Time to Consider Investments in Operating Businesses in Opportunity Zones
Stites & Harbison Client Alert, November 25, 2019
Opportunity Zones are depicted as transformative tools created to stimulate employment and achieve economic growth in distressed low-income communities. Like a public-private partnership, eligible taxpayers are entitled to significant tax incentives in exchange for investing unrealized capital gains in Opportunity Zones. Over the past year and a half since enactment, the Opportunity Zone Program has yet to take a major step in connecting private capital with operating businesses in these distressed communities. Up until now, real estate, the traditional bricks and mortar, has been viewed as the low-hanging fruit while operating businesses and venture-staged companies, the true engines that generate well-paying jobs and spur local economic growth, have yet to capture the attention of qualified Opportunity Funds. The reasons are pretty evident. As written, Section 1400Z-2 of the Internal Revenue Code, impedes investment in operating businesses. Unlike real estate which is affixed geographically with a single point of operation, e-commerce companies, manufacturers, distributors, and high-impact tech businesses in search of worldwide markets find themselves transacting business inside and outside Opportunity Zones. Also, from an investment perspective, private equity, the life blood of investment-staged companies, traditionally looks to generate the desired returns on their investments within a five to seven year horizon. The result is that their timeline is not aligned with the minimum 10-year hold required by qualified Opportunity Funds. Therefore, meaningful accommodations are required in order for private equity to follow operating businesses into Opportunity Zones.
Reacting to the facts that Opportunity Zones fail to recognize the correlation between investing in operating companies and stimulating economic growth in communities in need, the Internal Revenue Service (“IRS”), on April 17, 2019, issued a second set of proposed regulations (the “Proposed Regulations”) which seek to remove a number of obstacles which impede investments by qualified Opportunity Funds in operating businesses. The following are several provisions of the Proposed Regulations that should pique investors interests in operating businesses:
The 50% of Gross Income Test. An operating business with a national or global market faces the challenge of scaling its business by having to satisfy the 50% gross income test. Aware of this problem, the IRS has proposed three separate trade or business “safe harbor” tests and a separate fact and circumstances analysis that can be used to qualify a business under the 50% gross income test:
- Employment. To the extent a business is selling goods or services outside the Opportunity Zone, at least one half of the work performed by its employees, based on hours, must occur in an Opportunity Zone. In making the calculation for this test, all services performed by employees, independent contractors, and employees of independent contractors must be taken into account. The result is calculated by dividing the total hours worked in the Opportunity Zone divided by the total hours performed by these groups in and outside the Opportunity Zone.
- Compensation for Services. The total dollars paid by a qualified Opportunity Zone Business to employees and independent contractors for services performed within an Opportunity Zone must be at least 50% of the business' dollar amounts paid for services performed. The test calculation includes services performed by employees, independent contractors, and employees of independent contractors. The result is calculated by dividing total dollar amounts paid to these groups in the Opportunity Zone divided by the total amounts paid for services to such groups in and outside the Opportunity Zone.
- Necessary Tangible Property and Business Function. The combination of the work rendered by management and/or the operational staff with the use of the Qualified Opportunity Zone Business’s tangible property located in the Opportunity Zone are necessary to generate 50% of the business’s gross income. This is a conjunctive test – if both conditions are met, the business satisfies this safe harbor test.
If none of the three safe harbor tests are met, an operating business may still qualify as a Qualified Opportunity Zone Business, if, based on all of the facts and circumstances, at least 50% of the gross income is derived from the active conduct of business in an Opportunity Zone.
Reinvestment of Proceeds from the Sale of a Qualified Opportunity Zone Business. Venture capital and private equity, by design, typically dispose of their portfolio investments somewhere between three to seven years. In an effort to align the principles of private equity investing with those of Qualified Opportunity Zone Businesses, the Proposed Regulations acknowledge the recycling of proceeds from a return of capital event or the sale or disposition of Qualified Opportunity Zone Property by a Qualified Opportunity Fund so long as the proceeds are reinvested within a 12-month period in another Qualified Opportunity Zone Business. Any such proceeds must be held continually during this period, in cash, cash equivalents, or debt instruments with a term of 18 months or less. Also, while a sale or disposition of a Qualified Opportunity Zone business asset results in cash proceeds, such proceeds are not taken into account in calculating the 90% asset test so long as such proceeds are reinvested. While the qualifying reinvestment does not in any way taint a Qualified Opportunity Fund’s tax incentives, the IRS determined that the interim gains generated by the sale or disposition are subject to tax.
Investment in Qualified Opportunity Zone Business. By definition, to qualify as a Qualified Opportunity Zone Business, an existing business must satisfy the 70% Asset test on the date of the investment by the Qualified Opportunity Fund or a newly formed business must satisfy the 90% Asset test if such investment is made into a newly formed business. The Proposed Regulations extend the 31-month working capital safe harbor, previously available only for real estate projects, to the development of a trade or business within an Opportunity Zone. Consequently, a new and expanding operating business may take advantage of the reasonable working capital plan in order to cover payroll, inventory, and occupancy costs during the safe-harbor period.
Qualified Opportunity Zone Business Property.
- Inventory in Transit. To qualify as a Qualified Opportunity Zone Business, substantially all of the use of the business property must be in an Opportunity Zone. However, inventory of a new and expanding business finds itself, from time to time, in transit from a vendor or to a customer. The Proposed Regulations recognize that business inventory (including raw materials) will not fail to be used in a qualified Opportunity Zone solely because the inventory is in transit from a vendor outside the zone to a business facility in the zone or from a business facility in the zone to a customer outside the zone.
- Intangible Property. Companies that operate principally with intellectual property can qualify as a Qualified Opportunity Zone Business as long as a substantial portion of the business’s intangible property is used in the active trade or business in an Opportunity Zone. The Proposed Regulations defined “substantial” to mean 40%. What the regulations did not do was to define “the active conduct of business” which will likely require tech companies to rely on the definition of “active conduct of business” set out in IRC Section 162. A number of questions remain as to what constitutes use; how is the 40% substantial portion test calculated; and how does a business determine that the intellectual property is used in an Opportunity Zone.
The success of the Opportunity Zones will depend, in large part, on the investment in operating businesses by private capital. Private equity investing in operating and early-stage businesses is critical to job creation, economic growth, and the opportunities that come with growth. The Proposed Regulations removes several of the barriers keeping private equity on the sidelines, but more guidance is needed in order to make private capital a major investor in qualified Opportunity Zone businesses. One area which requires immediate attention is the administrative obligations imposed on operating businesses. The time, effort, and expense required to satisfy the numerous Opportunity Zone tests will take valuable time away from addressing the challenges facing such businesses and may hinder the flow of private capital to operating businesses in Opportunity Zones.