Part I: Much needed Guidance for Start-Ups and Operating Businesses
The IRS and Treasury issued a second round of proposed rules on April 17, 2019. The second round of Qualified Opportunity Zone (QOZ) guidance includes a total of 169 pages covering topics ranging from additional definitions of the commonly used OZ phrase “Substantially all;” transactions that could trigger the inclusion of gain and reinvestment; and guidance for start-ups and operating businesses.
(This blog is the first of a three-part post. Read part two here.)
- Operating Qualified Opportunity Zone Businesses (QOZB) – Up until Round II, one of the undefined factors for QOZB has been how to measure the requirement that 50% of gross income is earned in the QOZ. The proposed rules now provide three safe harbors, along with a facts and circumstances test, for determining if your QOZB meets this requirement. The main take away for all three tests is that it is possible for a QOZB to have clients and customers within and outside of the QOZ if you meet the tests below –
- 50% of services provided by employees and independent contractors are performed in the QOZ. The example provided in the proposed rules includes a software development company whose clients download its developed applications from locations around the world. The global company will meet this 50% gross income requirement if the location of the campus, where software is developed is in a QOZ, and more than 50% of the employees and independent contractors, work on software development on this OZ campus location.
- 50% of amounts paid for services – If a QOZB pays at least 50% of its payments for services to employees and independent contractors for services performed in the QOZ, it will meet this requirement. To continue the previous example, let’s assume that the software developer company has another branch location outside the QOZ. However, the payments made to the software developers in the QOZ location is at least 50% of their total payments to all employees and independent contractors in all locations, the business will have met this safe harbor requirement.
- Tangible Property and Management functions performed in the QOZ are necessary to generate 50% of the gross income – This safe harbor applies to a QOZB who has clients both within and outside of the QOZ but has its main office where operations and management functions take place and stores all equipment and supplies in the QOZ location. The example provided in the proposed rules is a landscaping company whose headquarters is in a QOZ, and all of its equipment and supplies are stored in a QOZ every day. Even though they are providing services within and outside the QOZ, they will have met this requirement.
- Working Capital Safe Harbor – As you may remember the proposed rules provided that to be Qualified Opportunity Zone Business Property (QOZBP), the property’s original use in the QOZ had to start with the QOZB (i.e., not previously used in a QOZ) or the property had to be substantially improved to be QOZBP. The first round of guidance provided that substantial improvement required the QOZB to essentially double the purchase price of the property (excluding land). The first round also provided a working capital safe harbor of 31 months to substantially improve the property.
Round II of the proposed OZ guidance made a change to this working capital safe harbor requirement that will help both start-ups and operating businesses. The working capital safe harbor provided in the first round requires that the QOZB have a written plan in place to spend the money that will substantially improve the property (defined above). Round II has included in the written plan for the development of a trade or business in a QOZ. So, it appears that if you buy an operating business or start a new business, rather than having to spend double the purchase price on new equipment, you could spend the money on developing the business, paying employees and other operating expenses, etc.
- Leased property – In Round II, there is a whole section on how leased tangible property can qualify as QOZBP. The basics include –
- The leased property must be acquired under a lease entered into after December 31, 2017;
- There is no original use requirement or substantial improvement requirement for the leased property; and
- No related party requirement, provided that if there is a related party lessor –
- The rate must be a market rate lease, and
- Prepayments of lease payments for a period over 12 months are not allowed.