Recently there has been a discussion of combining two distinct tax advantage provisions, the deferral or exclusion of capital gains on the sale of qualified small business stock (QSBS) with the benefits of Opportunity Zone investing. In general, the OZ rules allow investors to avoid capital gains from the sale or real estate or businesses located in Qualified Opportunity Zones if invested for at least ten years and defer the tax liability on capital gains invested in the OZs. Put together, these two incentives create a powerful incentive to invest capital in low-income communities identified as Qualified Opportunity Zones and obtain significant tax benefits. To understand how these two provisions can work together, each one must be examined separately: the exclusion of capital gain under Section 1202 for QSBS, the deferral of gain under Section 1045, and the benefits associated with Qualified Opportunity Funds.
SECTION 1202 CAPITAL GAINS RULES FOR QUALIFIED SMALL BUSINESS STOCK
Although it has been around for a number of years, the benefits associated with Qualified Small Business Stock only really became relevant to most investors when President Obama lifted gains from the sale of QSBS from the list of tax preference items (in the Protecting Americans from Tax Hikes Act, signed on Dec. 18, 2015. Initially, part of the Revenue Reconciliation Act of 1993 Section 1202 provides for a full exemption of either the greater of $10 million or 10 times an investor's tax basis on the sale of a QSBS. The requirements of a QSBS are as follows:
It must be a C corporation and not an S corporation or partnership entity like an LLC.
The shares must be held for at least five years.
The QSBS shares must be acquired from the original issuer or from a broker on behalf of an original issuer.
The C corporation must have less than $50 million aggregate gross assets at the time of issuance and immediately thereafter.
At least 80% of its assets must be used in the active conduct of a trade or business during substantially all of the taxpayer’s holding period.
At least 90% of the real property owned by the C Corporation must be used in that trade or business.
DEFERRAL OF GAIN FOR QSBS
Even if the QSBS shares are not held for five years but are held for more than six months, an investor can defer the gain associated with the sale of the QSBS by reinvesting the gain in another QSBS within 60 days.
One reason QSBSs have not been particularly popular is that they are C corporations not partnership or pass-through entities. However, the Tax Reform Bill of 2017 did at least create a tax benefit associated with investing in a C corporation. C corporations now enjoy not only a 21% federal tax rate but have an unlimited ability to deduct state and local taxes.
There are several businesses that cannot qualify as a QSBS. These include any corporation in the fields of: (1) health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services; (2) banking, insurance, leasing, financing, investing or other similar businesses; (3) farming businesses (including raising or harvesting trees); (4) any business operating a hotel, motel, restaurant or similar business; (5) any business where at least more than 10% of the assets consist of portfolio, stock or securities; and (6) as mentioned earlier no matter what the business consists of the QSBS must be engaged in any active conduct of a trade or business.
Importantly, a QSBS can be owned by an individual, trust, partnership, LLC, or an S corporation. A QSBS cannot be owned by another C corporation.
QUALIFIED OPPORTUNITY ZONE RULES
Opportunity Zones are generally low-income areas designated by the Treasury Department. There are OZs in every state and California has more OZs than any other state. The tax benefits associated with investing in an OZ include the following: (1) capital gain is deferred if generally invested in a Qualified Opportunity Zone Fund (QOF) within 180 days of the gain being recognized; (2) 10% of the gain is forgiven if invested in by the end of 2021 and the QOF is held on Dec. 3, 2026; (3) gain earned within the QOF Fund is not subject to tax if the QOF is held for at least 10 years.
Investing in a QOF requires certain provisions be satisfied; (1) the investor must contribute capital gain within 180 days of recognition to a QOF Fund or 180 days of a year end if the gain comes through a Schedule K-1, such as from a trust, partnership, LLC or S corporation; (2) the QOF must then invest at least 90% of its assets in a Qualified Opportunity Zone Business (QOZB) by a bi-annual testing date; (3) the QOZB must be acquired solely for cash at original issue.
A QOZB may own either real estate or an operating business. Although most of the literature focuses on the requirements for real estate, since a QSBS must be engaged in an active conduct of a trade or business, the rules for operating businesses become relevant. These rules are: (1) at least 70% of the QOZB assets must be used primarily in an OZ; (2) at least 40% of its intangibles must be used in an OZ; and (3) at least 50% of its income must be earned within an OZ. On the last requirement, the IRS regulations create three safe harbors which can be satisfied: (1) at least 50% of the employee and independent contractor working hours come from an OZ; (2) at least 50% of the amount paid to the employees and independent contractors are for services performed in an OZ; (3) the tangible property of the QOZB and the management or operation functions performed in an OZ are necessary for the generation of at least 50% of the QOZB's gross income.
As mentioned earlier, both the QOF and the QOZB must meet certain qualifications. For a QOF, at least 90% of its assets must be Qualified Opportunity Zone property determined by averaging the percentage of Qualified Opportunity Zone property measured on the last day of the first six month period of the QOF's year end and on the last day of its year end. For a QOZB, at least 70% of its tangible property which is either owned or leased must be a Qualified Opportunity Zone property. This requires that the property be: (1) acquired by purchase after Dec. 31, 2017; (2) if its real property purchased by the QOZB, the original use commences with the QOZB or the QOZB substantially improves the property; or (3) substantially all of the use of the tangible property is in an OZ.
Like the QSBS rules, there are certain excluded businesses. These businesses include so-called sin businesses as follows: (1) private commercial golf courses, (2) massage parlors; (3) hot tub facilities; (4) sun tan facilities; (5) race track or other facilities used for gambling; (6) any store whose principal business of which the sale of alcoholic beverages for consumption on premises.
Combining the provisions together, a sponsor creates a QOF which will invest in the QOZBs which will be QSBSs. This means they are C corporations which are small business (less than $50 million in assets) that will satisfy the QOZB requirements by having at least 70% of their tangible property owned or leased in an OZ. Although the general goal may be to hold the shares of the QOZBs were at least 10 years, the Section 1202 and Section 1045 Rules allow the QOF to sell the shares in a shorter period. Under Section 1045, if the QOZB shares have been held for at least six months, the QOF can reinvest the gain within a 60-day period beginning on the date of sale of the QSBS shares. If the QOF holds the shares for at least five years, the gain to the individual investors up to $10 million can be excluded from taxable income by the investors. Finally, if the QOZB shares are held for at least 10 years, all gain can be excluded for federal income tax purposes. This suggests that real tax benefits can be obtained by either starting a new business or investment in an OZ or relocating an existing business to an OZ.
We now have a new administration in Washington that might further the benefits of QSBSs and OZs. If the Biden administration is successful in increasing capital gains rates or having capital gains taxed at ordinary rates, the benefits of QSBSs and OZs will increase. The higher the federal tax rate, the more valuable this form of tax planning.
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