The Opportunity Zone Program – Ideal For Entrepreneurs

While the first set of Treasury Regulations and initial OZ statute primarily emphasized real estate projects as re-investment options, the final regulations clarified that operating businesses are also appropriate reinvestments for deferred gains. Unsurprisingly, most of the early Qualified Opportunity Funds (QOFs) focused entirely on real estate projects. However, once regulations had been finalized, investors and advisors have grasped the full flexibility and power of the OZ program. Additionally, private investors, PE firms and VC firms have come to realize that using the OZ program for operating businesses may yield even more substantial long-term benefits than real estate investments -- for investors as well as OZ communities.

While the first set of Treasury Regulations and initial OZ statute primarily emphasized real estate projects as re-investment options, the final regulations clarified that operating businesses are also appropriate reinvestments for deferred gains.

Unsurprisingly, most of the early Qualified Opportunity Funds (QOFs) focused entirely on real estate projects. However, once regulations had been finalized, investors and advisors have grasped the full flexibility and power of the OZ program. Additionally, private investors, PE firms and VC firms have come to realize that using the OZ program for operating businesses may yield even more substantial long-term benefits than real estate investments — for investors as well as OZ communities.

SINGIFICANT OZ BENEFITS FOR ACTIVE BUSINESSES

Both the Trump Administration and QOF architects view the use of the OZ program as a valuable tax and economic development tool for operating businesses for the following reasons:

– Increase overall commerce in and around OZ census tracts.
– Strengthen employment and workforce training within OZ communities
– Develop affordable and workforce housing in OZ communities
– Diminish poverty levels within OZ communities
– Stimulate and accelerate long-term business growth
– Modernize and improve local infrastructure

Operating business investments offer the following advantages in comparison to real estate projects:

– Arguably less risk since businesses are mobile while real estate is not
– Less capital outlay
– Quicker path to revenue and positive cash flow generation
– Less (or non-existent) entitlements
– Ability to alter business plan
– Potential for a higher price multiple upon exit

Considering these incremental benefits, serial entrepreneurs and investors with connections to successful business operators should view operating businesses as a highly attractive OZ investment. The regulations also provided flexible provisions and more liberal reinvestment periods as compared to real estate projects – now allowing up to 62-months to re-invest the QOZB funds.

The following analysis addresses these issues and compares and contrasts the various ways an OZ investor might acquire an operating business within a QOZB. After covering the basic requirements, we will analyze the three general ways in order of simplest to most complex.

OVERVIEW OF STATUTORY REQUIREMENTS FOR QOZBS

The core statutory requirements for a business to qualify as a QOZB are as follows:

1) At least 70% of the QOZB’s assets must be QOZB Business Property used in primarily in OZ census tracts,
2) At least 40% of all QOZB intangibles must be used in OZ census tracts ,
3) At least 50% of the QOZB income must be associated with OZ-sourced income, determined under
one of four “safe harbor” sets of rules contained in the regulations.

No minimum amount is required to invest in an operating business. Taxpayers can invest both qualified deferred gain and after-tax money into the business; however, only the qualified deferred gains invested into the QOF/ QOZB are eligible for the various OZ tax benefits. However, borrowing within the QOF or QOZB can leverage the benefits.

There are three general ways OZ investors can get involved with an operating business. These are summarized below.

Establishing a New Business Inside An OZ Census Tract

Establishing a new business (or starting a new division which offers a new product or service) within one or more OZ census tracts is the simplest way to qualify an operating business under the IRC and Treasury Regulations.

The reason a new start-up business is the cleanest way to meet the OZ qualifications is that the tangible property acquired for use in the new business will ordinarily be treated as eligible Qualified Opportunity Zone Business Property (QOZBP). If the property had been used in an OZ census tract prior to acquisition or was acquired from a Related Party (more than 20% common ownership in the QOF), it is not eligible QOZBP.

Leased assets, even when acquired from a Related Party, are treated as first used by the acquiring taxpayer, however, special Related Party lease rules for leased tangible assets (which are much less onerous than the Related Party rules applicable to purchased assets) must be followed to ensure QOZBP eligibility.

