A lot has been written about the tax benefits of investing in a Qualified Opportunity Fund. Some have suggested that the gain from the sale of a closely held business may be invested in such a fund in order to defer the recognition of this gain and to shelter some of the appreciation thereon.
In order to better understand and evaluate the potential tax benefits of such an investment, especially from the perspective a business owner who may be contemplating a sale, one must appreciate the underlying tax policy.[i]
Almost every aspect of a business, from the mundane to the extraordinary, involves some allocation of economic risk. In the broadest sense, “deals” get done when the parties to a transaction agree to terms that allocate an acceptable level of risk between them.[ii]
In the case of a closely held business, the owners will face a significant amount of risk throughout the life of the business. On a visceral level, their risk may seem greatest at the inception of the venture; however, this is also the point at which the owners will have less economic capital at risk, in both an absolute and a relative sense, than perhaps at any other stage of the business.[iii]
Fast forward. Let’s assume the business has survived and has grown. The owners’ investment in the business has paid off, but only after many years of concentrating their economic risk[iv] in the business. The owners may now be ready to monetize their illiquid investment,[v] and reduce their economic risk.
Sale of the Business
They will seek out buyers.[vi] Some of these buyers will pay: (1) all cash for the business at closing; (2) mostly cash plus a promissory note; (3) mostly cash plus an earn-out;[vii] (4) a relatively small amount of cash plus a promissory note; (5) mostly cash, but will also insist that the owners roll over some of their equity in the business[viii] into the buyer; or (6) equity in the buyer and, maybe (depending upon the structure of the transaction) some cash.
Each of these purchase-and-sale transactions presents a different level of risk for the owners of the business being sold, with an all-cash deal providing the lowest degree of risk, and an all-equity deal the greatest. What’s more, the equity deal will place the owner into a non-controlling position within the buyer. Generally speaking, few owners are willing to give up control of their business (and the benefits flowing therefrom) and yet remain at significant economic risk.
Gain Recognition and Economic Risk
In general, the timing of a taxpayer’s recognition of the gain realized on their sale of a property is related to the level of economic risk borne by the taxpayer.
Specifically, in the case of an all-cash, low risk deal,[ix] all of the gain realized on the sale of the business will be recognized in the year of the sale; where part of the consideration consists of a promissory note – such that the seller bears some credit risk vis-à-vis the buyer – that portion of the gain realized on the sale that is attributed to the note will be recognized only as and when principal payments are made.
Continuing Investment and Deferral
Where the buyer issues equity in exchange for the business, the gain realized on the exchange by the seller and its owners may be deferred until such equity is sold, provided certain requirements are satisfied. If the deal is structured in a way that allows the owners to receive some cash along with the equity, then gain will be recognized to some extent.[x]
The Code generally provides for the deferral of gain recognition in recognition of the fact that the selling owners’ investment remains at risk where they exchange their business for equity in the buyer; they have not liquidated their interest in the business or exchanged it for cash; rather, they are continuing their investment, albeit in a somewhat different form.[xi]
Public Policy and Deferral
There are other situations, however, in which the above-stated theoretical underpinning for the deferral of gain is not applicable – because the owners have converted their interest in the business into cash – but for which the Code nevertheless provides that the seller’s gain does not have to be recognized in the year of the sale.
In these situations, the Code is seeking to promote another economic or societal goal that Congress has determined is worthy of its support.
Consider, for example, the deferral of gain realized on the sale of “qualified small business stock,” which seeks to encourage investment in certain types of “small” business;”[xii] another is the deferral of gain from the sale of stock to an ESOP, which seeks to encourage employee-retirement plan ownership of the employer-C corporation.[xiii]
Enter the Qualified Opportunity Zone
The latest addition to the family of provisions, that seeks to encourage certain investment behavior through the deferral of otherwise taxable gain, entered the Code as part of the Tax Cuts and Jobs Act[xiv] in late 2017; regulations were proposed thereunder in October of 2018.[xv]
New Section 1400Z-2 of the Code,[xvi] in conjunction with new section 1400Z-1,[xvii] seeks to encourage economic growth and investment in designated distressed communities (“qualified opportunity zones” or “QOZ”) by providing federal income tax benefits to taxpayers who invest in businesses located within these zones.
