Since taking effect in January 2018, Subchapter Z of the U.S. tax code, also known as the Opportunity Zone provisions, has allowed investors to pour billions of dollars into a wide range of businesses , from real estate development companies to tech startups. Investments in Qualified Opportunity Funds (QOF) offer a number of distinct tax advantages, not the least of which is reduced capital gains tax. But the rules governing these investments are bizarre, confusing and, in some cases, extremely restrictive.
In this eighth in our series of articles on Qualified Opportunity Funds (QOF), we discuss the working capital safe harbor (WC safe harbor) that applies to businesses in the Qualified Opportunity Zone ( QOZB).
In our seventh article, we discussed the Non-Qualified Financial Property (NQFP) limitation and the general exception to the NQFP limitation for reasonable amounts of working capital held in cash, cash equivalents, and debt with a maturity of 18 months or less (short term). term debt). Areas of interest for this article are the more technical aspects of the WC safe harbor rules for taxpayers who wish to avoid the uncertainties of the general working capital rule.
As we mentioned in the previous article, a QOZB must limit the part of its property that is NQFP to less than 5%, measured on an unadjusted overall average basis:
A taxpayer may exclude working capital assets from the numerator, however, neither subchapter Z nor the Treasury regulations thereunder give explicit guidance as to what characterizes an asset as working capital. and whether the amount of those assets is reasonable, in general. Although we have made analogies with other areas of tax law (for exampletax on accrued profits under section 541 and following.), in our experience, the overwhelming majority, if not all, of QOZBs choose to qualify their working capital assets in accordance with the narrower, but more certain WC safe harbor, if at all possible.
Main effect: exclusion from the NQFP
If QOZB meets the WC Safe Harbor technical requirements with respect to a particular amount of cash, cash equivalents and/or short-term debt held by QOZB, such amounts will automatically be treated as reasonable amounts. working capital. This last point is key, as it is what allows the QOZB to exclude such assets from its NQFP.
The technical requirements
Primarily, there are three WC safe harbor technical requirements: the first two relate to when the putative working capital assets are acquired, or shortly thereafter, and the third applies on an ongoing basis until until these assets are spent.
First, the QOZB must prepare a written plan for the use of working capital assets in trade or business within the QOZ. Second, in addition to or as part of the written plan, the QOZB should prepare a written schedule for the expenditure of working capital assets, which schedule should normally cover no more than 31 months after receipt of the working capital assets and must be compatible with the ordinary start-up of a trade or business. Third, the QOZB must actually use and spend the revolving fund assets according to the written schedule.
Upon subsequent injection of working capital assets, a QOZB may qualify this second amount (or later) under the WC Security Plan. All of the same technical requirements apply to this amount, including the need for a written plan and schedule and use substantially in accordance with it. In addition, however, the subsequent injection of working capital assets must have been considered in the initial working capital plan, and the written schedule for the use of the new amounts must provide for the use of working capital assets. turnover over a period of 62 months. from the initial date of the first working capital plan.
Care and forethought should be exercised in preparing the written plan and schedule, as Treasury regulations generally do not allow a QOZB to alter, revoke or otherwise alter the written plan or schedule once in place. in place. It’s a place where proper guidance and skillful writing can preserve future flexibility (and project value).
A narrow, but seemingly prescient, exception in the proposed regulations is that a QOZB would be permitted to modify or rescind its written plan in the event that the QOZ in which it operates is in a federally declared disaster area. In this case, the QOZB would have up to 120 days after the expiry of the declaration to modify its written plan. Under current regulations, such a QOZB is granted an additional 24 months to utilize its working capital assets subject to the written plan and schedule. Apart from this, the QOZB is bound by its own written plan and must adhere to its schedule, at least until the specificity of its plan and the standard of use of working capital assets substantially conforms to the written plan and schedule. .
The trade-off a QOZB must make for WC safe harbor certainty is that each time the QOZB receives working capital assets, it must prepare a new written plan and schedule for each infusion separately. Otherwise, with regard to this infusion, the general rules, not yet written, apply. In the event of a large cash contribution during formation or loan proceeds that the QOZB receives for a major expansion, this may not be troublesome, but for more common cash inflows in the normal course of business, such as inventory sales, this requirement virtually prohibits the use of the WC Safe Harbor with respect to day-to-day QOZB transactions.
Side effects: Facilitate qualification for QOZB start-ups
In addition to allowing a QOZB to exclude working capital assets from the definition of the NQFP, the WC safe harbor goes further and makes it easier for a QOZB engaged in starting a business to meet the general requirements. to qualify as a QOZB.
While a QOZB is engaged in starting a business and has working capital assets that satisfy the WC safe harbor, that QOZB is automatically treated as satisfying the tangible ownership test during the period(s) of 31 months working capital (plus any extensions). In addition, any tangible property acquired, leased or improved with these working capital assets that should be QOZB property as a result of expenditures under the written plan will be treated as such for the purposes of the tangible property test during of any 31 month period. working capital period(s). Similarly, intangible assets acquired with such working capital assets are treated as used in the trade or business of QOZB, and any income generated by such tangible or intangible assets is considered favorably in the requirement that at least 50% of QOZB gross revenue is generated in a QOZ. However, no working capital asset itself is treated as real tangible property, intangible property or QOZB property for any purpose.