A Rare Revenue Sharing Ruling Sheds Light on Private Inurement and Excess Benefit

From the Charity Lawyer Blog

Private Letter Ruling 202443007 contains a pedestrian, yet comprehensive and helpful discussion of IRC 115, a provision exempting income earned by the exercise of an “essential government function,” as long as that income accrues to the state or political subdivision. But if you read closely, you can discern the Service’s deeper thinking about revenue sharing arrangements in tax exemption jurisprudence.  Old dogs, like myself, recall a time when revenue sharing constituted private inurement, per se.  Changes in the business of health care forced the Service to reconsider, and finally Congress enacted IRC 4958(c)(4) rejecting the notion that revenue sharing necessarily results in private inurement or excess benefit. Congress told Treasury to figure it out and let us know when revenue sharing is ok.  But the Treasury Department has yet to articulate exactly when revenue sharing causes private inurement.  This PLR provides an excellent start. 

The Letter answers the question whether a state owned and operated corporation is tax exempt (albeit under IRC 115), even though a portion of net revenue is paid to a private contractor as compensation for services.  If the corporation had been a charity, the private contractor would almost certainly be a “disqualified person” under IRC 4958(f)(1).  IRC 115 is contingent on all income accruing to the state so any private inurement defeats its application.  Thus, the PLR’s analysis sheds light on when revenue sharing constitutes private inurement, not just under IRC 115 but IRC 501(c)(3) and 4958 as well. 

It’s useful to call the corporation the State Public Records Access Corp (SPRAC) because its purpose is to help state and local government agencies provide electronic access to public records as required by state law.  It’s a public records computer software company, basically.  SPRAC hired a Management Company called System Manager to run the whole thing. System Manager makes all operational decisions, including those determining income and expenses:

SPRAC hired System Manager after soliciting bids for the contract through State’s negotiated procurement process dictated by State law. The contract between SPRAC and System Manager permits SPRAC to terminate the contract and rebid it at any time with notice to System Manager. System Manager develops, in consultation with SPRAC’s staff, a detailed annual business plan, tracks all projects, and provides monthly reports to SPRAC. No director, officer, committee member, or employee of SPRAC is a director, officer, committee member, or employee of, or has a financial interest in or compensation agreement with, System Manager.

System Manager employs a project manager, web developer, designer, systems administrator, software engineers, and developers to implement projects approved by SPRAC’s board of directors and staffs a help desk for SPRAC’s customers. System Manager is also responsible for all aspects of managing the network, including acquisition, installation, operation, maintenance, and testing of all hardware, software, and enhancements thereto, and the provision of backup, support, and network service to SPRAC.

Essentially, the stated-owned corporation hired a management company to run the whole operation, and the management company is paid a variable compensation equal to a “portion” of the net revenues.  Since the Management Company makes all spending and pricing decisions, the jurisprudential concern is that System Manager might skimp on spending or set high prices to increase its compensation.  In either event, the public benefit would decrease as private benefit increased. 

The Letter concludes that the income generated accrues to the state even though a portion is paid to the System Manager as compensation.  In making the determination – essentially that revenue sharing will not cause private inurement – the Letter focuses solely on the arms-length nature of the contract:

SPRAC pays System Manager a fee for providing management and operating services for SPRAC. These fees are paid pursuant to a contract that was negotiated under State’s public bidding laws. SPRAC and System Manager have renegotiated the fee structures several times to address the different risks and costs inherent in the business at different points in time. Moreover, System Manager is required to provide monthly reports to SPRAC’s board of directors regarding all planned and existing projects. Additionally, SPRAC maintains a conflict-of-interest policy and requires its directors to file an annual statement stating that they understand and agree to comply with SPRAC’s conflict of interest policy. Upon dissolution, SPRAC’s bylaws provide that all assets are required to be distributed, or shall revert to, State, a political subdivision of State, or another entity the income of which is excludable from its gross income by application of section 115(1) that performs an essential governmental function.

It is important to emphasize that none of SPRAC’s fiduciaries have a financial interest in the System Manager and all are subject to a conflict of interest policy. That’s the essence of “arms-length.”  Thus, the revenue sharing contract has enough guardrails, checks and balances – and was formed after arms-length bargaining evincing no divided loyalties– so that System Manager is probably unable to sacrifice public good for private benefit without the independent directors noticing and taking corrective action (including immediately terminating the contract).

I can’t imagine why the same analysis should not apply to revenue sharing arrangements with public charity insiders.   We could change the world “SPRAC” to “Charity,” and the result would, or ought to be, the same.  The Treasury should issue final regs to that effect under IRC 4958. 

darryll k. jones