdrawal to a particular expenditure, it is mystifying how the IRS and the Social Security Administration think programs can discharge this tracking and reporting duty.  No guidance whatsoever is provided on this point in the proposed regulations.  Given that some portion of the disabled community is expected to use ABLE accounts as transaction accounts, a requirement that states demand and examine invoices or receipts for each requested distribution, and determine in each case whether the amount is qualified or non-qualified and, if qualified, relates to housing, would substantially delay distributions and impose staffing requirements on programs or their contractors that would dramatically increase the expense ratios of ABLE investments. A distribution verification requirement is exactly what was amended out of Section 529 by Congress, and Congress did not reintroduce it statutorily when it enacted Section 529A.

This distribution tracking requirement, if not eliminated or clarified promptly by the IRS and the Social Security Administration, risks delaying or stopping many potential ABLE programs, particularly if interpreted to require anything more from the state program than a “check the box” section on distribution request forms.  States that are willing to proceed pending further clarification of this troubling element of the proposed regulations will likely provide account owners with distribution forms that ask that each requested distribution be broken down into subtotals relating to housing expenses, other qualified disability expenses, and unqualified expenses, all as determined and certified by the account owner under pains and penalties of perjury.  The state programs will make the required monthly reports to the Social Security Administration on the basis of such certifications.  Even the tracking of these subtotals and the related systems programming requirements will impose requirements on ABLE programs, and resulting expenses for ABLE program investors, that Section 529 programs are not burdened with and that are properly left between the Social Security Administration and those account owners receiving federal disability benefits.

By MAXWELL SOLET and CHRISTIE MARTIN

Treasury and IRS today announced a decision to withdraw the much-criticized portion of the notice of proposed rulemaking published in the Federal Register on September 16, 2013 (the “2013 Proposed Regulations”) related to the definition of issue price for tax-advantaged obligations and to propose a revised definition of issue price in its place. A determination by the IRS that the “issue price” has been erroneously calculated can have ramifications, including for the calculation of arbitrage yield, that could ultimately cause loss of tax-exempt status in the case of tax-exempt bonds and loss of federal subsidy in the case of Build America Bonds (BABs), hence the importance to the tax-exempt bond community of a clear and predictable definition.

The new proposed regulations (the “2015 Proposed Regulations”) are scheduled to be published in the Federal Register on June 24, 2015 and can be found here. A 90-day comment period will be followed by a hearing on October 28, 2015.

The 2015 Proposed Regulations eliminate most of the troublesome features of the 2013 Proposed Regulations, including maintaining a 10% standard rather than the 2013 Proposed Regulations 25% standard for what constitutes a “substantial amount” of obligations sold to the public. However, the 2015 Proposed Regulations do not maintain the long-established “reasonable expectations” standard for establishing issue price. Instead, the 2015 Proposed Regulations look to actual facts as the general rule.

In recognition of the need in the tax-advantaged debt world for certainty as of the sale date (particularly in the case of advance refundings), the 2015 Proposed Regulations helpfully provide an alternative method in the event a substantial amount of bonds have not been sold to the public as of the sale date. The alternative method allows reliance on the initial offering price if certain conditions are satisfied.

Procedures for satisfying the conditions for use of this alternative method will have to be developed, and underwriters may conclude that compliance will be difficult. In particular, a preclusion of sales at prices above the initial offering price unless it can be demonstrated that the differential is based on market changes could be problematic.

The 2015 Proposed Regulations will be effective for obligations that are sold on or after 90 days after final regulations are published in the Federal Register. However, issuers may rely upon the 2015 Proposed Regulations with respect to obligations that are sold on or after June 24, 2015, the date the 2015 Proposed Regulations will be published in the Federal Register.

By LEN WEISER-VARON

The IRS today published, right on deadline, its proposed regulations relating to Section 529A state-sponsored “qualified ABLE programs,” under which  tax-advantaged investment accounts may be established to fund future “qualified disability expenses” of eligible disabled individuals.

The regulations are detailed and this posting will not attempt to summarize them in their entirety. Rather, a few provisions of the proposed regulations are highlighted below, along with some initial reactions.

