Tax Reform's New Incentives for Investments in Low-Income Communities: Part 2

Please note:This alert was updated as of Oct. 24, 2018.

HIGHLIGHTS:

• Part 1 of this series of Holland & Knight alerts described a new tax incentive contained in the Tax Cuts and Jobs Act for investments in low-income communities designated as "Opportunity Zones." Part 1 also explained the process under which Opportunity Zones were nominated and designated.
• In Part 2, we discuss the requirements for formation and certification of a Qualified Opportunity Fund and the rules governing its operations. A Qualified Opportunity Fund is defined as any investment vehicle organized as a corporation or a partnership for the purpose of investing in "qualified opportunity zone property," and that holds at least 90 percent of its assets in "qualified opportunity zone property."
• In Part 3, we will discuss benefits for investing taxpayers.

Part 1 of this series of Holland & Knight alerts described a new tax incentive contained in the Tax Cuts and Jobs Act (the Act) for investments in low-income communities designated as "Opportunity Zones." The Opportunity Zone incentive is now embodied in Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code. Part 1 of this series discussed the process under which Opportunity Zones were nominated and designated. Part 2 discusses the requirements for formation and certification of a Qualified Opportunity Fund and the rules governing its operations. In Part 3, we will discuss the benefits for investing taxpayers, namely the deferral or exclusion from gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund, as well as the potential exclusion of gain from disposition of an investment in a Qualified Opportunity Fund.

Formation and Certification of Opportunity Funds

By law, a Qualified Opportunity Fund is defined in Section 1400Z-2(d)(1) as any investment vehicle organized for the purpose of investing in "qualified opportunity zone property," and that holds at least 90 percent of its assets in "qualified opportunity zone property."¹ Section 1400Z-2(e)(4) requires the Secretary of the Treasury to prescribe regulations necessary or appropriate to carry out the purposes of this provision, including rules for the certification of Opportunity Funds and rules to provide that a Qualified Opportunity Fund has a reasonable period of time to reinvest the return of capital from investment and to reinvest proceeds received from the sale or disposition of "qualified opportunity zone property." In late October, the IRS issued draft Form 8996 which will be used by Qualified Opportunity Funds to self-certify to the IRS that they are a Qualified Opportunity Fund. The Qualified Opportunity Fund will be required to file this form with their annual income tax return and requires the Qualified Opportunity Fund to report information about its assets.

Proposed guidance issued by the U.S. Department of Treasury and the IRS further clarifies that a Qualified Opportunity Fund can be any entity that is taxed as a partnership or a corporation for federal income tax purposes, which includes limited liability companies (LLC) treated as a partnership or corporation for federal income tax purposes. Proposed guidance also clarified how assets are valued in the application of the 90 percent asset test and provided flexibility on the testing dates for valuing assets.

The proposed regulations did not address what constitutes a "reasonable period of time" by which a Qualified Opportunity Fund can invest interim gains or reinvest proceeds received from the sale or disposition of "qualified opportunity zone property."

What Is Qualified Opportunity Zone Property?

Section 1400Z-2(d)(2) defines "qualified opportunity zone property" as one of the following:

• qualified Opportunity Zone stock
• qualified Opportunity Zone partnership interests, or
• Qualified Opportunity Zone Business Property

Therefore, a Qualified Opportunity Fund could acquire an equity interest in a business corporation (but not a nonprofit corporation), a partnership or a limited liability company taxed as a partnership or a corporation (but not a limited liability company that is disregarded for tax purposes), or could acquire and hold Qualified Opportunity Zone Business Property.

What Is Qualified Opportunity Zone Stock?

Qualified Opportunity Zone stock is stock in a domestic corporation acquired after Dec. 31, 2017, at its original issue by the corporation solely in exchange for cash. In addition, the corporation invested in must be, or be organized to be, a "qualified opportunity zone business" at the time of issuance of the stock, and it must continue to qualify as a "qualified opportunity zone business" for "substantially all" of the holding period of the stock.² Proposed regulations did not define what "substantially all" of the holding period of stock means. This will be addressed in forthcoming guidance.³ Proposed regulations provide that stock in pre-existing corporations may qualify as qualified Opportunity Zone stock so long as the corporation satisfies the qualification requirements at the time it chooses to be treated as a Qualified Opportunity Fund.

What Is a Qualified Opportunity Zone Partnership Interest?

A qualified Opportunity Zone partnership interest is any capital or profits interest in a domestic partnership that is acquired by the Opportunity Fund after Dec. 31, 2017, from the partnership solely in exchange for cash. In addition, the partnership invested in must be, or be organized to be, a "qualified opportunity zone business" and must remain so for "substantially all" of the Qualified Opportunity Fund's holding period in the interest. Proposed regulations provide that a partnership interest in a pre-existing partnership may qualify as a qualified Opportunity Zone partnership interest so long as the partnership satisfies the qualification requirements at the time it chooses to be treated as a Qualified Opportunity Fund.

What Is Qualified Opportunity Zone Business Property?

