Committed to a Zone
Last week’s post[i] considered how the newly-enacted qualified opportunity zone (“QOZ”) rules seek to encourage investment and stimulate economic growth in certain distressed communities by providing various federal income tax benefits to taxpayers who invest in businesses that operate within these zones.[ii] After describing these tax incentives, the post cautioned taxpayers who may have already recognized capital gain,[iii] or who are planning to sell or exchange property in a transaction that will generate taxable capital gain, that the tax incentives, although attractive, may be indicative of some not insignificant economic risk that is associated with the targeted investment.[iv]
This week, we continue our discussion of the QOZ rules,[v] beginning with the premise that the taxpayer already owns a business in a QOZ,[vi] or is already committed to investing in a QOZ.[vii] In other words, the taxpayer has already considered the risks of expanding within, or of moving into, such an area, and they have decided that it makes sense to do so from a long-term economic or business perspective. As to this taxpayer, the new tax incentives coincide with their long-term investment horizon, and also offer the opportunity[viii] to increase the taxpayer’s after-tax return on their investment.[ix]
What’s a Fund?
The use of the word “fund” may be misleading to some, who may interpret it strictly as a vehicle by which several investors can pool their resources for purposes of acquiring interests in one or more qualifying businesses.
The regulations proposed by the IRS provide that a QOF must be an entity that is classified as a partnership or as a corporation for federal income tax purposes. The reference to a “partnership” necessarily requires that there be at least two members that are respected as separate from one another for tax purposes.[xii]
The fact that a number of asset and wealth management businesses seem to have formed QOFs, and have begun to solicit investments therein from the “general public,” has reinforced the impression that a QOF must be some kind of pooled investment vehicle.[xiii]
Although such a vehicle generally offers single investors the opportunity[xiv] to combine their money to increase their “buying power,” decrease their individual risk, attain a level of diversification, and gain other advantages, such as professional management, there is nothing in the Code or in the regulations proposed thereunder that requires a QOF to be a multi-member investment vehicle.[xv]
In other words, so long as the subject entity is formed as a partnership, it can have as few as two investor-members and may still qualify as a QOF; in the case of a corporation, it can have only as few as one shareholder. Thus, a closely held business entity may be QOF.
That being said, there are a number of other requirements that the partnership or corporation must satisfy in order to be treated as a QOF, and that may prevent a closely held business from qualifying.
Requirements for QOF Status
Corporation or Partnership. The fund must be created or organized as a partnership or as a corporation in one of the 50 States, the District of Columbia, or a U.S. possession;[xvi] it must be organized for the purpose of investing in “QOZ property,” but not in another QOF.
A corporation may be a C corporation, or its shareholders may elect to treat it as an S corporation.[xvii] Alternatively, the fund may be formed as an LLC but elect to be treated as a corporation for tax purposes.[xviii]
New or Pre-existing. Moreover, the partnership or corporation may be a pre-existing entity and still qualify as a QOF,[xix] provided that the pre-existing entity satisfies the requirements for QOF status, including the requirement that QOZ property be acquired after December 31, 2017.[xx]
90 Percent of Asset Test. In addition, the fund must hold at least 90 percent of its assets[xxi] in “QOZ property,” determined by the average of the percentage of QOZ property held in the fund as measured (A) on the last day of the first 6-month period of the taxable year of the fund,[xxii] and (B) on the last day of the taxable year of the fund.[xxiii]
QOZ Property; QOZ Business Property
The following three kinds of property are treated as QOZ property that is counted toward the 90 percent test:
- QOZ stock,
- which is stock in a corporation that is acquired by the fund after December 31, 2017,
- at its original issue,[xxiv] from the corporation,
- solely in exchange for cash,
- as of the time the stock was issued, the corporation was a “QOZ business” (or the corporation was being organized for purposes of being such a business), and
- during “substantially all” of the fund’s holding period for the stock, the corporation qualified as a QOZ business;
- QOZ partnership interest,
- which is any capital or profits interest in a partnership,
- that is acquired by a fund after December 31, 2017,
- from the partnership,
- solely in exchange for cash,
- as of the time the partnership interest was acquired, the partnership was a “QOZ business” (or the partnership was being organized for purposes of being a QOZ business), and
- (c) during “substantially all” of the fund’s holding period for the partnership interest, the partnership qualified as a QOZ business; and
- QOZ business property,
- which is tangible property used in a trade or business of the fund,
- that was purchased by the fund after December 31, 2017,
- from an “unrelated” person,[xxv]
- for which the fund has a cost basis,
- (i) the “original use”[xxvi] of which within the QOZ commences with the fund, or (ii) which the fund “substantially improves;” and
- during “substantially all of the fund’s holding period” for the tangible property, “substantially all of the use” of the tangible property was in the QOZ.[xxvii]
N.B. Consequently, if a QOF operates a trade or business directly, and does not hold any equity in a QOZ business formed as a corporation or partnership, at least 90 percent of the QOF’s assets must be QOZ business property; i.e., it must be tangible property – no more than 10 percent of its property can be intangible property, such as goodwill.[xxviii]
Substantially Improved. The definition of QOZ business property basically requires the property to be used in a QOZ, and also requires that new capital be employed in a QOZ.
