The Qualified Opportunity Zone Investment Program was designed in part to encourage investment in rural and low-income communities. The plan was to allow the deferral of capital gains to stimulate traditionally undercapitalized areas. Yet most Qualified Opportunity Funds focused on real estate and in particular new construction. This type of investment may not have resulted in anticipated benefits to the community. However, this focus was understandable. Deferring[1] gains in real estate investments has been a tried and tested strategy for many years and when the QOZ program added potential step ups in basis after five, seven, and 10 years, the QOZ program was a concept that was comfortable for many real estate investors. Hence, the initial wave of QOZ funds weighed heavily on real estate projects. Yet as the program continued, many questioned whether the incentive achieved its goal of driving capital into poor, urban and rural areas that traditionally lacked long-term investment. Perhaps, one reason for this tension is that so far, many opportunity zone investors have overlooked the full breadth of the QOZ program. By focusing solely on real estate investments, potential investors have missed a different investment (with albeit higher risk) that can generate potentially higher returns: investing in an operating business as a Qualified Opportunity Zone Business.
Opportunity Zone benefits
The QOZ program provides three tax benefits: (1) deferral of tax until December 31, 2026, or the sale or exchange of the opportunity zone investment (Deferral Benefit);[2] (2) a basis step-up of 10% if the investment is held for five years with an additional 5% if the investment is held for seven years (Step-Up Benefit);[3] and (3) upon sale of the interest, investors do not need to pay tax on the appreciation if the opportunity zone investment is held for at least 10 years (Exclusion Benefit).[4]
To take advantage of the opportunity zone benefits, opportunity zone fund investments are generally structured as an investment in a QOZ fund, which in turn invests in one or more QOZ businesses.
Final regulation made clear that many operating businesses can meet the QOZ business requirements
There are three main hurdles to qualification as a QOZ business. The first requires that 70% of the tangible property of the business be in an opportunity zone. The second is that 40% of the intangible property of the business be used in the active conduct of a business within an opportunity zone. The last requirement is that the company must derive 50% of its gross income from the active conduct of a business in an opportunity zone. Each is described in more detail below:
- The Tangible Assets Must Be Opportunity Zone Property Located in Opportunity Zones.[5] The applicable statute provides that “substantially all” of the tangible property of a QOZ business must be tangible personal property used in the business of the QOZ business (Qualified Property). Regulations have clarified that, in the context of determining whether tangible property meets the opportunity zone requirements, “substantially all” means 70%.[6] Additionally, Qualified Property must have been: (1) acquired in 2018 or later; (2) first used in an opportunity zone by the QOZ business (or substantially improved by the same); and (3) “substantially all” of the use of the property is in an opportunity zone.[7]
- A Substantial Portion of Intangible Property Is Used in an Opportunity Zone.[8] A substantial portion of any intangible property must be used in the active conduct of the QOZ business trade or business in an opportunity zone.[9] Regulations clarify that a substantial portion means 40%.[10] Intangible property is treated as used in the QOZ business trade or business if the use of the intangible property is normal or customary and used in the opportunity zone to contribute to the generation of income.[11]
- Most Income Must Be Earned in an Opportunity Zone.[12] At least 50% of the company’s gross income of the QOZ business must be derived from the active conduct of its business in an opportunity zone.[13]Given the difficulty of determining where income is generated, the Treasury regulations provide three safe harbors that, if met, a QOZ business will be deemed to earn 50% of its income in an opportunity zone.[14] These safe harbors are: (1) more than 50% of the service hours of the QOZ business trade or business are performed in an opportunity zone; (2) more than 50% of the pay for services performed in the QOZ business trade or business is for services performed in an opportunity zone; or (3) the tangible property of the QOZ business trade or business located in an opportunity zone and the management and operational functions performed in an opportunity zone are necessary to generate at least 50% of the QOZ business's gross income.[15] Even if none of the safe harbors is met, facts and circumstances may still be used to show that more than 50% of the income was earned in an opportunity zone.
Perhaps one reason for investors’ reluctance to use the QOZ program for an operating business is that when it was first enacted there was still significant ambiguity regarding the requirements discussed above. Many businesses today are geographically fluid. Specifically, businesses rely on use of the internet, mobile human capital, and technology. In short, and particularly exacerbated during the pandemic, business is generally not conducted entirely in one place. Thus, without additional guidance, it was difficult to determine where “substantially all” of a business's assets were located, what constituted a “substantial portion” and what amount equated to “most income”. That ambiguity likely resulted in investors looking elsewhere.
Luckily, the Treasury regulations clarified many of these requirements. Using the 70% standard for property, a QOZ business can provide some services using its business property outside opportunity zones. Similarly, the clarification of the substantial portion of intangible property as 40% permits a QOZ business to allow some work involving intangible property to occur outsize an opportunity zone, such as accessing code or programs from a laptop. Perhaps, the most helpful is the safe harbor regarding the generation of income. These regulations provide concrete guidelines that businesses can follow to facilitate compliance with the statute. As a whole, the regulations opened the door for modern operating businesses that, while maintaining a substantial presence in the opportunity zone, are not constrained by impractical restrictions (the building in which they operate).
An impressive variety of operating businesses potentially qualify as QOZ businesses under the final regulations. In addition to location-bound businesses like brick-and-mortar stores or even manufacturers that ship products worldwide, many SaaS and other software businesses with high growth potential may qualify as QOZ businesses. A software company would meet several of the key QOZ business requirements by focusing on locating much of its property (both tangible and intangible) and workforce in an opportunity zone. If a majority of a software business’s work, both by hours and by compensation, is performed in an office located in an opportunity zone, the business should meet the QOZ business income requirement through both the first and second safe harbors. Furthermore, the software business could ensure that most of its tangible property, including equipment, is located in an opportunity zone, thereby meeting the QOZ business tangible property requirements. Finally, a business can meet the QOZ business intangible property requirement by ensuring that its intangible property is located and used in an opportunity zone. For example, if a business’s intangible property consists of software code, the business would want to ensure that the code is saved to devices used in an opportunity zone office and encourage employees to access the code in the opportunity zone office where possible. In short, with a bit of forethought and planning, QOZ funds may include a wide variety of businesses.
Many businesses may qualify as QOZ businesses, but careful planning is needed for compliance
While the QOZ program is certainly a great vehicle for real estate projects, QOZ funds may also find operating businesses ranging from manufacturers to software businesses attractive as they consider where to deploy deferred gains. The breadth of operating businesses that may qualify as QOZ businesses is perhaps underappreciated. This presents significant untapped potential for QOZ funds to diversify beyond real estate and enjoy the exclusion benefit for high growth operating businesses.[16] However, while the QOZ program is potentially available for a wide variety of businesses, failure to comply with its provisions could result in the loss of the program benefits and the imposition of penalties and interest. To that end, it is important that QOZ funds, considering the appropriateness of investments as QOZ businesses, consult with experienced advisors and counsel to ensure that businesses will operate in a manner that meets the QOZ program requirements.
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