Stroock Special Bulletin
Richard G. Madris, David C. Olstein, Jeffrey D. Uffner
The new tax incentive added by the 2017 Tax Cuts and Jobs Act, that is designed to promote long-time period boom in economically distressed areas called Qualified Opportunity Zones (“QOZs”), is gaining hobby among organizations and enterprise owners who’re thinking about beginning or increasing organizations in QOZs (or transferring current companies to QOZs).
Although real estate investments had been the primary focus of QOZ-associated investment interest thus far, interest is now turning to investments in operating corporations located in QOZs, along with such diverse investments as renewable strength, infrastructure, software program organizations, manufacturing, distribution centers and records centers.
This improved interest follows the issuance of the second one set of proposed QOZ regulations (the “New Proposed Regulations”) on April 17, 2019, which give steering on some of formerly unsure elements of the QOZ provisions.
This bulletin presents an outline of the QOZ provisions and addresses certain aspects of the steerage provided by means of the New Proposed Regulations that in particular relate to investments in operating groups, which includes a discussion of tax techniques that pertain to investments in such working groups.
Tax Benefits Available for Investments in a QOF
The QOZ software extends unique tax benefits to investors that could in any other case apprehend taxable advantage from a sale or change provided that the amount of such advantage is reinvested into Qualified Opportunity Funds (“QOFs”) that interact in financial hobby in QOZs. If a taxpayer reinvests all or a part of the taxable capital gain recognized on a sale or change right into a QOF usually within one hundred eighty days of such sale or alternate, the taxpayer will thereby become eligible for the subsequent tax advantages with appreciate to such reinvested gain. The investor will have a 0 basis in its QOF interest with recognize to the reinvested gain.
Deferral of Current Tax. Deferral of tax until the earlier of (i) the sale or alternate of the QOF or (ii) December 31, 2026. Unless the taxpayer disposes of its interest in a QOF prior to December 31, 2026, all deferred profits can be required to be diagnosed in 2026 (issue to the idea adjustment policies discussed below).
Partial Basis Step-Up. An growth in the taxpayer’s tax foundation (of 10% of the deferred gain) inside the QOF after protecting the QOF for five years, and a further boom (of five% of the deferred gain) after conserving the QOF for 7 years. After the investor’s deferred gain (reduced by using such basis step-ups) is identified, the premise is accelerated by using the amount of the deferred advantage recognized.
Exclusion of Gain From Income. If the QOF hobby is held for 10 years or more, elimination of any taxable benefit on ultimate sale of the QOF (i.e., no tax would be owed on the appreciation in fee of the QOF interest after its preliminary acquisition by means of the taxpayer). For the gain to be excluded from the taxpayer’s earnings, the remaining sale must be of the QOF or gain from the sale of qualifying belongings owned by way of the QOF along with sale of a QOZ Business (but, below gift steering, now not a QOZ Business’s sale of its assets).
Relevant Definitions for Purposes of the QOZ Program
Qualified Opportunity Fund. A QOF is either a company or a partnership established for the purpose of making an investment in Qualified Opportunity Zone Property (“QOZ Property”) (as defined under), other than some other QOF. At least 90% of the belongings of a QOF need to be QOZ Property. The ninety% take a look at is implemented with the aid of averaging the share of QOZ Property held by the QOF as of: (i) the final day of the primary 6-month period of the taxable 12 months of the QOF; and (ii) the closing day of the taxable year of the QOF.
QOZ Property. QOZ Property is either (i) “QOZ Business Property” or (ii) inventory or partnership hobbies in an entity that may be a “QOZ Business” on the time such interest changed into acquired and in the course of considerably all of the QOF’s conserving length for such hobby.
QOZ Business Property. QOZ Business Property is typically described as tangible property (i) used in a change or commercial enterprise of the QOF; (ii) acquired by means of purchase from unrelated events after December 31, 2017; (iii) appreciably all of the use of which turned into in a QOZ in the course of significantly all the QOF’s holding period for such property; and (iv) (a) the unique use of which starts with the QOF or (b) to which the QOF makes full-size improvements. A property is extensively stepped forward by means of a QOF if, all through any 30-month period beginning after the date of acquisition, additions to basis with admire to the assets with the aid of the QOF exceed the adjusted foundation of such assets at the start of such 30-month duration inside the fingers of the QOF.
QOZ Business. A QOZ Business is a qualifying exchange or business in which:
appreciably all (extra than 70%) of the tangible property owned or leased by way of the taxpayer is QOZ Business Property;
at the least 50% of the whole gross earnings of such trade or enterprise is derived from the lively behavior of such exchange enterprise within a QOZ;
a massive portion of the intangible belongings of such trade or enterprise is used in the energetic behavior of such exchange or commercial enterprise inside the QOZ; and
much less than five% of the average of the aggregate unadjusted bases of the assets of such alternate or enterprise is on account of nonqualified financial assets.
The proposed Treasury Regulations contain substantial exceptions and clarifications to these regulations, which are discussed underneath.
Application of QOZ Program to Investments in Operating Businesses
Before the New Proposed Regulations had been issued, there were giant uncertainty approximately how the fundamental necessities for qualification as a QOF could apply in a variety of commonplace truth styles. The New Proposed Regulations supplied useful steering on a number of these problems, eliminating a great deal of the uncertainty with respect to the way to structure QOFs and QOZ Businesses to qualify for the blessings of this application, especially for investments in running corporations.
Requirement that 50% of the Gross Income of a Business Earned Within a QOZ.
With admire to the requirement inside the definition of QOZ Business that at least 50% of the full gross earnings is derived from the lively conduct of a change or commercial enterprise inside a QOZ, prior to the issuance of the New Proposed Regulations, there have been no guidelines for figuring out (i) what constitutes the “lively conduct” of a alternate or enterprise or (ii) wherein income is deemed to be earned (inside or out of doors a QOZ). For corporations that bought items or provided services to clients placed outdoor of a QOZ, it became uncertain whether those organizations might qualify.
With recognize to the income requirement, the New Proposed Regulations offer a statistics and instances test and the subsequent three opportunity zone safe harbors for functions of determining whether at least 50% of the overall gross income of the exchange or commercial enterprise is derived from inside a QOZ. Notably the secure harbors encompass offerings carried out with the aid of unbiased contractors and the personnel of impartial contractors retained by means of the enterprise (in addition to the commercial enterprise’s own employees) but do not deal with how to determine the source of profits for businesses that don’t have their personal personnel or unbiased contractors. The safe harbors are as follows:
as a minimum 50% of the services achieved (based totally on hours) for such commercial enterprise by way of its personnel and impartial contractors are achieved inside the QOZ;
at the least 50% of the offerings carried out (primarily based on amounts paid for the services performed) for the enterprise through its employees and independent contractors are completed inside the QOZ; or
both (i) the tangible property of the enterprise this is in a QOZ and (ii) the management or operational functions finished for the business within the QOZ, are each vital to generate 50% of the gross income of the change or commercial enterprise.