Specifically, tangible property is treated as “substantially improved” by a QOF (for purposes of applying the definition of QOZ business property) only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOF exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOF; in other words, the fund must at least double the adjusted basis of the property during such 30-month period. For example, if property is acquired in February of 2019, it must be substantially improved by August 2021.
Significantly, if a QOF purchases a building located on land wholly within a QOZ, a substantial improvement to the purchased tangible property is measured by the QOF’s additions to the adjusted basis of the building only; the QOF is not required to separately “substantially improve” the land upon which the building is located.[xxix]
In order for a share of stock in a corporation, or for a partnership interest, to be treated as QOZ property in the hands of a fund, the issuing entity must be a QOZ business, which is any trade or business:
- In which “substantially all” of the tangible property owned or leased by the trade or business is QOZ business property;[xxx]
- At least 50 percent of the total gross income of which is derived from the “active conduct of business”[xxxi] in the QOZ;
- A “substantial portion” of the business’s intangible property is used in the active conduct of business[xxxii] in the QOZ; and
- Less than 5 percent of the average of the aggregate adjusted bases of the property of the business is attributable to “nonqualified financial property;”[xxxiii]
- nonqualified financial property does not include “reasonable amounts” of working capital held in cash, cash equivalents, or debt instruments with a term of no more than 18 months;
- nor does it include accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory property;
- The trade or business is not a golf course, country club, massage parlor, hot tub or suntan facility, racetrack or other facility used for gambling, or store whose principal business is the sale of alcoholic beverages for consumption off premises.[xxxiv]
Substantially All. A corporation’s or partnership’s trade or business is treated as satisfying the “substantially all” requirement (for purposes of applying the definition of QOZ business) if at least 70 percent of the tangible property owned or leased by the trade or business is QOZ business property.[xxxv] (This is to be compared to the requirement that 90 percent of the fund’s assets must be QOZ business property where the fund directly owns only a trade or business.)
Working Capital. For purposes of applying the limit on nonqualified financial property, working capital assets will be treated as reasonable in amount if all of the following requirements are satisfied:
- The amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ.
- There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets.
- Under the schedule, the working capital assets must be spent within 31 months of the receipt by the business of the assets.[xxxvi]
- The working capital assets are actually used in a manner that is “substantially consistent” with the foregoing.[xxxvii]
Similarly, a safe harbor is provided for purposes of applying the 50-percent test for gross income derived from the active conduct of business. Specifically, if any gross income is derived from property that is treated as a reasonable amount of working capital, then that gross income is counted toward satisfaction of the 50-percent test.[xxxviii]
Substantial Portion. The requirement that a “substantial portion” of the business’s “intangible property” be used in the active conduct of business will be treated as being satisfied during any period in which the business is proceeding in a manner that is substantially consistent with the use of the working capital described above.
Although these “safe harbors” are helpful, the absence of guidance on other requirements is troubling, including those related to the fund’s “active conduct of business;” for example, will rental real estate be treated as an active trade or business for this purpose?
N.B. It is noteworthy that the proposed safe harbor for working capital applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund, thereby making the 90 percent test more restrictive.