The Tax Benefits
Section 1400Z-2 provides three tax incentives to encourage investment in a QOZ:
- the temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”);[xviii]
- the partial exclusion of such capital gains from gross income to the extent they remain invested in the QOF for a certain length of time; and
- the permanent exclusion of post-acquisition capital gains (appreciation) from the sale or exchange of an interest in a QOF held for at least 10 years.
In brief, a QOF is an investment entity that must be classified as a corporation or as a partnership for federal income tax purposes, that is organized for the purpose of investing in QOZ property, and that holds at least 90 percent of its assets in such property.[xix]
Gain is eligible for deferral under the QOZ rules only if it is capital gain – ordinary income does not qualify. For example, the depreciation recapture[xx] that is recognized as ordinary income on the sale of equipment would not qualify; nor would the sale of inventory or receivables; but the capital gain from the sale of real property, shares of stock, or the goodwill of a business, would qualify.[xxi]
That being said, the gain may be either short-term or long-term capital gain. Thus, the gain recognized on the sale of a capital asset will qualify whether or not it has been held for more than one year.[xxii]
The capital gain may result from the actual or deemed sale or exchange of property. Thus, the gain recognized by a shareholder, on the distribution by an S corporation to the shareholder of cash in an amount in excess of the shareholder’s adjusted basis for its stock, would qualify for deferral.[xxiii]
In addition, the gain must not arise from the sale or exchange of property with a related person.[xxiv] In other words, the gain must arise from a sale to, or an exchange with, an unrelated person.
The gain to be deferred must be gain that would be recognized (but for the elective deferral) not later than December 31, 2026.[xxv]
Any taxpayer that would otherwise recognize capital gain as a result of a sale or exchange is eligible to elect deferral under the QOZ rules; this includes individuals, C corporations, partnerships, S corporations, estates and trusts.
Where a partnership would otherwise recognize capital gain, it may elect to defer its gain and, to the extent that the partnership does not elect deferral, a partner may elect to do so.[xxvi]
If the election is made to defer all or part of a partnership’s capital gain – to the extent that it makes an equity investment in a QOF – no part of the deferred gain is required to be included in the distributive shares of the partners.
To the extent that a partnership does not elect to defer capital gain, the capital gain is included in the distributive shares of the partners.
If all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under the QOZ rules – including the requirement that the gain did not arise from a sale or exchange with a person that is related either to the partnership or to the partner – then the partner generally may elect its own deferral with respect to the partner’s distributive share. The partner’s deferral is potentially available to the extent that the partner makes an eligible investment in a QOF.[xxvii]
A taxpayer may elect to temporarily defer, and perhaps even partially exclude, capital gains from their gross income to the extent that the taxpayer invests the amount of those gains in a QOF.
The maximum amount of the deferred gain is equal to the amount invested in a QOF by the taxpayer during the 180-day period[xxviii] beginning on the date of the actual sale that produced the gain to be deferred. Where the capital gain results from a deemed or constructive sale of property, as provided under the Code, the 180-day investment period begins on the date on which the gain would be recognized (without regard to the deferral).[xxix]
Capital gains in excess of the amount deferred (i.e., that are not reinvested in a QOF) must be recognized and included in gross income in accordance with the applicable tax rules.
In the case of any investment in a QOF, only a portion of which consists of the investment of gain with respect to which an election is made (the “deferred-gain investment”), such investment is treated as two separate investments, consisting of one investment that includes only amounts to which the election applies, and a separate investment consisting of other amounts.
