As part of the 2017 Tax Cuts and Jobs Act, Congress added a new provision to the Internal Revenue Code allowing investors to defer capital gains by making investments into Qualified Opportunity Funds (QOFs). However, many investors have remained on the sidelines waiting for the Internal Revenue Service (IRS) to clarify the rules on how this program will work.
On April 17, 2019, the IRS issued a second round of proposed regulations aimed at clarifying the rules for investing in QOFs and qualified opportunity zone businesses. Ulmer attorneys have reviewed these proposed regulations and identified five main takeaways.
Generally, a QOF must have 90 percent of its assets invested into qualified opportunity zone business property. The proposed regulations provide relief for new investments into a QOF. QOFs may exclude any amount invested in the QOF in the prior six months from being included in the 90 percent test as long as the new assets are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
One of the main concerns of potential investors in operating businesses owned by QOFs was the requirement that at least 50 percent of the gross income from the qualified opportunity zone business must be from within an opportunity zone. The proposed regulations provided much needed clarity to this requirement by adding three safe harbors:
(1) At least 50 percent of the services performed (using hours worked) for the business by employees and independent contractors occur within the opportunity zone.
(2) At least 50 percent of the services performed (based on the amounts paid for the services performed) for the business by its employees and independent contractors occur in the opportunity zone.
(3) The business’s tangible property that is located in a qualified opportunity zone and the management or operational functions performed for the business in an opportunity zone are each necessary to generate 50 percent of the gross income of the trade or business.
Even if a qualified opportunity zone business does not meet one of the safe harbors, the business can meet the 50 percent requirement if, based on all the facts and circumstances, at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in an opportunity zone.
The first round of proposed regulations provided a working capital safe harbor of 31 months for businesses to acquire, construct, and substantially improve tangible property. Initially, operating businesses did not have a similar safe harbor to deploy cash in the start-up phase of a business. The new proposed regulations expand the reasonable working capital safe harbor also to include a written plan for the development of a trade or business in the opportunity zone, in addition to acquiring, constructing, and substantially improving tangible property. Additionally, if the 31-month period is not met because of a delay caused by waiting for governmental action, such as permit approval, then the 31-month rule is not violated as long as the application to the government is made within the 31-month window.
The proposed regulations have an example approving a debt-financed distribution (refinancing) to partners or members as long as the amount or value of the distribution does not exceed the investor’s outside basis (as increased by the partner’s allocated share of debt) in the QOF.
QOFs have a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock or partnership interests and to reinvest proceeds from the sale or disposition of qualified opportunity zone property. The proposed regulations clarify this provision by allowing up to the last day of the 12-month period from the date of the distribution, sale, or disposition, to treat the proceeds that are to be reinvested as qualified opportunity zone property for purposes of the 90 percent asset test. This rule also requires the proceeds to be held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
The proposed regulations provide many other important guidelines clarifying the rules to qualify for the tax benefits available to investors in QOFs.
 This client alert assumes a working knowledge of the Opportunity Zone Program. For background information, please listen to the podcast and review the slides for Ulmer’s “Qualified Opportunity Zones: Too Good to be True?” seminar from December 5, 2018.