By Joseph B. Darby III and Jill Homan 

The Department of the Treasury and the Internal Revenue Service has collaborated to issue a seemingly innocuous document in the quietest possible manner – although that document seems destined to have thunderous repercussions on the Opportunity Zone industry.

The document, issued Aug. 4, was styled as “corrections” (herein the “IRS Corrections”) to Treasury Decision 9889, which of course was the “Final Regulations” under Code Section 14000Z-2, first published in the Federal Register on January 13, 2020, and then not-all-that-quietly amended by a further amending document published in the Federal Register on April 6, 2020.

The IRS Corrections document states: “As published on January 13, 2020 (85 FR 19082) the final regulations (TD 9889) contain errors that need to be corrected.”

Amendments to the Final Regulations in the Opportunity Zone industry

The IRS chose to “correct” just two specific matters: 

Decertification of QOFs:  Paragraph (a)(3) in Regulations Section 1.1400Z2(d)-1 is modified by chopping out an entire subparagraph, all for the laudable purpose of giving the IRS broader flexibility in how the Service allows a QOF  to decertify.  Decertification is an important and growing issue as some QOFs formed over the past few years have struggled to find economically viable investments and some taxpayers are increasingly willing to “throw in the towel” and unwind the QOF investment.  As we will discuss below, the IRS is still figuring out how the QOF Decertification process is going to unfold, but in the meantime they wanted to eliminate some language in the Final Regulations that may have tied their hands and limited their options.  Abracadabra – the problematic language is no longer a problem – or for that matter language. 

Safe harbor for working capital and property on which working capital is being expended.  If Decertification of QOFs is a big issue – and it is – then the latest tweaks to the Working Capital Safe Harbor (WCSH) are monumental.  The IRS revisited (for a second time) paragraph (d)(3)(vi)(D) of Regulations Section 1.1400Z2(d)-1, and with a relatively light but highly precise edit managed both to clarify and strikingly limit the scope of the WCSH in important ways.  The clarifying part was hugely welcome:  The IRS Corrections replace a clearly erroneous statutory reference with a statutory reference that clearly makes sense.  That is the good part.  The less happy result is that the new, clearer regulation may be significantly more narrow than some observers were believing, expecting and/or hoping.  Overall, this second correction was absolutely necessary and for many taxpayers will clear up ambiguity and uncertainty.  But for at least some taxpayers it may prove disappointing – or worse, it may make it clear that the WCSH is not available or applicable to their specific situation.

The Devil in the Details: The impact of the amendments for the Opportunity Zone industry

The edits to the QOF Self-Certification rules are straight forward and can be dealt with relatively quickly.  Prior to the IRS Corrections, the applicable paragraph, Section 1.1400Z2(d)-1(a)(3), read as follows: 

Self-decertification of a QOF. If a QOF chooses to self-decertify as a QOF, the following rules apply:


(i) Form and manner. The self-decertification must be effected in such form and manner as may be prescribed by the Commissioner in IRS forms or instructions or in publications or guidance published in the Internal Revenue Bulletin (see §§ 601.601(d)(2) and 601.602 of this chapter).

(ii) Time.The self-decertification becomes effective at the beginning of the month following the month specified by the taxpayer, which month must not be earlier than the month in which the taxpayer files its self-decertification as provided in paragraph (a)(3)(i) of this section.

Basically all that the IRS did was to chop out subparagraph (ii), thereby eliminating a timing constraint that the IRS apparently thought better of after due and proper reflection.  Decertification still needs to be implemented, with forms, instructions and other guidance, but this gives the IRS more freedom as it seeks to implement a sensible approach – including the exact timing and effective date of such elections.  Not exactly a nothingburger, but probably, at most, an appetizer.

By contrast, the changes to the WCSH constitute a major clarification that everyone should read and digest carefully. The following shows the language of paragraph (d)(3)(vi)(D) of Section 1.1400Z2(d)-1 before and after the edits with new language in orange and changed language in green:

"(A) Safe harbor for working capital and property on which working capital is being expended.

(1) Working capital.  If paragraph (d)(3)(v) of this section treats property of an entity that would otherwise be nonqualified financial property as being reasonable amount of working capital because of compliance with the three requirements of paragraphs (d)(3)(v)(A) through (C) of this section, the entity satisfies the requirements of section 1400Z-2(d)(2)(D)(i) only during the working capital safe harbor period(s) for which the requirements of paragraphs (d)(3)(v)(A) through (C) of this section are satisfied; however such property is not qualified opportunity zone business property for any purpose.