Another approach for getting assets into a new business is for the QOF investor to contribute qualifying assets into the QOF, in which case Related Party rules are not applicable. The downside of a contribution of assets (in lieu of cash) to a QOF is that no eligible gain is generated for OZ reinvestment and the contributing taxpayer’s eligible QOF reinvestment is limited to the lesser of their: i) tax basis in the property contributed or the ii) fair market value in the contributed asset. The secondary drawback is that the contributed assets are not treated as QOZBP since they not “purchased” after 2017. Dropping the assets down into a QOZB also causes technical issues which may complicate meeting the aforementioned 70/30 QOZB qualification test.

Due to the statute and regulations it is important that the QOZB purchase the assets and primarily run the business operation, rather than the QOF. Doing so allows the operating business to obtain the 31- month (or newly introduced 62-month) “start-up” business Working Capital Safe Harbor relief, and also secure the more liberal 70% QOZBP requirement vs. the stringent 90% requirement for QOF’s. This means the QOF can hold up to 30% non-QOZBP – or “bad assets” without subjecting the QOF to penalties (currently 5% annualized) for failing to meet the semi-annual qualification testing.

Acquiring or Relocating An Existing Non-OZ Business Into An OZ Census Tract(s)
Moving an existing business that has not previously operated in an OZ census tract into an OZ census tract can initially seem quite complex; however, with advanced planning and cash infusions, acquiring an existing business and qualifying it as a QOZB is indeed possible.

If the business is currently owned by more than 20% of the ultimate QOF equity owners, then the assets brought into the QOF or QOZB will be ineligible non-QOZBP. This does not disqualify the business from being a QOZB provided the investors plan on investing material amounts into the transferred business. In such a case the fund investors must just make sure that the good asset are at least 233% greater than the bad assets. This will ensure that the bad assets are 30% or less.

One quick example:

If the QOZB acquires business assets not previously used in an OZ census tract from a related party for $500,000, such assets are non-QOZBP, but if this amount remains less than 30% of total QOZB assets, the QOZB can still meet the criteria for the qualification tests. Therefore, provided the QOZB has at least $1,666,667 of total assets($500,000/ 30%), then the QOZB should meet the qualification test.

If tangible assets are acquired from a third-party, and if the QOZB doubles the basis in the depreciable assets acquired within 30 months, then QOZB will be treated as the “original user.” Additionally, all the acquired assets will be QOZBP and the total investment can be minimized as compared to the Related Party acquisition. Note that raw land and intangibles are not required to be “substantially improved”.

Qualifying an Existing OZ Operating Business For OZ Benefits

If an existing business has already been operating within an OZ census tract prior to 2018, all operating assets of the business are treated as ineligible and non-QOZBP since the assets had been used in the OZ before acquisition. Consequently, an existing entity with $500,000 of net tangible assets will only qualify as a QOZB if the new investors make investments large enough to drive down the non-qualified assets below 30%. Similar to the calculation above, the QOZB or QOF must be willing to invest at least 233% of additional funds ([$1,666,667 – $500,000]/ $500,000) into the business in order to dilute the $500,000 of non-QOZBP/ “bad assets” below 30%.

Similar investments will be required whether the existing business attempts to qualify itself as an OZ business for a third-party acquisition by making the additional expansion investment or if the business sells its equity to a QOZB or its assets to a QOF before the additional cash infusion, the new owner must invest at least 2.33 times/ 233% more into the business to meet the 70% test. Note that the QOF does not need to acquire 100% of the existing business in any of the scenarios above.

COMBINING QUALIFIED SMALL BUSINESS STOCK (SECTION 1202) AND THE FEDERAL OPPORTUNITY ZONE PROGRAM

While the new OZ program is arguably the most flexible and powerful tax diversification tools of the last four decades, §1202 – Qualified Small Business Stock (QSBS) may very well be a close second. The QSBS eligible gain exclusion amount is the greater of: (1) 10 times the taxpayer’s adjusted basis in the QSBS disposed of in that year “annual limitation”; or (2) $10 million reduced by the aggregate amount of QSBS gain on stock of that issuer excluded by the taxpayer in prior years “aggregate limitation”. While these annual and cumulative limits (per investor) are more restrictive than the unlimited OZ Program exclusion after a 10-year hold, most investors will be content with a 1,000% ROI or a $10,000,000 gain (per qualifying investor) exclusion.

