Municipal Projects

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Publication February 15, 2017

Municipalities hiring private contractors to operate municipal facilities now have more flexibility.

The IRS revised guidelines for management contracts with private contractors in January to address questions municipalities have been asking since the original guidelines were issued in August 2016. The new guidelines are more detailed.

Municipalities that issue tax-exempt bonds to finance schools, roads, hospitals and other public facilities must be careful not to allow more than 10% “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 latest guidelines are in Revenue Procedure 2017-13.

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.

It is not private business use for a private party to provide services before a project is placed in service. An example is construction management services.

In all other cases, the management contract must comply with the following guidelines to avoid being labelled 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 on the project being managed. 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 penalty amount should be set in advance in the contract. It can be a range of dollar amounts and expense targets.

The contractor can be paid any mixture of the following three kinds of compensation.

It can be paid a capitation fee, meaning a fixed charge for each customer served. A capitation fee can include an adjuster that would add up to another 25% to the original base fee to protect the contractor against an unforeseen workload.

The contractor can be paid a periodic fixed fee, meaning a fixed charge for each time period.

Or it can be paid a per-unit fee, meaning a stated dollar amount for each unit of service provided. An example is a fixed charge for each car allowed on a toll road.

All three types of fees can be adjusted by an inflation index or other outside index. The contractor can also receive payments on top of these fees that are tied to the quality of services, performance or productivity.

Payment of fees can be deferred due to insufficient cash flow, but only if the contractor is paid at least annually, interest or late payment fees apply to the deferred amount, and the deferred amount, plus interest or late payment fees, must be paid at the outside within five years after the original due date.

The contract cannot have a term longer than 80% 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% 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.

If any of these required contract provisions is materially amended, then the contract must be retested as of that date.


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