The temporary deferral and permanent exclusion provisions of the QOZ rules do not apply to the separate investment. For example, if a taxpayer sells stock (held for investment) at a gain and invests the entire sales proceeds (capital gain and return of basis) in a QOF, an election may be made only with respect to the capital gain amount. No election may be made with respect to amounts attributable to a return of basis, and no special tax benefits apply to such amounts.
In order to qualify for gain deferral, the capital gain from the taxpayer’s sale must be invested in an equity interest in the QOF; in addition to “common” equity interests, this may include preferred stock (in the case of a corporate QOF), or a partnership interest with special allocations (in the case of a partnership QOF).
The eligible investment cannot be a debt instrument.
Provided that the taxpayer is the owner of the equity interest in the QOF for federal income tax purposes, its status as an eligible interest will not be impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise.
This is an important point because it is possible that a taxpayer’s gain from a sale or exchange of property will exceed the amount of cash received by the taxpayer in such sale or exchange. Thus, a taxpayer may have to borrow money in order to make the necessary reinvestment and thereby defer the gain.
The taxpayer’s basis for a deferred-gain investment in a QOF immediately after its acquisition is deemed to be zero, notwithstanding that they may have invested a significant amount of cash.[xxx]
If the deferred-gain investment in the QOF is held by the taxpayer for at least five years from the date of the original investment in the QOF, the basis in the deferred-gain investment (the taxpayer’s equity interest in the QOF) is increased by 10 percent of the original deferred gain.
If the QOF investment is held by the taxpayer for at least seven years,[xxxi] the basis in the deferred gain investment is increased by an additional five percent of the original deferred gain.[xxxii]
Some or all of the gain deferred by virtue of the investment in a QOF will be recognized on the earlier of: (1) the date on which the QOF investment is disposed of, or (2) December 31, 2026.
In other words, the gain that was deferred on the original sale or exchange must be recognized no later than the taxpayer’s taxable year that includes December 31, 2026, notwithstanding that the taxpayer may not yet have disposed of its equity interest in the QOF.
This point is significant insofar as a taxpayer’s ability to utilize the basis adjustment rule is concerned. In order for the taxpayer to receive the “10 percent of gain” and the additional “5 percent of gain” basis increases, described above, the taxpayer must have held the investment in the QOF for five years and seven years, respectively.
Because the taxpayer’s deferred gain from the original sale will be recognized no later than 2026, the taxpayer will have to sell or exchange “capital gain property,” and roll over the capital gain therefrom into an equity interest in a QOF, no later than December 31, 2019 in order to take advantage of the full “15 percent of gain basis increase.”[xxxiii]
The amount of gain recognized in 2026 will be equal to (1) the lesser of the amount deferred and the current fair market value of the investment,[xxxiv] over (2) the taxpayer’s basis in their QOF investment, taking into account any increases in such basis at the end of five or seven years.
As to the nature of the capital gain – i.e., long-term or short-term – the deferred gain’s tax attribute will be preserved through the deferral period, and will be taken into account when the gain is recognized. Thus, if the deferred gain was short-term capital gain, the same treatment will apply when that gain is included in the taxpayer’s gross income in 2026.
At that time, the taxpayer’s basis in the QOF interest will be increased by the amount of gain recognized.
No election to defer gain recognition under the QOZ rules may be made after December 31, 2026.[xxxv]
Death of the Electing Taxpayer
If an electing individual taxpayer should pass away before the deferred gain has been recognized,[xxxvi] then the deferred gain shall be treated as income in respect of a decedent, and shall be included in income in accordance with the applicable rules.[xxxvii]
In other words, the beneficiaries of the decedent’s estate will not enjoy a basis step-up for the deferred-gain investment in the QOF at the decedent’s death that would eliminate the deferred gain.
Exclusion of Appreciation
The post-acquisition capital gain on a deferred-gain investment in a QOF that is held for at least 10 years will be excluded from gross income.
