This is covered in the second tranche of guidance and was recently addressed in a webinar done by the Arizona Commerce Authority, which you can find at www.azcommerce.com.
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How does a service business satisfy the 50% revenue test?
Does the revenue meet the 50% test if the operating company is based in an Opportunity Zone, although the services of the company are taking place outside the Opportunity Zone? A company performing lawn mowing services forms a new company in an OZ and buys a building to maintain lawn equipment. The company makes improvements to the building to clean, store and maintain the lawn equipment in the winter season. Backoffice staff spend time in the OZ building, but most staff are at client locations mowing the lawn and all of the lawn mowing is performed outside the OZ. The lawn mowing machines often remain at client sites for months. What if the service company performs maintenance on lawn mowing equipment they don’t own, by repairing the machines in the winter for example?
Answers
You have a fact pattern very similar to that in the 2nd set of regulations. The 50% test may be a bit more difficult for you since you seem to store more equipment outside the zone. With proper planning, modeling and oversight by an OZ specialist, you can likely qualify. The fact you own the building and manage the company within the zone helps.
There are several options to meet the 50 percent gross income test: From a presentation that will be part of a webinar the Arizona Commerce Authority is hosting today on the 2nd tranche of Treasury guidance on Opportunity Zones and funds. The first tranche of guidance said at least 50% of the gross income of a qualified OZ business must be derived from active conduct of trade/business in the Opportunity Zone. Second tranche covers options for how to comply: Share of service hours performed in the zone, or share of cost of services provided in the zone, or tangible property and management/operations in the OZ are needed to generate 50% of the business’ gross income, or facts and circumstances test. Effectively, you would want to try to meet the threshold on any of the first three tests.
The question in this scenario is not the 50% income test, where a safe harbor ought to apply. The real question is whether the tangible property has spent at least 70% of its holding period in the QOZ, which has not yet been answered even after the latest round of regulations.
The preamble to the April 2019 regulations contains an example of a landscaping concern that is run from and equipment is stored within a QOZ, but whose services are performed outside the QOZ. A business that fails the safe harbors may still establish that it satisfies the 50% Gross Income Test based upon relevant facts and circumstances. As a general rule, a QOZB must derive at least 50% of its gross income from the active conduct of trade or business within a QOZ (the “50% Gross Income Test”). The April 2019 regulations provide three safe harbors with respect to this requirement. First, a QOZB will meet the 50% Gross Income Test if at least 50% of the services provided by employees and independent contractors are performed in the QOZ. The preamble notes that service intensive businesses can use this safe harbor even when their sales occur outside of the QOZ. Second, a business will meet the 50% Gross Income Test if at least 50% of the amount paid for employee and independent contractor services are paid for services performed within the QOZ. Third, the 50% Gross Income Test will be considered satisfied if: (i) tangible property of the business within the QOZ and (ii) the management or operations with the QOZ are necessary to generate 50% of the gross income of the business. The example above fits under the third example. If a business uses intangibles, a substantial portion of such intangibles must be used in the active conduct of the QOZB. The April 2019 regulations define a “substantial portion” as at least 40% and define a trade or business with reference to activities that give rise to trade or business deductions under Code § 162. In addition, the April 2019 regulations contain a special rule that treats all leases of real property as trade or business activities but caution that this rule should be extended beyond the QOF rules. The April 2019 regulations provide additional clarity for businesses that hold real property straddling both a QOZ and a non-QOZ. Specifically, when it is necessary to determine whether a QOZ is the location of services, tangible property or business functions, all of the business’s property will be deemed to be located within a QOZ if two requirements are met. First, the amount of real property based on square footage located within a QOZ must be substantial as compared to the amount of real property based on square footage located outside of the QOZ. The real property outside of the QOZ must be contiguous to all or part of the real property located inside the QOZ.
Your question is very fact-specific. In general, if the highly compensated management staff is located in the Opportunity Zone building location, you will qualify. Revenue is earned by the company at its location, regardless of where the services are actually provided. Having your senior management getting their payroll at the QOZ location is likely critical.
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