Qualified Opportunity Zone Business Property is tangible property used in a trade or business of the Qualified Opportunity Fund if:

• such property was acquired by purchase (as defined in Section 179(d)(2) of the Code⁴) after Dec. 31, 2017
• the original use of such property in the Opportunity Zone commences with the Qualified Opportunity Fund or the Qualified Opportunity Fund substantially improves the property⁵, and
• during "substantially all" of the Qualified Opportunity Fund's holding period, "substantially all" of the use of such property was used in an Opportunity Zone

A special statutory rule provides that tangible property that ceases to be Qualified Opportunity Zone Business Property continues to be treated as Qualified Opportunity Zone Business Property for the lesser of 1) five years after the date on which such tangible property ceases to be so qualified or 2) the date on which such tangible property is no longer held by the Qualified Opportunity Zone Business.

What Is a Qualified Opportunity Zone Business?

A Qualified Opportunity Zone Business means a trade or business in which "substantially all" of the tangible property owned or leased by the taxpayer is Qualified Opportunity Zone Business Property (determined by substituting "qualified opportunity zone business" for Opportunity Fund in each place it appears). Proposed regulations defined “substantially all” as at least 70 percent. The trade or business must also meet the following requirements:

• at least 50 percent of its gross income is derived from the active conduct of such trade or business in an Opportunity Zone; the proposed regulations clarified that this "[in an Opportunity Zone]" language does apply
• a substantial portion of its intangible property is used in the active conduct of such trade or business in an Opportunity Zone
• less than 5 percent of the average of the aggregate unadjusted bases of such entity's property is attributable to "nonqualified financial property"⁶
• such entity's business is not a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises⁷

The requirements for a Qualified Opportunity Zone Business are very similar to the requirements for a "qualified active low-income community business" (QALICB) for purposes of the New Markets Tax Credit (NMTC). Accordingly, it appears that a Qualified Opportunity Fund could easily undertake a side-by-side investment with a NMTC community development entity (CDE), or it could qualify as both a Qualified Opportunity Fund and an NMTC CDE and make a single investment that qualifies for both incentives. Finally, an Opportunity Fund could acquire "qualified opportunity zone property to use in a trade or business and itself qualify as a NMTC QALICB.

What Happens if an Opportunity Fund Fails to Meet the Minimum Investment Standard?

If a Qualified Opportunity Fund fails to meet the requirement that 90 percent of its assets be invested in "qualified opportunity zone property" (the "Minimum Investment Standard"), the Qualified Opportunity Fund must pay a monthly penalty for each month in which it fails to meet this requirement. The penalty is calculated by multiplying the underpayment rate established under Section 6621(a)(2) for the applicable month by an amount equal to the excess of 1) 90 percent of the Opportunity Fund's aggregate assets over 2) the aggregate amount of "qualified opportunity zone property" it holds. Notwithstanding the foregoing, no penalty is to be imposed with respect to any failure if it's shown that the failure is due to reasonable cause. Because there is no explanation of "reasonable cause," this will presumably need to be addressed in forthcoming guidance.

Regulations

The Secretary of the Treasury is directed in Section 1400Z-2(e)(4) to prescribe regulations necessary or appropriate to carry out the purposes of this Section. In late October, the U.S. Department of Treasury and the IRS issued proposed regulations, an accompanying Revenue Ruling and the related draft form. (See Holland & Knight's alert, "New Guidance on Opportunity Zones: Incentives for Investments in Low-Income Communities," Oct. 22, 2018.)

Conclusion and Considerations

Congress has enacted a potent tax incentive for investors to reinvest investment capital gains in funds designed to provide capital to businesses in distressed communities.

There are many statutory and regulatory considerations in forming and operating a Qualified Opportunity Fund. Many issues still need to be worked out in guidance however recently issued guidance is very helpful for stakeholders who are trying to unleash the power of the new Opportunity Zone incentive.  
   

Notes

¹ Whether a Qualified Opportunity Fund holds 90 percent or more of its assets in "qualified opportunity zone property" is determined by averaging the percentage of "qualified opportunity zone property" held by the Fund a) on the last day of the first six-month period in the applicable taxable year of the Fund and b) on the last day of the applicable taxable year of the Fund. This is similar to the "substantially all" test under Section 45D of the Code, by which it is determined whether a New Markets Tax Credit (NMTC) community development entity (CDE) has invested "substantially all" of its equity in qualified low-income communities.

² Rules similar to those described in Code Section 1202 (c) (3) will apply to prevent a corporation from redeeming and then reissuing its stock to a Qualified Opportunity Fund.

³ This issue also affects the definitions of "qualified opportunity zone partnership interest."

⁴ The reference to Section 179(d)(2) of the Code would limit the acquisition of property from a related party. Section 1400Z-2(d)(2)(D)(iii) also provides a special variation from the related party rule of Section 179(d)(2)(A) whose meaning and application is unclear due to apparent drafting errors.

⁵ For this purpose, property is treated as "substantially improved" by the Qualified Opportunity Fund only if, during any 30-month period beginning after the date of acquisition, additions to basis with respect to such property in the hands of the Qualified Opportunity Fund exceed an amount equal to the adjusted basis of such property at the beginning of the 30-month period. A recent Revenue Ruling clarifies that when applying this test, the basis for any existing building is considered without regard to the purchase price that can be allocated to the basis of land.

⁶ The first three requirements are set forth by cross-referencing Section 1397(C)(2), (4), and (8) of the Code. Similar requirements apply to NMTC projects.

⁷ The requirement is set forth by cross-referencing Section 144(C)(6)(B) of the Code. A similar requirement applies to projects utilizing the NMTC.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.