Specifically, in the case of the sale or exchange of equity in a QOF held for at least 10 years from the date of the original investment in the QOF, a further election is allowed by the taxpayer to modify the basis of such deferred-gain investment in the hands of the taxpayer to be the “fair market value” of the deferred-gain investment at the date of such sale or exchange.[xxxviii]
However, under Sec. 1400Z-1, the designations of all QOZ in existence will expire on December 31, 2028. The IRS acknowledges that the loss of QOZ designation raises numerous issues regarding gain deferral elections that are still in effect when the designation expires. Among these is whether, after the relevant QOZ loses its designation, investors may still make basis step-up elections under Sec. 1400Z-2 for QOF investments from 2019 and later.[xxxix]
A taxpayer who invests their gains in a QOF may continue to realize and recognize losses associated with their investment in the QOF. After all, the QOF is a “business” like any other, notwithstanding its genesis in Congress.
Moreover, its purpose is to invest in certain distressed communities (QOZs); that’s why the income tax incentives are being offered – to encourage investment in businesses located within QOZs.
In the case of a fund organized as a pass-through entity, a taxpayer-investor may recognize gains and losses associated with both the deferred-gain and non-deferred gain investments in the fund, under the tax rules generally applicable to pass-through entities.
Thus, for example, an investor-partner in a fund organized as a partnership would recognize their distributive share of the fund’s income or deductions, gains or losses, and the resulting increase or decrease in their “outside basis” for their interest in the partnership.[xli]
Aside from the ordinary business risk, an investor should also be aware that if a QOF fails to satisfy the requirement that the QOF hold at least 90 percent of its assets in QOZ property, the fund will have to pay a monthly penalty;[xlii] if the fund is a partnership, the penalty will be taken into account proportionately as part of the distributive share of each partner.
The following example illustrates the basic operation of the above rules.
Assume a taxpayer sells stock for a gain of $1,000 on January 1, 2019, and elects to invest $1,000 in the stock of a QOF (thereby deferring this gain). Assume also that the taxpayer holds the investment for 10 years, and then sells the investment for $1,500.
The taxpayer’s initial basis in the deferred-gain investment is deemed to be zero.
After five years, the basis is increased to $100 (i.e., 10 percent of the $1,000 of deferred gain).
After seven years, the basis is increased to $150 (i.e., $100 plus an additional 5 percent of the deferred gain).
At the end of 2026, assume that the fair market value of the deferred-gain investment is at least $1,000, and thus the taxpayer has to recognize $850 of the deferred capital gain ($1,000 less $150 of basis).
At that point, the basis in the deferred gain investment is $1,000 ($150 + $850, the latter being the amount of gain recognized in 2026).
If the taxpayer holds the deferred-gain investment for 10 years and makes the election to increase the basis, the $500 of post-acquisition capital gain on the sale after 10 years is excluded from gross income.
What Does It All Mean?
QOFs are just now being organized. The IRS’s guidance on QOFs and their tax benefits is still in proposed form. The clock on the deadline for recognizing any gain that is deferred pursuant to these rules will stop ticking at the end of 2026 – that’s when the deferred gain must be recognized; generally speaking, the shorter the deferral period, the less beneficial it is to the taxpayer. In order to enjoy the full benefit of the gain reduction provided by the 15 percent of basis adjustment rule, a taxpayer will have to generate eligible gain and invest the amount thereof in a QOF prior to December 31, 2019.[xliii] Finally, in order to exclude the post-investment appreciation in a QOF interest, a taxpayer must hold that interest for at least ten years – that’s a long time.
Let’s start with the premise that, unless a taxpayer has a good business reason for selling an investment, including, for example, their business, they should not do so just to take advantage of the QOZ rules.
Assuming the taxpayer has decided that it makes sense to sell, aside from the hoped-for tax benefits, they have to consider the “tax rule of thumb” described at the beginning of this post:[xliv] economic certainty and tax deferral share an inverse relationship – there is generally an economic risk associated with long-term deferral.