For the sale of QSBS by non-C Corporation shareholders, a partial or full exclusion of gain is allowed under §1202. Section 1202 defines QSBS as stock:

i. Issued by a domestic C Corporation with gross assets (generally determined by tax basis) equal
to or less than $50 million;
ii. Issued after August 10, 1993 for money, other property (not including stock), or as
compensation for services;
iii. Issued by a corporation that uses at least 80 percent (by value) of its assets in the active
conduct of one or more qualified trades or businesses during substantially all of the taxpayer’s
holding period for such stock, and such corporation must be an eligible corporation;
iv. Held by a person that is not a C corporation;
v. Held for more than five years;
vi. With some exceptions, acquired at original issue; and
vii. Qualified Small Business issuer may not redeem its stock within specified time periods.

The portion of the taxpayer’s eligible gain exclusion depends on when the taxpayer acquired the stock.
For QSBS acquired between:

• August 11, 1993 and February 17, 2009, the exclusion is 50%;
• February 18, 2009 and September 27, 2010, the exclusion is 75%;
• September 28, 2010 and thereafter, the exclusion is 100%

Therefore, properly structuring a QSBS entity within a QOZB can yield even more flexibility and possibly more favorable tax results upon an exit prior to ten years.

To the extent a QOF acquires or establishes a QSBS-eligible entity pursuant to §1202 (being conscious of certain non-qualifying trades or business such as most service and real estate operations) the entity can be eligible for a 100% federal (and most state) gain exclusion after the QOF holds the entity for at least five years – rather than the 10-year OZ holding period. PE and VC Funds tend to like this strategy since a five-year holding period is more in line with their general disposition time frames.

One strategy to consider is establishing the QOZB as an LLC/ Partnership, allowing start-up losses to flowthrough to the partners and then to convert to the required C corporation status once the entity turns profitable; thereby starting the five-year QSBS holding period clock.

Therefore, combining the new OZ provisions with QSBS classification gives investors two bites at the federal exemption apple and dramatically enhance their investment flexibility.

Section 1045

Section 1045 is another very valuable and taxpayer-friendly section that coincides with §1202. Section1045 allows non-C Corporation taxpayers to elect to defer recognition of gain from the sale of QSBS. The election must be made on a timely filed tax return (including extensions), and the taxpayer must purchase replacement QSBS within a 60-day period beginning on the date of the QSBS sale. The amount of gain deferred is calculated in a manner similar to gain deferred in a like-kind exchange (§1031). Unlike §1202, the minimum holding period of the relinquished QSBS under §1045 is only six months and there is no limit to the amount of the gain deferral.

This further allows interim dispositions within the OZ fund without triggering gain.

Combining Other Tax Benefits With The OZ Program

The added advantage of using the OZ program for operating businesses is that additional federal and state tax incentives are available to the QOZB, QOF and/ or equity holders. This includes various hiring and asset tax credits, grants, exemptions and other benefits. This can further compound the after-tax ROI on OZ investments.
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Blake Christian, HCVT
Learn About Opportunity Zones

Blake is a nationally recognized expert and frequent author and speaker on State and Federal Location-based Incentive Credits (LBIC’s), including State Enterprise Zone Credits, Federal Empowerment, Renewal Community, Indian Tribal Lands and Gulf Opportunity Zone Credits. He has also assisted in the development of specialized software, which is used by over 200 tax departments throughout the U.S. to identify LBIC’s. Blake’s clients include multi-national, publicly traded corporations, as well as closely held owner-managed businesses. His industry concentration includes manufacturing and distribution, service companies, restaurant, shipping and transportation, energy and healthcare. In addition to corporate, partnership and individual tax compliance and planning, Blake is experienced in the design and implementation of executive compensation plans.

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