Clarity for OZ Businesses in Second Tranche of Opportunity Zone Regulations

The second tranche of Opportunity Zone regulations (found here:
https://www.irs.gov/pub/irs-drop/reg-120186-18-nprm.pdf ) have been sent to the Office of the Federal Register (OFR) for publication. Although these proposed regulations are subject to slight changes, many questions have been answered. Most notably, these regulations have opened up the opportunities for investing in Qualified Opportunity Zone Business (QOZB) by lowering the barriers in how a business’ operations are assessed in order for the business to become a QOZB.

In previous regulations, a QOZB must have derived at least 50% of their gross income from the active conduct of a trade or businesses within the Opportunity Zone. This requirement single handedly sidelined the majority of business investments because it was interpreted that this test is tied to where the customer is located as opposed to the headquarters of the business. This would have nearly made it impossible for an Opportunity Fund to invest in a tech company or manufacturing company, or any company that the majority of their sales are derived from outside of Opportunity Zones. Below is a direct excerpt from the second tranche of regulations:

“The proposed regulations provide three safe harbors and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a qualified opportunity zone for purposes of the 50-percent test in section 1397C(b)(2). Businesses only need to meet one of these safe harbors to satisfy that test. The first safe harbor in the proposed regulations requires that 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 opportunity zone. This test is intended to address businesses located in a qualified opportunity zone that primarily provide services. The percentage is based on a fraction, the numerator of which is the total number of hours spent by employees and independent contractors (and employees of independent contractors) performing services in a qualified opportunity zone during the taxable year, and the denominator of which is the total number of hours spent by employees and independent contractors (and employees of independent contractors) in performing services during the taxable year.

For example, consider a startup business that develops software applications for global sale in a campus located in a qualified opportunity zone. Because the business’ global consumer base purchases such applications through internet download, the business’ employees and independent contractors are able to devote the majority of their total number of hours to developing such applications on the business’ qualified opportunity zone campus. As a result, this startup business would satisfy the first safe harbor, even though the business makes the vast majority of its sales to consumers located outside of the qualified opportunity zone in which its campus is located.

The second safe harbor is based upon amounts paid by the trade or business for services performed in the qualified opportunity zone by employees and independent contractors (and employees of independent contractors). Under this test, if 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 opportunity zone, based on amounts paid for the services performed, the business meets the 50-percent gross income test found in section 1397C(b)(2). This test is determined by a fraction, the numerator of which is the total amount paid by the entity for employee and independent contractor (and employees of independent contractors) services performed in a qualified opportunity zone during the taxable year, and the denominator of which is the total amount paid by the entity for employee and independent contractor (and employees of independent contractors) services performed during the taxable year.

For illustration, assume that the startup business described above also utilizes a service center located outside of the qualified opportunity zone and that more employees and independent contractor working hours are performed at the service center than the hours worked at the business’ opportunity zone campus. While the majority of the total hours spent by employees and independent contractors of the startup business occur at the service center, the business pays 50 percent of its total compensation for software development services performed by employees and independent contractors on the business’ opportunity zone campus. As a result, the startup business satisfies the second safe harbor.

The third safe harbor is a conjunctive test concerning tangible property and management or operational functions performed in a qualified opportunity zone, permitting a trade or business to use the totality of its situation to meet the requirements of sections 1400Z-2(d)(3)(A)(i) and 1397C(b)(2). The proposed regulations provide that a trade or business may satisfy the 50-percent gross income requirement if (1) the tangible property of the business that is in a qualified opportunity zone and (2) the management or operational functions performed for the business in the qualified opportunity zone are each necessary to generate 50 percent of the gross income of the trade or business. Thus, for example, if a landscaper’s headquarters are in a qualified opportunity zone, its officers and employees manage the daily operations of the business (occurring within and outside the qualified opportunity zone) from its headquarters, and all of its equipment and supplies are stored within the headquarters facilities or elsewhere in the qualified opportunity zone, then the management activity and the storage of equipment and supplies in the qualified opportunity zone are each necessary to generate 50 percent of the gross income of the trade or business. Conversely, the proposed regulations provide that if a trade or business only has a PO Box or other delivery address located in the qualified opportunity zone, the presence of the PO Box or other delivery address does not constitute a factor necessary to generate gross income by such business.

Finally, taxpayers not meeting any of the other safe harbor tests may meet the 50-percent requirement based on a facts and circumstances test if, based on all the facts and circumstances, at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in the qualified opportunity zone.”

Real estate investments have been dominating Opportunity Zone conversations, but we now have the clarity we need to open up the floodgates for business investments. This will be a key tool for economic development professionals in recruiting new business and industry to their Opportunity Zone(s).

Written by Kyle Wiese – Founder & Managing Member of OZI™

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