With that, it will behoove the taxpayer to consult with their accountant and financial adviser, not to mention their attorney, prior to jumping into a QOF. Although questions remain, the QOZ rules provide some attractive tax benefits. Provided the taxpayer takes a balanced approach, there may be a place for a QOF investment in their portfolio.[xlv]
[i] I am neither a proponent nor an opponent of such investments. I am not qualified, nor do I purport, to give financial advice – I leave that to the financial planners. My goal is to give you something to think about.
[ii] Think Goldilocks. “Just right.”
[iii] Compare the passive investor who is willing to fund the new venture, provided they receive a preferred return for placing their money at risk, or the lender who is willing to extend credit to the business, but only at a higher rate, and maybe with the ability to convert into equity.
[iv] Not to mention their time and labor. Opportunity costs.
[v] After all, there is no market on which they may readily “trade” their equity.
[vi] Hopefully with the assistance of professionals who know the market, who can educate them in the process, who will “run interference” for them with potential buyers, and who can crunch the numbers in a meaningful way to compare offers.
[vii] Which may require the owners’ continued involvement if they hope to attain the earn-out targets.
[viii] As in the typical private equity deal.
This may be done on a pre- or post-tax basis; in the former, the owners will contribute their equity interest or assets to the buyer in exchange for equity in the buyer – the recognition of the gain inherent in the contributed property is thereby deferred; in the latter, they will take a portion of the cash paid to them (which is taxable) and invest it in the buyer.
[ix] Of course, I am ignoring the level of risk associated with the reps, warranties, and covenants given by the owners and the target business under the purchase-and-sale agreement, the breach of which may require that the now-former owners of the business indemnify the buyer for any losses incurred attributable to such breach – basically, an adjustment of the purchase price and a re-allocation of risk.
[x] For example, a forward corporate merger will allow some cash “boot” to be paid along with stock of the acquiring corporation; gain will be recognized to the extent of the cash received. In the case of a contribution to a partnership in exchange for an interest therein plus some cash, the so-called disguised sale rules will apply to determine the tax consequences.
[xi] To paraphrase Reg. Sec. 1.1001-1(a), the gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is treated as income sustained. In the context of the corporate reorganization provisions, we refer to there being a “continuity of business enterprise” and a “continuity of interest.” IRC Sec. 368; Reg. Sec. 1.368-1(d) and (e).
This recalls the like kind exchange rules under IRC Sec. 1031, the benefits of which are now limited to exchanges of real property. See Sec. 1031, as amended by the Act. https://www.law.cornell.edu/uscode/text/26/1031.
[xii] IRC Sec. 1202. Under this provision, non-corporate taxpayers may be able to exclude all of the gain from the sale of “qualified small business stock” held for more than five years. In order to qualify as qualified small business stock, several requirements must be satisfied, including the following: C corporation, original issue, qualified trade or business, gross assets not in excess of $50 million, at least 80% of the value of the assets must be used in the active conduct of the qualified trade or business. Query whether the reduction in the corporate tax rate, to a flat 21%, will spur interest in this provision and investment in qualifying corporations and businesses.
[xiii] IRC Sec. 1042. This provision affords the individual shareholder of the employer corporation the opportunity to sell stock to the ESOP (the ESOP must own at least 30%) and to defer the recognition of the gain realized on such sale by reinvesting the proceeds therefrom (within a 15-month period that begins three months prior to the sale) in the securities of other domestic corporations. This allows the owner to take some risk off the table, and to diversify their equity by investing in publicly traded corporations. In the meanwhile, the owner may continue to operate their business.
[xiv] P.L. 115-97 (the “Act”). I know, you’re tired of seeing this cite. I’m tired of . . . citing it. It is what it is.
[xvi] IRC Sec. 1400Z-2. https://www.law.cornell.edu/uscode/text/26/1400Z-2 . “Z” is so ominous. Anyone read the novel “Z” by Vassilikos?