The 90 Percent of Assets Test
As indicated above, a QOF must undergo semi-annual tests to determine whether its assets consist, on average, of at least 90 percent QOZ property. For purposes of these semi-annual tests, a tangible asset can be treated as QOZ business property by a find that has self-certified as a QOF (or an operating subsidiary corporation or partnership) only if it acquired the asset after 2017 by purchase.
For purposes of the calculation of the “90 percent of assets test” by the QOF, the QOF is required to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year.[xxxix]
Failing the 90 Percent. In general, if a fund fails to satisfy the 90 percent test, a monthly penalty will be imposed on the fund in an amount equal to the product of:
(A) the excess of (1) the amount equal to 90 percent of the fund’s aggregate assets, over (2) the aggregate amount of QOZ property held by the fund, multiplied by (B) the underpayment rate. This penalty will not apply before the first month in which the entity qualifies as a QOF.
Working Capital Safe Harbor. Query whether cash be an appropriate QOF property for purposes of the 90 percent test if the cash is held with the intent of investing in QOZ property? Specifically, because developing a new business or the construction or rehabilitation of real estate may take longer than six months (i.e., the period between testing dates), QOFs should be given longer than six months to invest in qualifying assets.[xl]
The proposed regulations provide a working capital safe harbor for QOF investments in QOZ businesses (i.e., partnerships and corporations) that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an opportunity zone.
The safe harbor allows qualified opportunity zone businesses a period of up to 31 months, if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and the business substantially complies with the schedule. Taxpayers would be required to retain any written plan in their records.[xli]
If a corporation or partnership qualifies as a QOZ business, the value of the QOF’s entire interest in the entity counts toward the QOF’s satisfaction of the 90 percent test. Thus, if a QOF operates a trade or business (or multiple trades or businesses) through one or more partnerships or corporations, then the QOF can satisfy the 90 percent test if each of the entities qualifies as a QOZ business;[xlii] among other things, “substantially all” of the tangible property owned or leased by the entity must be QOZ business property.
A business will be treated as satisfying the substantially all requirement for this purpose if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property.[xliii]
N.B. Again, it is noteworthy that the proposed 70 percent test for purposes of satisfying the substantially all requirement applies only in determining whether a partnership or corporation in which a QOF owns an interest (a lower-tier entity) qualifies as a QOZ business. It does not apply to a trade or business that is owned directly by a fund; it appears that no more than 10 percent of the assets of such a business can be cash or intangibles (like goodwill).
Certification as a QOF
In order to facilitate the investment process, and minimize the information collection burden placed on taxpayers, a corporation or partnership that is eligible to be a QOF is allowed to self-certify that it is organized as a QOF.
The self-certification must identify the first taxable year that the fund wants to be a QOF; it may also identify the first month (in that initial taxable year) in which it wants to be a QOF.[xliv]
If a taxpayer who has recognized gain invests in a fund prior to the fund’s first month as a QOF, any election to defer such gain with that investment is invalid.
Return. It is expected that a fund will use IRS Form 8996, Qualified Opportunity Fund,[xlv] both for its initial self-certification and for its annual reporting of compliance with the 90-percent test. It is also expected that the Form 8996 would be attached to the fund’s federal income tax return for the relevant tax years.[xlvi]
The proposed regulations allow a QOF both to identify the taxable year in which the entity becomes a QOF and to choose the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial taxable year as a QOF is treated as the first month that the eligible entity is a QOF.[xlvii]
The QOZ rules were enacted in December of 2017. Regulations were proposed in October of 2018. The IRS has indicated that a second round of proposed regulations will be released relatively soon. The period for recognizing capital gains that will be eligible for reinvesting in QOFs and enjoying the resulting tax benefits expires in 2026.[xlviii] Many questions remain unanswered.
Although a closely held business entity (a fund) that chooses to own a business directly, and to operate such a business in a QOZ, may qualify as a QOF into which its taxpayer-owner may invest their post-2017 capital gains, it appears that the IRS has placed some obstacles in its path to doing so. Whether these were intentional or not remains to be seen. In the meantime, the clock continues to run.
What is a business owner (the “Taxpayer”) to do if they are planning a liquidity event, such as a sale of the business to an unrelated person, in the near future and want to defer their gain by taking advantage of the QOZ tax benefits, but without giving up control over their investment? They can create and capitalize their own fund (within the prescribed investment period), that will try to start a QOZ business that satisfies the tests described above, including the requirement that they timely purchase QOZ business property, and such property shall represent at least 90 percent of the fund’s assets. Good luck.