Applicability: The regulations are issued as proposed regulations, and therefore technically are not in effect. Comments are due within 90 days of the publication date in the Federal Register, and a public hearing on the regulations will be held on October 14, 2015. The preamble to the regulations indicates taxpayers and state programs can rely on the proposed regulations until final regulations are adopted. Somewhat perplexingly, the preamble also indicates that the final regulations will be applicable to taxable years beginning after December 31, 2014. To the extent this suggests that the final regulations will be applicable retroactively, it appears inconsistent with the promise made in IRS Notice 2015-18 that “[t]he Treasury Department and the IRS intend to provide transition relief with regard to necessary changes to ensure that the state programs and accounts meet the requirements in the [regulatory] guidance, including providing sufficient time after issuance of the guidance in order for changes to be implemented.” One hopes that the IRS will clarify that such a transition period will be provided after final regulations are adopted, versus retroactive application of such final regulations to any taxpayer or program that has not complied with the proposed regulations; otherwise, programs and taxpayers may be forced to comply with the proposed regulations even though they are not legally effective.

Who May Establish an ABLE Account: Section 529A requires that the tax owner of any ABLE account be the eligible disabled beneficiary. The proposed regulations provide that if the beneficiary cannot establish the account on his or her own, it may be established on the disabled beneficiary’s behalf by an agent under power of attorney or, if there is no such agent, by a parent or legal guardian. This narrows the field of potential relatives who can establish an ABLE account for a disabled individual, and eliminates the ability of a non-parent to establish such an account unless he/she has a power of attorney or is a legal guardian. It also appears to preclude, or at least not acknowledge, the use of custodial accounts, such as an UTMA account, which is surprising.

Eligible individual determination: The proposed regulations are disappointing from the perspective of administrative ease and clarity on the key question of what documentation is required to establish and maintain an ABLE account. As an initial matter, the regulations cast the responsibility for verifying eligibility status on the state programs. The regulations indicate that a “qualified ABLE program must specify the documentation that an individual must provide, both at the time an ABLE account is established for that individual and thereafter, in order to ensure that the designated beneficiary of the ABLE account is, and continues to be, an eligible individual.”

There are two statutory methods for an individual to qualify as eligible for an ABLE account. One is the filing of a disability certification with the Secretary of the Treasury that certifies that the individual has a qualifying disability or is blind and that such disability or blindness occurred before the individual’s 26th birthday; the certification must include a physician-signed diagnosis of the relevant disability or blindness. The proposed regulations provide that “a disability certification will be deemed to be filed with the Secretary once the qualified ABLE program has received the disability certification.” The regulations are silent on what level of diligence the state program must engage in, if any, to establish that papers that purport to be a disability certification comply with the substantive requirements (including type of diagnosis) of the regulatory definition of a disability certification. This provision is likely to be perceived as problematic by state programs and to provoke a high level of pushback during the comment period from state administrators who believe that eligibility status should be between the taxpayer and the federal government, not something that a state has any role in verifying.

An alternative statutory basis for ABLE account eligibility is eligibility for Social Security Act benefits based on blindness or disability that occurred before the individual’s 26th birthday. The proposed regulations are silent on a state’s role in verifying this type of eligibility. The preamble to the proposed regulations states that “for example, a qualified ABLE program could require the individual to provide a copy of a benefit verification letter from the Social Security Administration and allow the individual to certify, under penalties of perjury, that the blindness or disability occurred before the individual’s 26th birthday.” While this non-regulatory example appears potentially less onerous in terms of state verification responsibility than the unclear role of a state program under the proposed regulations upon its receipt of a disability certification, it still raises some potentially thorny questions, such as, for example, whether a program is required to make a competency determination before relying upon a declaration signed by a disabled individual.

The proposed regulations’ treatment of eligibility determinations for years following the year in which an account is established is even vaguer. The regulations provide that “a qualified ABLE program may choose different methods of ensuring a designated beneficiary’s status as an eligible individual and may impose different periodic recertification requirements for different types of impairments.” The proposed regulations suggest that, with respect to the frequency of annual recertifications, ABLE programs “may take into consideration whether an impairment is incurable and, if so, the likelihood that a cure may be found in the future,” a suggestion that casts state officials entrusted with administering a financing program in the combined role of physicians and Nostradamus. The proposed regulations further suggest that a state program may establish a sliding scale of frequency of recertification based on the type of impairment. Less fantastically, the regulations suggest that “[i]f the qualified ABLE program imposes an enforceable obligation on the designated beneficiary or other person with signature authority over the ABLE account to promptly report changes in the designated beneficiary’s condition that would result in the designated beneficiary’s failing to satisfy the definition of eligible individual, the program also may provide that a certification is valid until the end of the taxable year in which the change in the designated beneficiary’s condition occurred.” This type of presumption that an individual continues to be eligible unless the program receives notice to the contrary is on the right track, but what constitutes an “enforceable obligation” by a disabled individual or his or her agent, parent or guardian to report a change in condition is anybody’s guess.

