We are currently recommending the two-tier structure to our clients, as it is totally clear that this works within the regulations.
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Since the working capital safe harbor applies to QOZ businesses, why can’t a fund also be a trade or business?
I am aware that the ownership and operation of real estate can be a trade or business for tax purposes. Some people say you must use a two-tier entity structure to use the safe harbor, others say you can use a single tier. My attorney says it’s a grey area and is pushing towards a two-tier but I'd prefer that we can apply the safe harbor at the fund level.
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The 31 month working capital safe harbor only applies to a qualified opportunity zone business. A QOF cannot use the safe harbor.
I am not a lawyer, but my understanding is that the safe harbor applies only to the business invested in by the fund, not by the fund itself.
I don’t know why it can’t be. It’s admittedly a grey area.
It's a good question. My personal view is that the WCSH should apply at the QOF level as a matter of implication, but if you're playing it safe, the most straightforward interpretation is that the WCSH only applies for QOZBs and not QOFs. In practice, I don't think that'll be the way it's enforced, though -- I think it'll apply to QOFs as well. The foregoing is general information and not legal or tax advice.
Unfortunately, the two-tier structure is required because of a glitch in the language the IRS to provide the working capital safe harbor. The working capital exception is not available at the QOF level.
There is no working capital safe harbor at the fund level. Do a two tier. Much more security and flexibility so long as you structure into it properly.
I think the two tier is best.
This is a great question. First, a QOF (the "upper tier") must have at least 90% of its assets be in one of the following: (A) QOZ stock, (B) QOZ partnership interests, or (C) QOZ business property. By definition, the first two of those items ((A) and (B)) represent two-tier investments, answering your question. The upper tier is the Fund, and the lower tier is either a corporation or a partnership (which can include an LLC taxed as a partnership). Before I talk about direct ownership, let me note a couple of things about the two-tier route: First, the statute says that a lower-tier entity is okay if it IS a QOZ business, or if it is newly formed for the purpose of BEING a QOZ business. This has been interpreted to mean that a lower-tier entity does not have to be in a trade or business from the start. It can be formed and LATER BECOME a QOZ business. When your project is not yet built, or your "active trade or business" is still in the development stage, you don't have a trade or business YET, so this ability to BECOME a business can be very important. Second, if you go the two tier route, you also become subject to a bunch of technical requirements, one of which is a rule that requires the lower tier entity to comply with several of the requirements of Section 1397C of the Internal Revenue Code. One of those requirements is that not more than 5% of the lower tier company's assets be in "nonqualified financial property," PROVIDED THAT the company can also have a reasonable amount of "working capital." Trying to interpret that rule favorably to taxpayers, the IRS wrote a rule provides that a LOWER TIER ENTITY'S cash on hand is "reasonable" if it will be invested in a qualifying project, provided that there is a 31-month written plan to develop a project or start a business. So, to sum up: (1) if you do your business in two tiers, then you don't have to already be in business; you can plan to BECOME a business. (2) if you have a lot of cash at the lower tier, that's OKAY, as long as you have a 31-month written plan. On the other hand, if you want to run a business DIRECTLY at the FUND level, then you are subject to a different rule. Now, you need for the business to be item (C) in my list, that is, the directly owned asset must be "QOZ business property." Unfortunately, QOZ business property doesn't have a "formed to be" exception like the one for lower-tier entities. Instead, the rule simply requires that the assets be "tangible property used in a trade or business." So, if you buy undeveloped land, or a used building that has to be rehabilitated, then you will have to do some building before you can pass the "used in a trade or business" requirement. SO, out of the box, it looks like you will fail the trade or business test while you are out there building your building. Of course, everything in the OZ world has exceptions, and this is no different. At the Fund level, you do have the benefit of the 6-month test. So, you could even have the property acquired by the fund in its "raw" state, and have the fund do the development work, PROVIDED you can get the property in service by the next 6-month testing date. Alternatively, you could build the property OUTSIDE the fund, and have the fund acquire the property and place it in service sometime on or after the acquisition, and on or before the next 6-month testing date. On either of these fact patterns, you'd be okay. But REMEMBER: the 31-month working capital rule simply doesn't even apply to work done at the Fund. The "permitted working capital" rule ONLY applies to lower-tier entities. All a FUND has is a "Pass the 90% test every six months" rule, and that rule is pretty unforgiving. Bottom line: Sitting on a lot of cash, with a plan to build a building, whether or not you have a 31-month written plan, will NOT pass the 90% test. So, typically, you won't do building development at the Fund level. BUT, if you think that you can develop the property before the next 6-month testing date, then you could build your project that way. Similarly, if someone else will build the project, and you are just going to buy it from them, then Fund ownership could also work there. (BUT if you go THAT route, then don't forget that you have to buy the property from someone who is UNRELATED to you! So, don't develop the property and then figure that you can sell it to a QOF that you own 20% or more of!)
Most people working in this area agree that the 31-month Working Capital Safe Harbor applies to Qualified Opportunity Zone Businesses, which requires a legal entity to be formed under the QOF. You would likely want to use the two-tier structure for operational and exit flexibility. Yes, operating real estate can be treated as operating a trade or business but will not allow the safe harbor without establishing a subsidiary entity - which can be problematic if you are constructing or rehabbing the property.
Working capital safe harbor is only available for QOZBs not QOFs. See Prop. Reg. § 1.1400Z-2(d)-1(d)(5)(iv).
There is no requirement to use a two-tier structure for a trade or business. On the contrary, a fund absolutely can be a trade or business. However, it is generally strategically advantageous to use a two-tiered structure and I would suggest that a qualified and knowledgeable attorney and CPA team would be able to review your fact pattern and advise you in detail as to why. But I will tell you in this general e-mail that the advantage of a two-tiered structure related to the fact that the fund level entity must meet the 90% asset test, whereas the 2nd tier (non-fund entity) entity that would operate as a trade or business only has to meet the 70% test in order to qualify as QOZBP. And if the sub-entity meets that 70% test, then 100% of the asset value of said sub-entity counts toward the 90% at the fund level. There may be additional advantages with regard to flexibility in ownership changes, etc., but I would suggest an engagement with professional advisors to direct you.
The QOF needs to invest in Qualified Opportunity Zone Property, which is defined as: Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership interest, or Qualified Opportunity Zone Business Property. Whether the QOF may operate the business directly needs additional study, but may be implied in the definition of Qualified Opportunity Zone Business Property. Nevertheless, the structure of the deal must respond to the priorities and needs of all parties involved.
I don't think it is grey. The issue is that a QOF has to have 90% of its assets in qualifying investments and cash doesn't apply. The working capital safe harbor doesn't apply to that 90% requirement. The working capital safe harbor applies to the restriction on the QOZB regarding nonqualified financial property. That is why folks think that the two-tier structure is advantageous if you will have a bunch of cash and need to hold it for more than six months.
As the proposed regulations are currently drafted, the working capital safe harbor only technically applies to a Qualified Opportunity Zone Business, and not Qualified Opportunity Zone Business Property. Therefore, the working capital safe harbor does not apply to a Qualified Opportunity Fund that directly owns QOZ Business Property that I used in a trade or business. My opinion is that you should use a two-tier entity structure to use the safe harbor, and would follow your attorney's recommendation unless there is a change in the final regulations.
As written in the second round of proposed regulations, the working capital safe harbor is specific to the QOZB (two-tier, indirect) structure.
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