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New proposed Opportunity Zones rules, RFI released by IRS

April 18, 2019
By: Jason Rittenberg

The IRS released its long-anticipated second tranche of rules on Wednesday, and the regulations provide some clarity around using Opportunity Zones to invest in businesses. Specific examples include details on defining a business’ operations within a zone and funds’ ability to reinvest proceeds. However, further clarification is needed, including around investors’ treatment of interim sales, and additional changes are forthcoming. A partial summary of the 169 pages of new rules follows, and SSTI will provide additional updates as the full implications become clearer.

SSTI’s letter to the Treasury on the first set of rules emphasized three areas that required clarity, and the new rules take steps toward all three items.

1.    Safe harbor for initial investments by Qualified Opportunity Funds (QOFs)

QOFs are required to certify twice per year that at least 90 percent of their investments qualify for the benefits. However, while the certification timeline is set, the periods for receiving a new commitment from an investor was not. This could lead funds faced with a potential commitment close to a deadline choosing among rejecting the investment, closing a qualifying investment with undue haste, or failing the certification.

The new rules offer QOFs an opportunity to exclude commitments received within the last six months from their certification consideration — so long as those investments are held in cash, equivalents, or debt with terms under 18 months.

2.    Provision for Reinvestment by Qualified Opportunity Funds

QOFs investing in small businesses are particularly likely to experience churn in their investments as businesses expand beyond OZ eligibility or fail. Therefore, rules clarifying the tax and management impacts of interim gains (or losses) are critical to establishing a QOF for business investment. The new rules provide complicated guidance around reinvestment that require further deliberation and will almost certainly be revised in further guidance.

For the QOFs, the IRS offers a 12-month safe harbor, similar to the initial safe harbor, that will allow qualifying reinvestments to occur so long as the proceeds are held as cash, equivalents, or debt with terms under 18 months. This rule clearly assists a QOF in meeting its certification requirements.

The impacts are less clear for investors. On one hand, the rules state that the tax benefits to investors are derived from their investment in the fund itself and that the fund’s selling of assets in the interim therefore do not necessarily threaten the investor’s ability to claim deferral or exclusion benefits from their investment in the fund. However, the IRS also states that interim sales with gains — even when reinvested — are taxable, and certain fund structures will be required to pass those taxable gains to the investors.

More concerning, the IRS requests input on “possible burdens imposed if [QOFs] are required to reset the holding period for reinvested gains.” The question suggests that the IRS is considering requiring that reinvestments will require extending the timeframes for receiving OZ tax benefits. This would seem to be at odds with the earlier clear language on investor benefits deriving from the investment in the fund. Further rules will clearly be necessary.

3.    50 Percent Gross Income Test

An unexpected rule in the first set of IRS guidance required qualifying businesses to derive 50 percent of their income from an OZ. In this guidance, the IRS has established three, reasonably clear and generous rules for meeting this requirement. Businesses must meet either any one section of a three-part test or convince the IRS through the overall facts of their case. The test follows:

  • “At least 50 percent of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the qualified OZ.
  • “At least 50 percent of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the qualified OZ, based on amounts paid for the services performed.
  • “The tangible property of the business that is in a qualified OZ and the management or operational functions performed for the business in the qualified OZ are each necessary to generate 50 percent of the gross income of the trade or business.”

Additional Provisions

Several other portions of the guidance already stand out:

  • The working capital safe harbor provision, which gives companies 31 months to keep their investments as working capital before making improvements, has been expanded to include business development costs.
  • The IRS plans to adjust the form used to report qualifying investments and may include details about the business receiving the investment. There will be a separate RFI for feedback on reporting.
  • New rules clarify how funds that mix qualifying and non-qualifying will need to treat gains. These rules also state that carried interest will count as non-qualifying investments for all funds.

For additional rules, particularly the many additions for real estate investment, Novogradac & Co. has published the first of a two-part summary.

Next Steps

Once published in the Federal Register, the IRS will hold a 60-day comment period on these rules. A follow up hearing will be held in early July. An additional set of guidelines should be expected, at least to address areas that the guidance described as still uncertain.

SSTI will be submitting a letter to the IRS in response to this guidance. Members interested in participating in the letter-drafting process should contact Jason Rittenberg (rittenberg@ssti.org | 614.901.1690).

opportunity zones