Residency requirement: Consistent with Section 529A, the proposed regulations require that, at the time an ABLE account is established, the designated beneficiary must be a resident of the state offering the program or a resident of a state without a program that has contracted with such other state for purposes of making its residents eligible to participate in such program. The proposed regulations state that for purposes of such residency requirement residency is determined under the law of the designated beneficiary’s state of residence. There is no guidance on whether any proof of residency is required or whether a state may rely on a certification made by or on behalf of the beneficiary as his or her state of residency. The proposed regulations confirm that a change in the beneficiary’s state of residency after an ABLE account is established does not affect the beneficiary’s right to continue to use the applicable ABLE account.

Cumulative contributions limit: The proposed regulations affirm that for purposes of the statutory cumulative contributions limit, which equals the cumulative limit imposed by the applicable state under its Section 529 qualified tuition program, it is permissible for the program to refuse additional contributions that would cause the limit to be exceeded (versus tracking the lifetime contributions to the account, irrespective of investment gains or losses.) This methodology is used by many Section 529 programs but had not been officially blessed by the IRS in that context.

Qualified disability expenses: The proposed regulations provide a hoped-for generous definition of “qualified disability expenses” which states that such term “includes basic living expenses and [is] not limited to items for which there is a medical necessity or which solely benefit a disabled individual.”

State role regarding qualified disability expenses: Quite unexpectedly, the proposed regulations state that “[a] qualified ABLE program must establish safeguards to distinguish between distributions used for the payment of qualified disability expenses and other distributions, and to permit the identification of amounts distributed for housing expenses as that term is defined for purposes of the Supplemental Security Income program.” This purported duty of state programs to monitor the use of distributions from ABLE accounts has no basis in the Section 529A statutory language, is inconsistent with the manner in which similar language in Section 529 has been construed by the IRS, and is at odds with other provisions of the proposed regulations that provide for qualified distribution expenses to be determined by the taxpayer on an annual basis, not by tracing of particular distributions to particular expenses. This provision is highly problematic from a practical as well as a legal perspective and will likely provoke a high level of pushback during the comment period.

Medicaid lien: The proposed regulations state that an ABLE program “must provide that a portion or all of the balance remaining in an ABLE account of a deceased designated beneficiary must be distributed to a State that files a claim against the designated beneficiary or the ABLE account itself with respect to benefits provided to the designated beneficiary under the State’s Medicaid plan … after … the date on which the ABLE account, or any ABLE account from which amounts were rolled over or transferred to the ABLE account of the same designated beneficiary, was opened….” The proposed regulations provide no guidance on whether the program must keep an ABLE account open for a particular period of time following a designated beneficiary’s death, or whether the beneficiary’s estate can direct closure of the account at any time and distribution to the estate of all amounts remaining in the account.

Reporting: The proposed regulations include detailed reporting requirements for ABLE programs, including references to new forms to be used by state programs in reporting data regarding the establishment of ABLE accounts (Form 5498-QA) and in reporting distribution data (Form 1099-QA). The preamble to the proposed regulations also references a Congressional report “that States should work with the Commissioner of Social Security to identify data elements for the monthly reports [required to be submitted to the Commissioner of Social Security], including the type of qualified disability expenses.” As noted above, the suggestion that States will have a duty to report types of qualified disability expenses is both legally and practically problematic.

 

 

By LEN WEISER-VARON

Pi Day comes but once a century, on 3/14/15. The Internal Revenue Service receives praise approximately as frequently. But the IRS deserves applause for its Notice 2015-18, released March 10, 2015, giving the green light to states to proceed with the establishment of tax-free investment programs for the disabled under new Section 529A of the Internal Revenue Code.

