Recently, substantial attention has been paid to how the Opportunity Zone (“OZ”) program applies to direct investments in real estate assets, with many early adopters hustling to use the program to make such brick-and-mortar investments. But a common question I’m receiving is how the program applies to investments in operating businesses, and venture-stage companies in particular. There’s been considerably less activity in that space, and for good reason: it’s an odd fit.
The Opportunity Zone program offers three tax incentives to investors with unrealized capital gains: (1) tax deferral until the earlier of sale of the investment or December 31, 2026 (deferral); (2) a step-up in basis for the original investment of 10% if held for at least 5 years, or of 15% if held for at least 7 years (reduction); and (3) if the investment is held for 10 years, the elimination of taxation on capital gains accrued during the holding period (elimination). To reap these benefits, among other requirements, a taxpayer must invest through an entity that collects capital (an “Opportunity Fund”) to deploy in assets or entities with a nexus to designated “Opportunity Zones,” certain census tracts in economically distressed areas. Read our previous articles here and here for more on these tax benefits.
The primary requirement for Opportunity Funds is that at least 90% of their assets (tested semiannually) must be invested in qualified opportunity zone property (“QOZ Property”), of which there are three types:
- Qualified opportunity zone stock (“QOZ Stock”);
- Qualified opportunity zone partnership interests (“QOZ Partnership Interests”); and
- Qualified opportunity zone business property (“QOZ Business Property”).
QOZ Stock is stock in a U.S. corporation if the Opportunity Fund acquired the stock from the corporation, in exchange for cash, as an original issuance after December 31, 2017; and the corporation was (or was being organized to be) a qualified opportunity zone business (“QOZ Business”) both at the time of such issuance and for substantially all of the holding period.
Similarly, a QOZ Partnership Interest is any interest in a U.S. partnership if the fund acquired the interest, in exchange for cash, from the partnership after December 31, 2017; and the partnership was (or was being organized to be) a QOZ Business both when the interest was acquired and for substantially all of the holding period.
QOZ Business Property is tangible property used in a trade or business if the fund purchased the property in the OZ after December 31, 2017; the original use of the property started with the fund, or the fund substantially improved the property; and during substantially all of the fund’s holding period, substantially all of the use of such property was in an OZ.
A critical component of the QOZ Stock and QOZ Partnership Interest tests is that the entity receiving the Opportunity Fund investment must be a QOZ Business, which is a trade or business that satisfies all of these additional tests:
- Asset Test: At least 70% of its owned or leased tangible property is QOZ Business Property
- Income Test: At least 50% of its total gross income is derived from the active conduct of business in the OZ. Treasury regulations issued on April 17, 2019 propose a few approaches to the 50% gross income test:
- At least 50% of the services of the company’s employees and contractors (measured by hours or dollars spent) are performed in the OZ; or
- The business’s tangible property is in the OZ and management or operational functions performed for the business in the OZ are necessary to generate 50% of the gross income
- Intangible Property Test: At least 40% of its intangible property is used in the active conduct of business in the OZ
- Financial Property Test: Less than 5% of its property can be attributable to nonqualified financial property (this essentially precludes holding stock, partnership interests and certain debt instruments, although there is a safe harbor for “reasonable amounts of working capital”)
- Prohibited Activity: It is not a “sin business,” which includes golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks, gambling facilities and liquor stores
Application to Venture-Stage Companies
Due to the number and complexity of the QOZ Business tests, the universe of opportunities that are suitable for the program is pretty narrow – and traditional venture capital fund investments don’t appear to be a good match. Because VCs seek to generate returns within three to seven years, their timeline isn’t aligned with that of OZ-eligible taxpayers, who have incentive to hold investments for up to 10 years. That said, it’s worth noting that the April 17, 2019 proposed regulations would allow proceeds from the sale or disposition of QOZ Property (such as upon an exit for a VC-backed company, for example) to be reinvested within a 12-month period following such disposition; therefore, proceeds from an exit theoretically could be “recycled” into another qualifying investment to satisfy the 10-year holding period requirement. While conceivable, this redeployment represents a permutation of the traditional VC model.
Venture capitalists also typically aim for returns of at least 10x on their investments, which may not be feasible with businesses that can’t achieve national or global scale. A big challenge under the QOZ Business rules is to ensure that the portfolio company’s gross income is at least 50% derived from commerce within the OZ, and there’s a tension between this geographical “anchor” and scalability. The 70% tangible property test also could be challenging to satisfy, for the same reason, depending on the industry.
Finally, the administrative burden of satisfying the asset, income, intangible property and financial property tests will necessarily fall on the portfolio companies, which, being start-ups, may not have the bandwidth or appetite to be subject to the limitations and careful recordkeeping requirements of those tests. And such monitoring and recordkeeping certainly would be a distraction from the important work of the company’s founders and early employees to shape and grow the company.
Ultimately, for the reasons stated above, in the absence of a shift in the prevailing VC model, it seems unlikely that venture capitalists will seek to launch funds utilizing the OZ program. It is imperative that any taxpayer looking to apply the OZ program rules to an investment opportunity engage an adviser that is knowledgeable about the rules and their application.
If you need guidance with applying the OZ program rules to your project or business, please contact Cary Zimmerman at firstname.lastname@example.org or 216.736.7275, or reach out to any of our Corporate, Private Equity or Economic Development professionals.
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