QOZ Investors Receive More Clarity on Rules for Operating Businesses

Investors interested in creating operating businesses in Qualified Opportunity Zones (“QOZ”) have been on the sidelines.  It took the second round of proposed U.S. Treasury Department regulations, issued on April 17, 2019, to get this group into the game. QOZs are the result of The Tax Cuts and Jobs Act of 2017, which can provide significant tax benefits to investors who re-invest capital gains into long-term investments within communities designed by state governors and the federal government for economic development.

Prior to the new regulations, there was little guidance on whether an operating business would be considered a “qualifying asset” of a QOZ fund and therefore qualify as a QOZ business.  This is important because a QOZ fund needs “qualifying assets” to avoid penalties.  The issue was that the law requires a QOZ business to derive more than 50% of its gross income from the “active conduct of a business within a Qualified Opportunity Zone”. However, there were no rules for determining what is “active conduct” or where income is earned (inside or outside a QOZ).

Gross Income Test Safe Harbors

The new regulations provide more clarity around the 50% gross income test in the form of three “safe harbors” or tests.  A QOZ business will satisfy the 50% gross income test if it achieves any one of the following:

1. More than 50% of the service hours performed for the business by its employees and independent contractors are performed within the QOZ; or
2. More than 50% of the compensation and/or contractor expenses for the business are incurred by its employees and independent contractors within the QOZ; or
3. The QOZ business locates both tangible property and its management or operations within a QOZ that are necessary to generate 50% of the gross income of the business.

An illustrative example could be a tech company.  It involves a startup business that develops software applications for global sale in a campus located in a QOZ.  A majority of the total hours of the start-up’s employees and contractors developing software applications are located in the QOZ.  The startup business would satisfy the 50% gross income test even though the business makes the vast majority of its sales to consumers located outside of the QOZ.

Other Clarifications

Other taxpayer-friendly provisions for operating businesses include leases, 31-month working capital safe harbor and intangible property for a QOZ business. The underlying leased property will be considered a “qualifying asset” so long as the lease has been entered into after Dec. 31, 2017, the terms are market rate and at least 70% of the leased property is in a QOZ.  These conditions apply to related party leases as well, however, there are prepayment and personal property rules that need to be considered.  The 31-month working plan in the 2018 Proposed Treasury Regulations only applied to property development.  The updated regulations address the oversight by expanding the working capital plan to include the development of a trade or business.  Intangible property is considered QOZ business property, or a “qualifying asset”, if “substantially all” of the intangible property in the business is used within a QOZ.  The new regulations 2.0 clarify “substantially all” to mean at least 40%.

While the second round of guidance was a step in the right direction, there are still some questions.

First, the duration for funds that hold operating businesses is typically five to seven years.  Obviously, this conflicts with the important 10-year hold period for QOZ fund investors (i.e. an investor can exclude the tax on capital gains attributable to the assets within a QOZ fund if the qualifying assets are held for at least 10 years).  The new regulations did include a “recycling” provision, or the ability to sell QOZ Fund assets and roll the proceeds in another QOZ asset without triggering the deferred capital gain or jeopardizing the 10-year holding period.  However, a sale of a QOZ fund asset that is held for less than 10 years would generate taxable gain to the investors.

One remedy that would allow for recycling and no taxable gain recognition would be an investment in Qualified Small Business Stock (QSB Stock).   There is a 100% capital gain exclusion on the sale of QSB Stock for non-corporate investors if the stock is held for more than five years.  Also, non-corporate investors can exclude capital gain up to the greater of 10 times their stock basis or $10 million.  A Qualified Small Business is required to be structured as a C corporation, in which case the QOZ Fund would hold C corporation stock that is also a QOZ Business.    There are a few other conditions for a Qualified Small Business, including a total assets test, original issuance requirement, and an exclusion of certain businesses.  Assuming a QOZ fund owned QSB Stock and the stock was sold in year six, there would be no taxable gain allocated to the investors (if the capital gain was within the parameters described above).  Furthermore, if the QOZ fund invested the sale proceeds in another QOZ business within a 12-month period and that business was sold in five years, then the capital gain from that sale would be tax-free to the investors as well.  Full recycling can be accomplished within a QOZ fund if the right structure, the right business and certain tax requirements are satisfied.

Second, operating businesses that are expanding usually do so in strategic markets.  Limiting the expansion to QOZs can cause financial risk to the enterprise and create an inherent conflict between the investors and the management team.  Thoughtful consideration should be given, before investing in operating businesses, to the expansion plan and the use of affiliated entities.

In summary, the new QOZ regulations should provide investors, fund managers and entrepreneurs with more assurance related to operating businesses within QOZs.  While additional guidance would be helpful, the tax framework for operating businesses within QOZs is in a much better place than before the new regulations were published.  For inquiries, please contact us at QOZ@cressetpartners.com.

You can reference the proposed regulations that provide guidance under new Section 1400Z-2 of the Internal Revenue Code here: https://www.federalregister.gov/documents/2019/05/01/2019-08075/investing-in-qualified-opportunity-funds.

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