[xvii] Which sets forth the requirements for a Qualified Opportunity Zone. We will not be discussing these requirements in this post. https://www.law.cornell.edu/uscode/text/26/1400Z-1 . See also https://www.irs.gov/pub/irs-drop/rr-18-29.pdf
[xviii] We will not be discussing the requirements for QOF status in any detail.
[xix] QOZ property, in turn, is defined to include QOZ stock, QOZ partnership interest, and QOZ business property. Although these terms are defined is some detail by the Code, one might say that the common denominator is that there be a qualified business that is conducted primarily within the QOZ. A penalty may be imposed for failing to satisfy this requirement. See EN xxxvii and the related text.
[xx] IRC Sec. 1245.
[xxi] IRC Sec. 1221, 1231.
[xxii] IRC Sec. 1222. This “attribute” of the gain is preserved for purposes of characterizing the gain when it is finally recognized.
Section 1231 property must be held for more than one year, by definition.
[xxiii] IRC Sec. 1368. This is often the case when an S corporation liquidates (or is deemed to liquidate) after the sale (or the deemed sale, under IRC Sec. 338(h)(10)) of its assets.
[xxiv] See IRC Sec. 267(b) https://www.law.cornell.edu/uscode/text/26/267 and Sec. 707(b)(1) https://www.law.cornell.edu/uscode/text/26/707 ; substitute “20 percent” in place of “50 percent” each place it appears.
[xxv] A taxpayer with gain, the recognition of which would be deferred beyond this time under the Sec. 453 installment method, would probably not elect to defer such gain under the QOZ rules. After all, why accelerate the recognition event? However, query whether there are circumstances in which it would make sense to elect out of installment reporting so as to utilize Sec. 1400Z-2? IRC Sec. 453(d). Perhaps to take advantage of the exclusion of gain after satisfying the ten-year holding period?
[xxvi] These proposed regulations clarify the circumstances under which the partnership or the partner can elect, and also clarify when the applicable 180-day period begins.
[xxvii] The proposed regulations state that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.
[xxviii] This investment period should be familiar to those of you who are experienced with like kind exchanges.
[xxix] A partner’s 180-day reinvestment period generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred. Query, however, whether the partnership will distribute the proceeds from the sale to its partners to enable them to make the roll-over investment – individual partners may have to use other funds (or borrow) in order to achieve the desired deferral.
[xxx] That being said, if the QOF is a partnership that has borrowed funds, the investor may be allocated a portion of such indebtedness, which amount would be added to their basis for their partnership interest. See IRC Sec. 752.
[xxxi] I.e., two more years.
[xxxii] Yielding basis equal to 15 percent of the original deferred gain.
[xxxiii] 2019 plus 7 equals 2026.
[xxxiv] Ah, the risk of an investment in equity.
[xxxv] Thus, the gain from a sale in 2025 may be deferred for one year. The gain from a sale during or after 2026 is not deferred under these rules.
[xxxvi] For example, before 2026.
[xxxvii] IRC Sec. 691.
[xxxviii] Query if this is the correct formulation; for example, what if the QOF is a partnership that generates losses which flow through to its members, thereby reducing their basis – does the statute intend for the members to wipe out this basis reduction and never recapture the benefit thereof on a subsequent sale? See the Example, below.
[xxxix] The proposed regulations would permit taxpayers to make the basis step-up election after the QOZ designation expires.
[xl] See EN 1. The IRS says as much in the preamble to the proposed regulations.
[xli] See EN xxxiii and the related text.
[xlii] Unless the failure is due to reasonable cause.
[xliii] An investment by December 31, 2021 may enjoy the 10 percent basis adjustment, which follows a five-year holding period.
[xliv] I know, you can’t remember that far back. I apologize. Lots to say this week.
[xlv] The saying “meden agan” was inscribed on the temple of Apollo at Delphi. It means “nothing in excess.”