By Vadim D. Ronzhes Esq., CPA
Qualified opportunity zone (QOZ) legislation is one of the greatest and effective tax incentives implemented by the U.S. Congress. The program provides incredible opportunities for building wealth by encouraging investment in historically underutilized neighborhoods. The Internal Revenue Code and Regulations provide significant guidance for purchasing, constructing, and rehabilitating real estate. While developers have been successfully using the program, it has been largely ignored by operating businesses.
In summary, a QOZ provides an economic benefit to investors that would enable them to both defer and ultimately eliminate certain gains associated with selling a business investment. The project needs to be placed in service by June 30, 2027, and the hold period is 10 years. A properly structured QOZ investment could result in significant tax savings by eliminating tax on gains when the investment is sold.
The rules make it impossible for certain businesses, such as financial institutions and insurance companies who hold financial assets, to use the program by limiting the type and amount of assets a business can hold. While there may be compliance challenges, businesses can qualify for the benefits including brokers, consultants, manufacturers, retailers, and technology companies. The rigorous restrictions can be overcome through planning, monitoring, and periodic review.
An opportunity zone business is required to physically hold at least 70 percent of its tangible property (inventory; real estate; and fixtures, furniture and equipment) in an QOZ. Real estate development projects are a perfect fit for opportunity zone investments because the development, physical assets and operations all take place at one location. On the other hand, operating businesses may be required to operate outside a single location based on functionality and client demands. For example, a manufacturer that outgrows its facility, may be limited when identifying new locations. An equipment leasing business would have a difficult time satisfying the requirement because its equipment would be held at client locations in-and-out of opportunity zones.
A business may have multiple locations by entering into a lease for its primary operation facility in an opportunity zone. An overlooked fact is that for the purpose of the test, the discounted value of the lease payments is treated as tangible property for the purpose of the 70 percent tangible property test. A company can manage its exposure by signing smaller and shorter leases for locations maintained outside an opportunity zone. Moreover, the business can strategically use remote employees and outsourcing functions to an extent to limit the exposure.
A business is not limited to having operations in one opportunity zone. With 12 percent of the country qualifying as an opportunity zone, QOZ restrictions can be managed under most circumstances.
With 12 percent of the country qualifying as an opportunity zone, QOZ restrictions can be managed under most circumstances.
In addition to having physical assets inside the QOZ, a business must place in service new tangible property or substantially improve existing property. When purchasing used property, substantial improvement means the company must make an investment in tangible property at least equal in value to the cost of the used property.
For a new business, the requirement can easily be met assuming there is no real estate. The value of a lease and purchase of new furniture and equipment would immediately satisfy the requirement. Meaning, after the first dollar is spent on purchasing new equipment, substantial improvement has been achieved because the company did not purchase previously held property that required improvement.
An existing business can convert to one eligible for QOZ benefits with relative ease. When a company already owns expensive equipment, such as a manufacturing plant, more investment capital is typically required. For a technology or service company that needs little capital, substantial improvement can be satisfied with minimal investment. The company would have 30-months after receiving its initial investment to satisfy the test. The rules do not require a business to own or lease any physical property.
The COVID-19 pandemic reshaped the American workplace by increasing the teleworker community. The pandemic proved that remote workers’ productivity increased with amplified use of communication tools such as emailing, chat messaging, and video conferencing.
Multiple studies on the development reported that employees have incredibly positive teleworking experiences due to the flexibility it provides, especially when it comes to a healthy work life balance. Employees will continue to seek remote opportunities alongside technological advances aimed at enhancing remote productivity.
For an operating business that wants to qualify for QOZ benefits, remote work could become problematic. The program requires that a least 50 percent of the activity be conducted from a QOZ location. The rules identify four alternative methods to measure the business activity: work hours inside the opportunity zone over total work hours; total compensation paid to employees inside the opportunity zone over total compensation paid; the location where tangible assets are held and the management and operation functions are performed; and, the undefined and subjective, facts and circumstance test.
A company must implement strategies to ensure that over time the business continues to meet the QOZ activity requirement. One strategy is to require management level employees, who are generally the highest compensated, to work inside an opportunity zone location. A company can also utilize a flexible workspace office in other opportunity zones for out of state employees. If the physical location requirement is (or becomes) untenable, outsourcing via management and service agreements can become useful options.
After the operational strategy is implemented, a company must also develop monitoring mechanisms to ensure that the activity is taking place in a QOZ. There are various human resource managements tools available that can assist with tracking and monitoring each employee’s activity. As a company grows, its strategy and measurement selection can change year to year.
An operating QOZ business requires additional planning, oversight, and documentation. Speculating the future value of an operating business is more challenging. To provide flexibility for investors, the QOZ benefits can be coupled with other tax strategies, such as issuing qualified small business stock and using available tax credits. With proper planning, the additional compliance hurdles for operating a business in a QOZ are minimal considering the benefits for companies, investors, and the community.
Vadim D. Ronzhes Esq., CPA, is Tax Director at Rosen, Sapperstein & Friedlander, LLC, a leading Mid-Atlantic region full-service CPA firm that caters to middle-market businesses and ultra-high net worth families. Vadim can be reached at email@example.com.