Alternatively, they can create their own fund, identify one or more existing QOZ businesses (C corporations or partnerships) that are ready to expand and, over the next six months, try to negotiate a cash investment in such a business in exchange for equity therein (including a preferred interest) that also provides the Taxpayer with a significant voice in the management of the business as to major decisions (“sacred rights”), including any decisions that may affect the business’s qualification as a QOZ business or the qualification of the Taxpayer’s investment vehicle as a QOF. The QOZ business would have 31 months in which to use the Taxpayer’s infusion of working capital to acquire QOZ business property.[xlix]
Failing these options, the Taxpayer may invest timely in an “institutional” fund, but with the understanding that they will have little-to-no voice therein. It may not be ideal, but it is much easier to accomplish than the alternatives described above.[l]
[i] Any “quoted” terms that are not defined herein were either defined in last week’s post or have not yet been defined by the IRS.
[ii] The temporary deferral of inclusion in gross income of certain capital gains to the extent they are reinvested in a qualified opportunity fund (“QOF”); 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.
[iii] And whose 180-day period for reinvesting the gain(s) from such sale(s) has not yet expired. As an aside, any taxpayer planning to take advantage of the QOZ rules should start investigating reinvestment options well before their capital gain event.
[iv] For example, the investment is being made in an economically-challenged area, the deferral ends in 2026, at which point the taxpayer who invests their gain in a QOF may not have the liquidity to pay the tax; in order for a taxpayer to enjoy the full 15 percent reduction in the deferred gain, they must acquire an interest in a QOF before the end of 2019 and then hold the interest for at least seven years; and the exclusion from income of any appreciation above the deferred gain requires that the taxpayer hold their investment in the QOF for at least ten years.
[v] I.e., IRC Sec. 1400Z-1 and 1400Z-2, and the regulations proposed thereunder; the regulations generally are proposed to be effective on or after the date they are published as final in the Federal Register. However, a QOF may rely on the proposed rules with respect to taxable years that begin before the final regulations’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner.
[vi] A complete list of designated qualified opportunity zones is found in Notice 2018-48, 2018-28 I.R.B. 9.
[vii] Consider, for instance, the number of businesses that had already moved, or had decided to move, into Long Island City, N.Y. before the enactment of these incentives as part of the Tax Cuts and Jobs Act (P.L. 115-97).
[viii] Pun intended.
[ix] Assuming all goes well.
[x] The “taxpayer” may be an individual, a C corporation, a partnership, an S corporation, an estate, or a trust.
[xi] Capital gain, which may be realized in a number of different scenarios under a number of Code provisions. The election to defer tax on an eligible gain invested in a QOF is made on Form 8949, Sales and Other Dispositions of Capital Assets, which is attached to a taxpayer’s federal income tax return.
[xii] You can’t have a tax partnership among a grantor, a 100% grantor trust, and an LLC that is wholly-owned by the grantor and disregarded as an entity separate from the grantor.
[xiii] For example, UBS circulated an email to that effect just last week.
[xiv] There’s that word again.
[xvi] In addition, if the entity is organized in a U.S. possession, but not in one of the 50 States or in the District of Columbia, then it may be a QOF only if it is organized for the purpose of investing in QOZ property that relates to a trade or business operated in the possession in which the entity is organized.
[xvii] The latter cannot have more than 100 shareholders. IRC Sec. 1361(b).
[xviii] Reg. Sec. 301.7701-3.
[xix] Or as the issuer of “QOZ stock” or of a “QOZ partnership interest.”
[xx] Which requirement, by itself, may prevent a pre-existing entity from qualifying.
[xxi] By “value;” see below.
[xxii] With respect to an entity’s first year as a QOF, if the entity chooses to become a QOF beginning with a month other than the first month of its first taxable year, the phrase “first 6-month period of the taxable year of the fund” means the first 6-month period (i) composed entirely of months which are within the taxable year and (ii) during which the entity is a QOF. For example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90 percent testing dates for the QOF are the end of September and the end of December. Moreover, if the calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.
[xxiii] June 30 and December 31 in the case of a taxpayer with a December 31 YE.
[xxiv] Directly or through an underwriter.
