The qualified opportunity zone rules create a special opportunity for serial entrepreneurs and investors in startup companies. In the TCJA of 2017, Congress created an opportunity for investors to reinvest capital gain, which would result in the deferral of such gain for six years, a 10% reduction of such gain (e.g. when recognized six years later), and possibly the elimination of any future appreciation from the new investment (if the new investment is held for 10 years). December 20, 2019 treasury regulations were issued, and with the onset of the coronavirus pandemic, the IRS relaxed some of the rules, the result of which is a tremendous opportunity for investors. However, the window for this opportunity is reduced drastically after December 31, 2020. To take advantage of this opportunity, Investors must use an investment structure in conjunction with a business plan (“working capital plan” or “WCP”), which details how invested capital will be spent in setting up an operating business. The beauty of the working capital plan is that it allows up to 55 months for the business to get up and running. This is an especially great opportunity for entrepreneurs or for investors, who are looking to start or invest in a business.
The intent of the legislation was to promote investment in underdeveloped areas, referred to as “Qualified Opportunity Zones” (or “QOZs”). Qualified Opportunity Zones are essentially designated by each state based on the 2010 census, and in some cases those areas are fairly well developed as of today (e.g., Williamsburg Brooklyn lies within a qualified opportunity zone even though it is a fairly hot real estate neighborhood in New York City).
- Eligible Investors can be U.S. citizens, U.S. corporations, or non-resident alien investors, who have realized capital gain that would otherwise be subject to taxation (this includes owners of a pass-through entity who have been allocated capital gain).
- Capital gain must have been realized during one of the following periods:
- between October 4, 2019, and any time in 2020 for individuals; or
- at any time during 2019 and any time in 2020 for Investors who were allocated capital gain from a pass-through entity.
Time to Act:
- The investor must set up a qualifying structure before December 31, 2020, including but not limited to the following:
- The investor must create a two-tier structure — holding company (a corporation or a partnership) with a subsidiary that operates an underlying business (also a corporation or partnership);
- the underlying business must have a working capital plan in place; and
- the holding company must file certain forms and make certain certifications.
- For capital gain realized in 2019, the Investor must file an election with a timely filed tax return or with an amended return prior to December 31, 2020. The election is to be submitted with the Investor’s 2019 tax return, however, given the coronavirus pandemic the election may be made up until December 31, 2020. If Investor has already filed his/her tax return for 2019, then an amended return would need to be filed before 12/31/2020.
- For capital gain realized in 2020, the election would be made on a timely filed 2020 tax return.
Highlights of the Investing Opportunity:
- New Legislation from TCJA of 2017 allows eligible taxpayers to shelter capital gain by rolling some or all of such gain into their own investment vehicle for their next entrepreneurial venture.
- For each dollar of capital gain invested, the Investor can defer tax on such gain until 12/31/2026 (the gain would then be taxed at the capital gains tax rates in effect at that time).
- When the deferred gain is recognized, only 90% of the gain is recognized – e.g., on 12/31/2026, 10% of the prior capital is permanently excluded from taxation.
- If the new venture is a success and the Investor holds such investment for 10 years, then 100% of the gain from a sale of the new venture will be tax-free.
- By creating their own investment vehicle, an Investor can take up to 55 months (and in certain cases 86 months) to implement a reasonable working capital plan for their new business will need to operate in a QOZ, but as part of the working capital plan, the Investor can take some time to identify a location in which to conduct the business – e.g. such as securing a lease in a QOZ. There are certain requirements that must be satisfied (tangible asset test, intangible asset test, income test, etc.), however, all of these tests are suspended as long as a working capital plan is in place (e.g., these requirements can be suspended for up to 55 or 86 months).
- Investor’s capital (e.g., that has been invested into the vehicle and reserved for expenditures under the working capital plan) can be invested in securities while the working capital plan is in effect. In fact, 30% to 37% of invested capital can remain permanently invested in securities while the remaining 63% to 70% is deployed according to the working capital plan. If structured properly, up to 15% of the capital could be invested in any type of securities (e.g., such as equities) and the balance would need to be invested in short-term debt securities with a maturity no longer than 18 months.
