The Internal Revenue Services (IRS) issued Notice 2014-67 on Oct. 24, 2014, to “amplify” Revenue Procedure 97-13 by (i) creating a new five-year safe harbor for management contracts, and (ii) expanding the permitted types of productivity awards allowed.

Rev. Proc. 97-13 describes certain “safe harbor” arrangements that tax-exempt healthcare facilities financed with tax-free bonds can rely on to ensure any “management, service or incentive payment contract” between the facility and a service provider does not result in private business use. Many physician service agreements fall within this category.

In recognition of the Affordable Care Act, the IRS anticipates that tax-exempt healthcare providers will be entering into management or service contracts that take into account quality performance standards and Medicare fee-for-service expenditures relevant to participation in the Shared Savings Program. As a result,  the Notice adds to the list certain annual productivity rewards that would not be considered compensation based on a share of the facility’s net profits (and thus would not give rise to private business use) as long as: (1) eligibility is based on the quality of services being provided rather than based on an increase in revenue or decrease in expenses; and (2) the amount of the award is a stated dollar amount, a periodic fixed fee, or a tiered system based solely on the level of performance achieved.

In addition, the Notice adds a new 5-year safe harbor for management contracts in which compensation is based on a stated amount, a periodic fixed fee, a capitation fee, a per-unit fee, or any combination thereof.  For purposes of the new safe-harbor, the tiered productivity award described above also will be treated as a stated amount or periodic fixed fee, as applicable.  In addition, the compensation may include a percentage of either (but not both) gross revenues or expenses.  This new safe harbor covers most of the compensation arrangements that are currently allowed protection under Rev. Proc. 97-13.  Yet unlike the current safe harbors, this new safe harbor does not require the management contract to grant the tax-exempt health care facility any early “without cause” termination rights.

Historically, most physician service contracts have had to be structured to fit within the per-unit or percentage of revenue safe harbors, which require either a 3-year or 2-term respectively and certain “without cause” termination rights.  Going forward, this new safe harbor provides more flexibility not only for service contracts that include a quality component in the compensation terms, but also for service contracts that have historically required a much shorter term in order to protect against private business use.

The IRS Notice applies to contracts entered into, materially modified, or extended (other than pursuant to renewal) on or after Jan. 22, 2015.  It may also be applied to contracts entered into before Jan. 22, 2015.