[xxv] IRC Sec. 1400Z-2(d)(2)(D)(i)(I), Sec. 179(d)(2).
[xxvi] The IRS did not propose a definition of “original use” and is seeking comments on possible approaches to defining the “original use” requirement, for both real property and other tangible property. For example, what metrics would be appropriate for determining whether tangible property has “original use” in an opportunity zone? Should the use of tangible property be determined based on its physical presence within an opportunity zone, or based on some other measure? See Revenue Ruling 2018-29 regarding the acquisition of an existing building on land within a QOZ. Stay tuned.
[xxvii] Hopefully, the forthcoming second round of proposed regulations will address the meaning of “substantially all” in each of the various places where it appears. The IRS has requested comments.
[xxviii] See below.
[xxix] Although the foregoing guidance is helpful, questions remain. For example, how will a fund’s satisfaction of the “substantial improvement” test be affected if it elects to expense some of its investment under Section 179 of the Code, or if it elects bonus depreciation under Section 168?
[xxx] See the definition of QOZ business property, above. Query how the asset rules will be applied to leases.
[xxxi] Hopefully, this will be defined in the next round of guidance.
[xxxii] Stay tuned for this, too.
[xxxiii] This includes debt, stock, partnership interests, annuities, and derivative financial instruments (for example, options and futures).
[xxxiv] I guess Congress doesn’t want to encourage the presence of such vile establishments in distressed areas.
[xxxv] The value of each asset of the entity as reported on the entity’s “applicable financial statement” for the relevant reporting period is used for determining whether a trade or business of the entity satisfies this requirement. Reg. Sec. 1.475(a)-4(h). If a fund does not have an applicable financial statement, the proposed regulations provide alternative methodologies for determining compliance.
[xxxvi] 31 months?! Has the IRS ever tried to develop property in N.Y.C. or on Long Island? Delays caused by legislators and regulators are standard fare.
[xxxvii] If some financial property is treated as being a reasonable amount of working capital because of compliance with the requirements above regarding the use of working capital, and if the tangible property acquired with such working capital is expected to satisfy the requirements for QOZ business property, then that tangible property is not treated as failing to satisfy those requirements solely because the scheduled consumption of the working capital is not yet complete.
[xxxviii] The requirement that the QOZ business derive at least 50 percent of its income from the QOZ may be more difficult to satisfy.
[xxxix] See EN xxxi. If a QOF does not have an applicable financial statement, it may use the cost of its assets. The IRS has requested comments on the suitability of both of these valuation methods, and whether another method, such as tax adjusted basis, would be better.
[xl] What if a QOF sells its interest in QOZ stock or its QOZ partnership interest? It should have “a reasonable period of time” to reinvest the proceeds therefrom. For example, if the sale occurs shortly before a testing date, the QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 percent test. According to the IRS, soon-to-be-released proposed regulations will provide guidance on these reinvestments by a QOF.
[xli] This expansion of the term “working capital” reflects the fact that the QOZ rules anticipate situations in which a QOF or operating subsidiary may need up to 30 months after acquiring a tangible asset in which to improve the asset substantially. The IRS has requested comments about the appropriateness of any further expansion of the “working capital” concept beyond the acquisition, construction, or rehabilitation of tangible business property to the development of business operations in the opportunity zone.
[xlii] Query whether the IRS will eventually permit some sort of aggregation for purposes of applying this rule.
[xliii] This 70 percent threshold is intended to apply only to the term “substantially all” as it is used in section 1400Z-2(d)(3)(A)(i).
[xliv] If the self-certification fails to specify the month in the initial taxable year that the eligible entity first wants to be a QOF, then the first month of the eligible entity’s initial taxable year as a QOF is the first month that the eligible entity is a QOF.
[xlv] Instructions for Form 8996 were released January 24, 2019. A corporation or partnership will use the form to certify that it is organized to invest in QOZ property; they will also file the form annually to report that they meet the investment standard (or to calculate the penalty if they fail to satisfy the standard).
[xlvi] Form 1120, 1120S or 1065.
[xlvii] A deferral election under section 1400Z-2(a) may only be made for investments in a QOF. Therefore, a proper deferral election under section 1400Z-2(a) may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.
[xlix] This option appears to be more manageable.
[l] There’s that inverse relationship again.