This short article outlines the requirements for starting an active business in a qualified opportunity zone (“QOZ”).
The US tax legislation that created QOZs was enacted in early 2018, and is intended to encourage long-term investment in economically distressed communities. The IRS issued two substantive sets of proposed regulations outlining rules for QOZ investments (in October, 2018, and April, 2019), and finalized the regulations in December, 2019. Investors and entrepreneurs are still absorbing these rules. Nevertheless, the tax benefits from a successful QOZ investment in an active business can be substantial. These primarily include (1) a deferral of tax on the amount of gain that is reinvested into a QOZ investment until 2026, and (2) the ability to sell a QOZ investment held for 10 years on a tax-free basis.
Real estate has been the main focus for QOZ investors, and a cottage industry in QOZ real estate investments has emerged. In addition, an entrepreneur who is starting a new business would do well to consider whether he or she can locate the new business in a QOZ and comply with complex rules to qualify as a QOZ business.
The main definitions and applicable rules are summarized below:
- A “QOZ Fund” is an investment vehicle formed as a partnership or corporation for the purposes of investing in an eligible QOZ Property. The QOZ Fund is required to hold at least 90% of its assets in QOZ Property.
- “QOZ Property” means: (a) QOZ stock, which is original issue stock in a domestic corporation acquired for cash where the corporation is a QOZ Business, (b) QOZ partnership interest, which is any capital or profits interest in a domestic partnership acquired for cash where the partnership is a QOZ Business, or (c) “QOZ Business Property,” which is tangible property used in a trade or business of the QOZ fund, where the original use of the property in the QOZ begins with the QOZ Fund, or the QOZ Fund “substantially improves” the property (generally, a 30 month test to double the value of the property).
- A “QOZ Business” is generally an active trade or business where substantially all (ie, more than 70%) of the tangible property owned or leased by the taxpayer (through the QOZ Fund) is QOZ Business Property. In addition, a QOZ Business is a business where:
- at least 50% of the total gross income of such trade or business is derived from the active conduct of such trade business within a QOZ (the “50% gross income test”),
- a substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business in the QOZ, and
- less than 5% of the average of the aggregate unadjusted tax bases of the property of such trade or business is attributable to nonqualified financial property.
While there was initially significant uncertainty around the 50% gross income test, the Regulations provide more clarity by providing three safe harbor tests. Based on the Regulations, a QOZ business will satisfy the 50% gross income test if any of the following apply:
- More than 50% of the service hours performed for the business by its employees and independent contractors are performed within the QOZ,
- More than 50% of the compensation and/or independent contractor expenses for the business are incurred by its employees and independent contractors within the QOZ, or
- 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.
A business that does not meet the safe harbor tests also may meet the 50% gross income requirement based on a facts and circumstances test if, based on all the facts and circumstances, it can demonstrate that at least 50% of the business’ gross income is derived from the active conduct of the business in the QOZ.
The Regulations contain an example of a tech company. The business is a startup business that develops software applications for global sale and is located in a QOZ. A majority of the total hours of the startup’s employees and contractors developing software applications are performed in the QOZ. The example provides that the 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.
There are many additional issues for entrepreneurs to consider in starting a QOZ Business, including timing issues to invest capital, valuation issues to satisfy the IRS’ tests, leasing issues if property is leased, related party issues if property is purchased or leased from a related party, and tax reporting issues. It also may be possible to move an existing business into a QOZ, though this requires careful planning and additional investment.
Note that the state income tax treatment of a QOZ interest may be different than the federal income tax treatment. For example, New York recently decoupled its tax law from the federal QOZ law with respect to the deferral of gains that are reinvested in QOZ Businesses (although New York appears to have retained the exclusion of gain from taxation on the sale of QOZ Businesses held for more than 10 years).
Despite the complexity of the law, the overall benefits to distressed communities, and the tax benefits, for QOZ Businesses can be substantial.
If you are interested in starting an active business in a QOZ, you should speak with a tax attorney to guide you through the requirements of the QOZ rules.