Section 529A, which became effective January 1, 2015, grants tax-free treatment to the earnings in so-called ABLE accounts established for eligible disabled beneficiaries and used for qualified disability expenses. As is the case with Section 529 programs, which offer tax-free investment for higher education expenses, Section 529A programs must be established by state instrumentalities and must comply with a variety of statutory requirements. But unlike Section 529, which permits anyone to establish a Section 529 account (subject to the imposition of taxes and tax penalties on amounts withdrawn for purposes other than the account beneficiary’s higher education expenses), Section 529A imposes restrictions on the front end designed to ensure that the account beneficiary is disabled. (Section 529A likewise imposes taxes and tax penalties on amounts withdrawn for purposes other than the account beneficiary’s qualified disability expenses.)

Many families with children or other relatives who meet Section 529A’s disability definition and the statute’s requirement that the disability have occurred before age 26 are understandably eager to establish nest eggs that are not only tax-free but also, by statute, disregarded (up to a balance of $100,000) for purposes of determining the beneficiary’s financial eligibility for federal disability benefits. However, states seeking to make ABLE accounts available to their residents must work through a host of legal, contractual and investment option issues before launching these new programs.

By releasing Notice 2015-18, the Treasury Department and IRS have addressed, wisely and effectively, one factor that threatened to delay the launch of ABLE programs: uncertainty over how the Treasury Department and IRS will interpret certain provisions of Section 529A.

In particular, while Section 529A is clear that an ABLE account beneficiary’s disability qualification is determined by or through the federal government (through the beneficiary’s receipt of Social Security disability benefits or the beneficiary’s filing with the Treasury Department of a disability certification accompanied by a physician’s diagnosis), it is silent on whether the state program has some unspecified duty to obtain assurances or confirm that such actions, which don’t involve the state program, have occurred. Section 529A, which permits disability status to be established at any time during a tax year, also does not specify the treatment of account contributions made to or received by an ABLE account on a date in a tax year that precedes the date on which the beneficiary satisfies the disability status requirements for the applicable tax year. In addition, there is no statutory clarity on what a program is required to do to confirm compliance with Section 529A’s state residency restrictions.

The legislation pursuant to which Section 529A was enacted requires that the Treasury Department promulgate regulations under Section 529A by June 19, 2015 (six months from enactment.) It is unclear whether the Treasury Department will be able to meet this deadline. Even if the Treasury Department were to meet that deadline, some states might have concerns about structuring, much less launching, an ABLE program before there is regulatory guidance resolving some of the statutory ambiguities potentially affecting the program’s tax-exemption under Section 529A.

Notice 2015-18 straightforwardly acknowledges the tax uncertainty concerns and addresses them, asserting that “[t]he Treasury Department and the IRS do not want the lack of guidance to discourage states from enacting their enabling legislation and creating their ABLE programs, which could delay the ability of the families of disabled individuals or others to begin to fund ABLE accounts for those disabled individuals.” The Notice goes on to state that “the Treasury Department and the IRS are assuring states that enact legislation creating an ABLE program in accordance with section 529A, and those individuals establishing ABLE accounts in accordance with such legislation, that they will not fail to receive the benefits of section 529A merely because the legislation or the account documents do not fully comport with the guidance when it is issued.”

The Notice further states that “the Treasury Department and the IRS intend to provide transition relief with regard to necessary changes to ensure that the state programs and accounts meet the requirements in the guidance, including providing sufficient time after issuance of the guidance in order for changes to be implemented.”

This language represents a fairly extraordinary expression by the Treasury and the IRS of their intent to get out of the way as a potential obstacle to, or delaying factor in, the launching of ABLE programs. This approach is sympathetic to the cause and needs of families of disabled individuals, and deserves commendation. Although the Notice will not result in instantaneous availability of ABLE programs given the non-tax complexities of structuring the programs, it makes the states’ task in launching such programs appreciably less daunting.

Notice 2015-18 also includes an advance notice which acknowledges that, although Section 529A requires that the disabled beneficiary of an ABLE account be the account owner, someone other than the disabled beneficiary may have signature authority for the account. The advance notice, unsurprisingly, indicates that the regulatory guidance when issued will preclude any such person with signature authority who is not the account owner from acquiring a beneficial interest in the account, and will require such person to administer the account in the interests of the account owner/beneficiary.

