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IRS Sheds Brighter Light on Opportunity Zones

April 23, 2019

The IRS has issued a much-anticipated second round of proposed regulations better outlining the framework of the Qualified Opportunity Zone (QOZ) program. Operating businesses that have been waiting on the QOZ sidelines should now have enough clarity to begin to tap into the program’s benefits.

Key takeaways from these proposed regulations:

Active trade or business

The QOZ statute contains a requirement that at least 50% of a QOZ business’ gross income must be derived from the active conduct of a trade or business in the QOZ. However, prior to the most recent proposed regulations, it was not clear how this would apply to non-real estate businesses. The proposed regulations provide three safe harbors for what constitutes active conduct of a trade or business in the QOZ. As long as a business meets any of the three safe harbors provided below, the business will be deemed to have met the 50% gross income test. A business that does not meet any of the safe harbors may still rely on the facts and circumstances to determine whether it satisfies the 50% gross income test. The safe harbors are as follows:

  1. At least 50% of the hours worked by employees and independent contractors for the QOZ business are performed in a QOZ.
  2. At least 50% of the total amount paid for services by the QOZ business is paid for services performed in a QOZ.
  3. The tangible property of the QOZ business and the management or operational functions performed in a QOZ are each necessary for the generation of at least 50% of the gross income of the QOZ business.

The preamble to the proposed regulations sheds some additional light on the application of these safe harbors with the following examples:

  • Example 1: A company develops software applications in a campus located in a QOZ. Because the business’ global consumer base purchases such applications through Internet download, the business’ employees and independent contractors are able to devote the majority of their total number of hours to developing such applications on the business’ QOZ campus. As a result, this business would satisfy the first safe harbor, even though the business makes the vast majority of its sales to consumers located outside of the QOZ.
  • Example 2: Assume that the business described in Example 1 also utilizes a service center located outside of the QOZ, and that more employees and independent contractor working hours are performed at the service center than the hours worked at the business’ QOZ campus. While the majority of the total hours spent by employees and independent contractors of the business occur at the service center, the business pays 50% of its total compensation for software development services performed by employees and independent contractors on the business’ QOZ campus. As a result, the business satisfies the second safe harbor.
  • Example 3: A landscaping business is headquartered in a QOZ. Its officers and employees manage the daily operations of the business from its headquarters, and all of its equipment and supplies are stored within the headquarters facilities or elsewhere in the QOZ. The management activity and the storage of equipment and supplies in the QOZ are necessary to generate 50% of the gross income of the trade or business, thus meeting the third safe harbor.

Triple net leases

Triple net leases will not qualify for the benefits of the QOZ program. The proposed regulations state that while the ownership and operation (including leasing) of real property is the active conduct of a trade or business, merely entering into a triple-net-lease with respect to real property is not the active conduct of a trade or business.

Asset sales by a Qualified Opportunity Fund (QOF)

Under the statute, it is clear that where an investor sells an interest in a QOF held for more than 10 years, the capital gains from this sale would be excluded from the investor’s income. However, it was unclear whether the same would apply to assets sold by the QOF. The most recent proposed regulations state that capital gains from such asset sales, if they satisfy the 10-year holding period applicable to the investors, can be excluded from the investor’s income.

Reinvestment of proceeds from sale of assets by a QOF

If a QOF sells assets before the 10-year holding period has been met, the gain from such sales will not be excludable from the investor’s income. Many commentators had asked for a way to roll over such gains into a replacement QOZ property, but the IRS concluded that there was no legal basis for such a rule.

Carried interests

The proposed regulations do not take a taxpayer-favorable view on carried interests. They state that only the portion of an investor’s equity that is attributable to capital is eligible for the exclusion from capital gains after the 10-year holding period is met. For example, if an investor contributes 10% of the capital but receives an interest in 20% of the profits above a certain IRR threshold, only the 10% interest would be eligible for the capital gains exclusion.

Although these regulations clarify much of the original QOZ statute, many variables still exist. Please reach out to your KSM advisor to determine relevancy for your situation.

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