Tax Law Income

Beginning an Lively Firm in an Alternative Zone | Cole Schotz

June 10, 2021
Jason W--ilson

This short article describes the requirements for starting an active business in a Qualified Opportunity Zone (“QOZ”).

The U.S. tax law that created QOZs was enacted in early 2018 and is designed to encourage long-term investment in economically distressed communities. The IRS has issued two key sets of proposed regulations outlining the rules for QOZ investments (in October 2018 and April 2019) and finalizing the regulations in December 2019. Investors and entrepreneurs are still adopting these rules. Still, the tax benefits of a successful QOZ investment in an active company can be substantial. These primarily include (1) a tax deferral on the amount of profit reinvested in a QOZ investment through 2026 and (2) the ability to sell a 10 year QOZ investment tax-free.

Real estate has been the main focus for QOZ investors and a home industry in QOZ real estate investments has emerged. In addition, an entrepreneur starting a new business should carefully consider whether he or she can establish the new business in a QOZ and follow complex rules in order to qualify as a QOZ company.

The most important definitions and applicable rules are summarized below:

  1. A “QOZ Fund” is an investment vehicle established as a partnership or corporation for the purpose of investing in a suitable QOZ property. The QOZ Fund must hold at least 90% of its assets in QOZ Property.
  2. “QOZ Ownership” means: (a) QOZ Shares, which are originally issued shares of a domestic corporation that were acquired for cash if the corporation is a QOZ business; (b) QOZ partnership interest, which is any equity or Profit sharing in a domestic partnership is acquired for cash if the partnership is a QOZ business, or (c) “QOZ business property” which is tangible property used in a trade or business of the QOZ Fund with the original use of the property beginning in the QOZ with the QOZ fund or the QOZ fund “substantially improves” the property (generally a 30 month test to double the property’s value).
  3. A “QOZ business” is generally an active trade or business in which substantially all (ie, greater than 70%) of tangible property is owned or leased by the taxpayer (through the QOZ Fund) is QOZ business property. In addition, a QOZ business is a business in which:
    1. at least 50% of the total gross income of such trade or transaction comes from the active pursuit of such trade within a QOZ (the “50% Gross Income Test”),
    2. a substantial part of the intangible property of such trade or business is used for the active pursuit of such trade or business in the QOZ, and
    3. less than 5% of the average of the total unadjusted tax bases of the assets of such a business or company is attributable to unqualified financial assets.

While there was initially significant uncertainty about the 50% gross income test, the regulations provide more clarity by providing three Safe Harbor tests. According to the regulations, a QOZ company will pass the 50% gross income test if any of the following applies:

  1. More than 50% of the service hours provided by its employees and independent contractors for the company are provided within the QOZ,
  2. More than 50% of the compensation and / or expenses for independent contractors for the company arise through its employees and independent contractors within the QOZ, or
  3. The QOZ business locates both tangible property and its management or operation within a QOZ required to generate 50% of the company’s gross income.

A company that does not meet the Safe Harbor Tests may also meet the 50% gross income requirement based on a fact and fact test if it can demonstrate, based on all facts and circumstances, that at least 50% of the gross income of the Company is derived from active business activity in the QOZ.

The regulations include an example of a technology company. The company is a startup developing software applications for worldwide distribution and is based in a QOZ. Much of the total hours of the startup’s employees and contractors developing software applications are spent in the QOZ. The example suggests that the company would pass the 50% gross income test even though the company makes the majority of its sales to consumers outside of the QOZ.

There are many additional aspects that entrepreneurs need to consider when starting a QOZ business, including timing questions about investing, valuation questions to meet IRS tests, leasing issues when renting property, issues with related parties when buying or leasing real estate Party and tax reporting issues. It may also be possible to move an existing business to a QOZ, but doing so requires careful planning and additional investment.

Note that the state income tax treatment of a QOZ holding may be different from the state income tax treatment. For example, New York recently decoupled its tax laws from federal QOZ law regarding the deferral of profits reinvested in QOZ businesses (although New York appears to have excluded profits from the sale of QOZ businesses made for more than $ 10 Years).

Despite the complexity of the law, the overall benefits for communities in need and the tax benefits for QOZ businesses can be substantial.

If you are interested in starting an active business in a QOZ, you should speak to a tax attorney to walk you through the requirements of the QOZ rules.