By LEN WEISER-VARON

The IRS recently published a December 9, 2014 Chief Counsel Advice Memorandum to the effect that the defeasance of taxable Build America Bonds (BABs) causes a tax reissuance of the bonds, with the consequence that the municipal issuer ceases to be eligible for federal government interest subsidies for the period from the defeasance date to the redemption date.  (A “reissuance” means that from a tax perspective existing bonds are deemed exchanged for new bonds issued on the reissuance date.)  The BABs subsidy was available for bonds issued in 2009 and 2010; bonds issued or deemed issued in 2014 are ineligible.

This internal counsel advice is not particularly consequential in the specific context to which it applies.  As noted in a Bond Buyer article on the advice memorandum, defeasance escrows for taxable bonds tend to be established for short periods, usually the thirty day period between the date a redemption notice is mailed and the redemption date.  Accordingly, any loss of BABs subsidy to the issuer resulting from a purported reissuance is minor.  Similarly, though a reissuance of taxable bonds may accelerate realization of gain or loss by a bondholder, if the reissuance occurs 30 days before the redemption date, it is unlikely to change the tax year in which such gain or loss occurs.

The larger point is that the advice memorandum reflects a troubling approach by the IRS to the interpretation of its rules.  A legal defeasance of taxable bonds generally causes a reissuance (which is why taxable bond indentures provide for “covenant defeasance”, which permits the creation of a defeasance escrow that economically defeases the bonds while the issuer retains theoretical liability for any escrow shortfall.)  However, the reissuance regulations provide an exception for municipal bonds.  The reissuance exception applies to “tax-exempt bonds”, which IRS Regulation 1.1001-3(f)(5)(iii) defines as “a state or local bond that satisfies the requirements of § 103(a).”  Section 103(a) of the Internal Revenue Code sets forth the requirements that must be satisfied by tax-exempt municipal bonds.

BABs are required to meet the requirements of Section 103(a) in order to be eligible for the federal subsidy.  This is because the BABs subsidy, which is paid by the Treasury to the issuer and offsets the issuer’s interest cost, is merely an alternative mechanism for lowering the interest costs to a municipal issuer of issuing bonds that satisfy the criteria for a federal subsidy.  Instead of exempting the bondholder from income tax on the bond interest, thereby lowering the rate the issuer must pay to attract bond purchasers, the BABs mechanism pays a subsidy directly to the issuer, which some believe to be a more cost-effective form of federal subsidy.  But in order to be eligible for either form of subsidy – tax-exemption of interest, or direct subsidy payments to the issuer by the federal government – the applicable bonds must comply with the same Section 103(a) requirements.

So why does the IRS advice memorandum conclude that the reissuance exception for defeasance of bonds that satisfy the requirements of Section 103(a) is inapplicable to BABs?  The memorandum acknowledges that the legislation creating BABs was enacted subsequent to the promulgation of the relevant reissuance exception, and that the regulatory exception was not revised at that time to exclude BABs from  the exception.  But the memorandum asserts that the concerns that gave rise to the reissuance exception for such defeasances focused on preserving the tax-exemption of interest to bondholders, and that taxable BABs do not present the same concerns for bondholders.  Respected bond counsel dispute the advice memorandum’s characterization of the regulatory history of the reissuance exception.

But the more troubling feature of the IRS analysis is that BABs satisfy the literal requirements of the reissuance exception for defeasance.  Regulatory history and speculation as to whether the rulemakers would or wouldn’t have included BABs if they had focused on the question should only be relevant if there is ambiguity in the regulation.  In this instance, there is none.

Issuers should be entitled to rely on the plain meaning of IRS regulations in structuring their bond issues and/or refinancing their bond issues.  If circumstances change and the IRS does not wish a rule that literally applies to such changed circumstances to be applicable, the burden should be on the IRS to change the rule, versus expecting issuers and practitioners to pre-clear with the IRS whether some unwritten carveout to the rule exists in the minds of individuals at the IRS.  A more famous (and tonally adept) Babs once sang “If You Could Read My Mind,” but that is no way to run a tax system.