(2) Tangible property acquired with covered working capital.  If tangible property referred to in paragraph (d)(3)(v)(A) of this section is expected to satisfy the requirements of section 1400Z-2(d)(2)(D)(i) as a result of the planned expenditure of working capital described in paragraph (d)(3)(v)(A), and is purchased, leased, or improved by the trade or business, pursuant to the written plan for the expenditure of the working capital, then the tangible property is treated as qualified opportunity zone business property satisfying the requirements of section 1400Z-2(d)(2)(D)(i), during that and subsequent working capital periods the property is subject to, for purposes of the 70-percent tangible property standard in section 1400Z-2(d)(3).

(D) Safe harbor for working capital and property on which working capital is being expended—

(1) Working capital for start-up businesses. For start-up businesses utilizing the working capital safe harbor, if paragraph (d)(3)(v) of this section treats property of an entity that would otherwise be nonqualified financial property as being a reasonable amount of working capital because of compliance with the three requirements of paragraphs (d)(3)(v)(A) through (C) of this section, the entity satisfies the requirements of section 1400Z-2(d)(3)(A)(i) only during the working capital safe harbor period(s) for which the requirements of paragraphs (d)(3)(v)(A) through (C) of this section are satisfied; however such property is not qualified opportunity zone business property for any purpose.

(2) Tangible property acquired with covered working capital. For any eligible entity, if tangible property referred to in paragraph (d)(3)(v)(A) is expected to satisfy the requirements of section 1400Z-2(d)(2)(D)(i) as a result of the planned expenditure of working capital described in paragraph (d)(3)(v)(A), and is purchased, leased, or improved by the trade or business, pursuant to the written plan for the expenditure of the working capital, then the tangible property is treated as qualified opportunity zone business property satisfying the requirements of section 1400Z-2(d)(2)(D)(i), during that and subsequent working capital periods the property is subject to, for purposes of the 70% tangible property standard in section 1400Z-2(d)(3)."



What the changes mean for the Opportunity Zone investors and professionals

First of all, the provision as originally drafted contained a reference to Code Section 1400Z2(d)(2)(D)(i) that made no sense:  That referenced Code provision sets forth the definition of “qualified opportunity zone business property” which means “tangible property used in a trade of business” of an eligible entity if certain important statutory requirements are met.  Thus, the statement that “the entity” (which in the context used means a qualified opportunity zone business or QOZB) “satisfies the requirements of section 1400Z-2(d)(2)(D)(i)” (meaning that such entity is in effect tangible property) on its face was a non sequitur.

The real question, however, was how to extract or divine the “sequitur” from this enigmatic and frustrating cross-reference. Many capable professionals concluded that the purpose of the first subparagraph, as originally written, was to “turn off” all testing of QOZB status during the WCSH period.  It was suggested, for instance, that it applied to all types of QOZB businesses (not just start ups) and that it turned off any and every applicable QOZB test – including the 70% tangible property requirement, the 50% gross income requirement, the intangible property requirement, the NQFP requirement, and perhaps even the “sin” business prohibitions.
 
What the new IRS amendments clarify about the Opportunity Zone regulations

The IRS Corrections provide clarity and certainty on this issue, but at a price:  The IRS makes it clear that subparagraph (1), dealing with “working capital” held in a WCSH, applies only to start-up businesses and not to all businesses seeing to qualify as a QOZB through the use of the WCSH.  Moreover, the IRS Corrections eliminate the nonsensical reference to QOZBP and instead provide a reference that makes sense – except that is it also narrower than many observers expected.  The new reference is to Code Section 1400Z-2(d)(3)(A)(i) that means a QOZB that meets the requirement that substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property (i.e., the 70% tangible property test).  That is logical but also strikingly narrow:  To meet the safe harbor for “Working Capital” the business in question needs to be a “start-up” (which, by the way, is not defined anywhere in the statute, the concept having arrived at the dance just recently) and is merely deemed to meet the 70% test during the WCSH period.

Ok, but what about the 50% gross income test?  Or the NQFP test?  Even for a start-up, these requirements could be problematical.  For example, if a QOZB is formed to acquire an existing property currently used and occupied by commercial tenants, for the very QOZB-like purpose of converting the old building with a huge makeover into residential apartments (meeting at the very least the substantial improvement test and, if the building is torn down or “scraped” and a brand new building is constructed, it probably meets the “original use” test as well).  But assume the commercial tenants still have two years to run on their leases before they can be evicted.  During that time the QOZB will own a property generating what is very likely “bad” income and have very little if any “good” income.  The QOZB may well fail the 50% gross income test for its first two years – and without any apparent relief under the Working Capital rules, since those now seem only to address and provide a safe harbor for the 70% tangible property requirement.