- The working capital plan provides investors with a lot of optionalities while they try to implement a business plan for their new venture. If the new business venture is not successful, then the Investor could take his investment out before 2026, however, the Investor would then take the deferred gain into income at that point in time (this is referred to as an “inclusion event”).
- Even if the new business is not successful, the Investor can take the gain he or she would otherwise recognize (e.g., which would constitute an inclusion event when withdrawn) and roll it into another QOZ investment or create a new vehicle (note: the 10-year holding period would be re-set as well as the 5-year holding period for the 10% gain exclusion on 12/31/2026.
- The new business can be any business with just a few prohibitions – it cannot be a golf course, country club, massage parlor, hot tub facility, suntan facility, liquor store, racetrack, or a gambling facility.
- The optionality of this opportunity is attractive – even if the new venture is not successful, the benefits are twofold: 10% of today’s capital gains is eliminated and the remaining 90% of today’s capital gains is deferred for six years. If the new venture is successful there is an added benefit in that the appreciation of this new venture can be entirely tax-free. Also, a considerable portion of the invested capital can be placed in a combination of securities.
Investor realizes $100 of capital gain on November 1, 2019. Investor uses that $100 to make a qualifying investment via a qualifying 2-tier structure no later than December 2020. At a capital gains rate of 20%, the tax would have been $20 in 2019. Investor uses the $100 in the structure to start a new business that he/she has been contemplating. With the coronavirus pandemic still ongoing, Investor puts the $100 into qualifying securities while Investor seeks to rollout the business plan over the next 55 months. At the end of 55 months the new investment must have exhausted $63 of the $100 and there must be an ongoing trade or business, which is conducted in a Qualified Opportunity Zone; otherwise, Investor will recognize the deferred capital gain and have to pay his $20 at that point in time. Assuming that Investor is able to set up a new business by the end of 55 months, then $90 of the $100 in deferred gain would be recognized in income December 31, 2026. Assuming the capital gains rates stay the same as they are today, Investor would pay a tax of $18 (e.g., 20% of $90). Also, if Investor holds his investment in the business through the end of 2030, then Investor would pay no tax on any appreciated value of the trade or business when it is ultimately sold.
The opportunity and benefits of the qualified opportunity zone legislation are great, the rules are complex and the time for acting to take full advantage of the benefits will expire at the end of 2020. Given the steps needed to set up a structure, interested investors should act quickly. Please contact Steve Lueker at Offit Kurman P.A. to learn more about the qualified opportunity zones and determine whether such an investment makes sense for your business objectives. Steve Lueker is an attorney who has over 24 years of experience structuring sophisticated transactions and tax planning. In addition to working as an attorney he worked for KPMG’s M&A group and for UniCredit, a large Italian bank, where he ran the bank’s special situations portfolio.
Disclaimer: The contents of this article are for discussion purposes only and do not represent tax or legal advice.
 In an effort to simplify the rules, this is written from the prospective of September 2020.
 For nonresident alien investors, they must irrevocably waive any treaty benefits that would exempt gain from US federal taxation.
 It should be noted that the mechanics of this election need to be evaluated properly so as to make the election for an already filed 2019 tax return.
ABOUT STEVE LUEKER
Steve.Lueker@offitkurman.com | 929.476.0037
Steve has both transactional and litigation experience, spanning a career of more than 20 years. Steve helps guide his clients from the ground up, whether forming and structuring the best entity, hiring key executives, entering into software licenses, raising capital, litigating disputes or acquiring or selling assets or equity. A considerable portion of Steve’s practice involves mergers and acquisitions, capital raising, technology transfers/licenses, and taxation. He has found that his transactional experience is insightful when litigating commercial issues. Conversely, his litigation experience, which is rare for many transactional attorneys, provides unique insights when drafting contracts. Additionally, while most transactional attorneys do not understand tax considerations, Steve’s taxation knowledge is invaluable in structuring transactions where understanding and avoiding tax pitfalls can mean the difference between a successful deal or an insurmountable gap between the parties’ objectives.
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