By Maxwell D. Solet

On October 24, 2014, the Internal Revenue Service issued Notice 2014-67 (the “Notice”), which provides important guidance and increased flexibility for issuers and conduit borrowers of tax-exempt bonds regarding contracting with private parties in a manner that avoids “private use” by such parties of bond-financed facilities. The Internal Revenue Code restricts private use of facilities financed by certain categories of tax-exempt bonds, including governmental bonds and bonds issued for the benefit of hospitals and other organizations that are tax exempt under Section 501(c)(3) of the Internal Revenue Code. The Notice addresses so-called “management contracts,” i.e., contracts (other than leases) with private parties that provide services with respect to bond-financed property, and, as discussed below, states that no private use will be deemed to arise from such contracts provided their term does not exceed 5 years and the compensation methodologies adhere to an expanded menu of permissible arrangements.

The Notice also addresses the treatment, for private use purposes, of Accountable Care Organizations (ACOs) established under the Affordable Care Act, and provides helpful guidance for participation in such organizations without creating “private use.”

The New 5-Year Safe Harbor

The Notice “amplifies” Revenue Procedure 97-13, which provides various safe harbors under which management contracts will not be treated as causing private use of bond-financed facilities. Both the National Association of Bond Lawyers and the American Bar Association have urged that this 1997 Revenue Procedure be updated to reflect substantial changes since its publication in the sorts of arrangements being proposed or used in connection with bond-financed facilities, including the use of ACOs.

The Notice’s new safe harbor for contracts with a term not exceeding five years improves on the existing safe harbor for contracts of similar length in several respects:

  • The new 5-year safe harbor permits a binding contract for the full 5-year term. The existing one required that the contract be terminable without penalty by the issuer or conduit borrower at any earlier date than their full term.
  • The existing 5-year safe harbor required that at least 50% of the compensation payable to the private party under the contract be fixed. The new 5-year safe harbor, as confirmed by informal conversations with the IRS, permits any combination of the permissible compensation methods outlined in the 1997 Revenue Procedure, including a 100% variable compensation methodology based on a percentage of revenues or a percentage of expenses (but not both, since that would be considered a proxy for participation by the private party in the bond-financed facility’s net profits, which is a third rail for “private use” purposes.)
  • While Revenue Procedure 97-13 allowed an annual “productivity award” based on achievement of revenue or expense goals, the Notice permits a new type of annual incentive payment keyed to satisfying quality performance standards.

IRS private letter rulings approving management contracts outside the safe harbors for some time have focused principally on the absence of an interest in net profits. The new safe harbor established under the Notice does the same, eliminating most of the detailed compensation rules under the existing 5-year and shorter safe harbors. The IRS can be expected at some point to promulgate a new Revenue Procedure which will eliminate those no longer necessary provisions.

While the Notice has a January 22, 2015 effective date, it specifically allows application to earlier bonds or contracts. Accordingly, the enhanced flexibility in compensation methodologies can be built into new contracts, and existing contracts can be amended if desired to take advantage of the new flexibility without jeopardizing tax-exemption of outstanding bonds.

Treatment of ACOs

The Notice also clarifies that hospitals or other health care organizations will not be treated as creating private use of bond-financed facilities through their participation in ACOs mandated by the Medicare Shared Savings Program under the Affordable Care Act.  The United States Treasury and the IRS have been focused on ensuring that federal tax policy not be inconsistent with federal health care policy, which has increasingly encouraged and in some cases mandated collaboration between tax-exempt 501(c)(3) organizations and for-profit entities. ACOs are a prime example. The IRS previously, in Notice 2011-20, provided favorable guidance on the effect of ACO participation on the tax-exempt status of such charitable organizations.

While an argument could be made that ACO arrangements are just a variation on third-party payment arrangements, and third-party payers have never been treated by bond counsel as “users” of bond-financed facilities, the need for this guidance arises, first, from the fact that ACOs must be distinct legal entities, frequently partnerships, which are separate from the health care provider and separate from insurers, and, second, from the fact that these arrangements provide for financial sharing between the exempt and non-exempt participants which might be viewed as problematic for the private use analysis. Under the Notice, upon satisfying multiple stated requirements, ACOs will not be treated as creating an impermissible net profits interest by the ACO or its private participants (such as doctors’ organizations) and therefore will not be treated as private use. This guidance is consistent with recommendations made by industry groups, including the National Association of Bond Lawyers. The major shortcoming of those recommendations and this guidance is the failure to deal with ACOs other than those which are created under the Affordable Care Act. In fact, health care providers are under increasing pressure to participate in ACOs to deal with other third-party payers, and such ACOs may include features which are not blessed under the Notice.