Potential restrictions of the new changes to the Opportunity Zone regulations

Note also that, prior to the IRS Corrections, the authors are aware of capable advisors who believed that the prior language was intended to “turn off” all testing and requirements during the WCSH period – and concluded that cash held in the QOZB could therefore be invested not just in cash equivalents, but in leveraged and aggressive investment assets – bitcoins, options, gold futures, you name it.  That level of “freedom” seems clearly limited by the new language, which again provides an explicit waiver only on the 70% tangible property requirement.

Given the rather substantial facelift to subparagraph (1), subparagraph (2) now seems to have a clearer purpose as well as a sharper focus.  Subparagraph (2) is now for “any eligible entity” – meaning all QOZBs, not just a “start up” businesses.  Subparagraph (2) provides that if an eligible entity (presumably including a non-startup business) has a working capital written plan that will meet the 70% tangible property test when completed, then as that tangible property is “purchased, leased, or improved by the trade or business,” it is treated as qualified opportunity zone business property satisfying the requirements of section 1400Z-2(d)(2)(D)(i), during that and subsequent working capital periods the property is subject to, for purposes of the 70% tangible property standard in section 1400Z-2(d)(3).  In effect, as tangible property is purchased with WCSH cash, or leased, or improved, it is treated as meeting the definition of “QOZBP” for purposes of the 70% test, even though it is not yet completed, or not yet placed in service by the non-startup business.

Is Subparagraph (2) a huge safe harbor? Well, it depends on the transaction.  If a business can claim to be a start-up. Subparagraph (1) is not concerned about when property is purchased, leased or improved – the 70% tangible property test is deemed met (the common vernacular is to say the test is “turned off”) during the WCSH period.  Under Subparagraph (2) the test is definitely not turned off – it is just made relatively easy to meet, so long as property is actually being purchased, leased or improved.  But this suggests that timing, and dare we add haste, seem to become an important part of the WCSH for non-startup businesses.  If the QOZB bank account is merely holding cash for an indefinite period of time, assuming that there are still 31 months, or 55 months, before it needs to be spent – well, that is probably wrong.  Rather, the non-startup QOZB needs to get its tangible property purchased, leased or improved pretty much pronto so that the QOZB can meet the 70% tangible property test in the first year or, failing that, in the first 18 months of the project.
 
Why the new Opportunity Zone amendments might raise questions

An area of great confusion, and perhaps even an outright disservice to taxpayers, was an unintended outcome of the forbearance issued by the IRS under Notice 2020-39 and later Notice 2021-10, allowing a QOF to claim an automatic waiver of the 90% penalty at the QOF level because of automatic eligibility for “reasonable cause.”  But where a QOF has been holding a QOZB that has been funded with “bad” property and has been sitting in that configuration for the last 18 or 24 months, it may be far from clear that the QOZB has been or will be able to meet the qualifications to be a QOZB, particularly if that QOZB is not considered a “start-up” business. While the 70% tangible property test has not been turned off for non-startup businesses, it has merely been made somewhat easier to satisfy.  Moreover, if money has been sitting in the bank account at the QOZB level, and the QOZB is not a “startup business,” that raises serious questions about whether some deals are already “dead in the water” from the combination of inaction (seemingly permitted and encouraged by the Notices) and the failure to meet the “substantially all” requirement at the QOZB level.  Note also that “during substantially all of the qualified opportunity fund’s holding period” of QOZ stock or QOZ partnership interest, the applicable entity must qualify as a QOZB.  Note that this particular “substantially all” test requires meeting a 90-percent threshold.

The qualification of a QOZB to meet all its statutory requirements is complicated – like everything else in the Land of OZ. There is a regulatory statement – essentially a fiat – that if an entity is a QOZB on the last day of its taxable year it is a QOZB for the entire year. Second, there is a one-time “get out of jail free” card that allows a non-compliant QOZB a six-month period to come back into compliance – and presumably obviate the failure to meet the QOZB standard for the previous year. But no one wants to be out of compliance for one or two years at the very outset of the QPF/QOZB project, and so a careful reading of these IRS Corrections – much clear than before, but arguably also much narrower than expected – must be high on your agenda over the next week or two.

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