What does it take to be a Qualified Opportunity Zone Business for an Arizona Opportunity Zone Fund investment?
In December 2017, Congress amended the Federal tax code by passing legislation commonly referred to as the “Tax Cuts and Jobs Act of 2017.” Under the TCJA of 2017, a program was created to incentivize investment into certain economically-distressed areas in the United States by providing preferential tax treatment to those that invested certain capital into these economically-distressed areas named “Opportunity Zones. The AZ-OZ Fund encourages developers and investors to utilize the new Opportunity Zones page on the Arizona Commerce Authority to discover local communities with great development potential.
Opportunity Zones have garnered attention because of the tax incentive benefits for investments in real estate; however, our program creates opportunities for investment in businesses that operate in Opportunity Zones as well. In April of 2019, the Treasury Department released guidance to aid investors in selecting Opportunity Zone businesses that qualify for investment.
As small businesses often struggle to access capital from traditional venture capital and private equity sources due to the business’ scale and growth trajectory, it is important for business owners to take advantage of funding whenever possible. Below, we summarize the IRS guidance issued to help you determine if your business might qualify as an Opportunity Zone Business.
What does it take to be a Qualified Opportunity Zone Business for Opportunity Zone Fund investment?
A Qualified Opportunity Zone Business (“QOZ-Bus.”) must be a partnership or corporation (no sole-props.) for federal income tax purposes located in a qualified Opportunity Zone (“QOZ”).
Here’s the additional detail you need on each test:
- The “70 Percent Test”
Exactly 70% or more of the tangible property owned or leased by the business must be Qualified Opportunity Zone Business Property (“QOZBP”), located in a QOZ. QOZBP is tangible property acquired by a QOZB after December 31, 2017, and either the original use of such property needs to start with the Qualified Opportunity Fund investment or the Fund investment must substantially improve the property. If this is applied to a business that is seeking investment from a Qualified Opportunity Fund, a business owner may want to consider what property would be purchased with a potential Fund investment or what aspect of its existing business property (machinery and equipment, for example) can be improved with funds from a Qualified Opportunity Fund investment.
- The “50 Percent Test”
At least 50% of the gross income of the business must be derived from the active conduct of a QOZB within a QOZ. The New Proposed Regulations provide three methods that can be used to determine whether this 50% requirement has been met:
- Hours-of-work: a minimum of 50% of the total hours of services performed by the business (i.e. by employees, independent contractors) are performed in the Opportunity Zone
- Cost-of-services: a minimum of 50% of the total cost of the business’ services (i.e. to employees, independent contractors) paid for by the business was paid for work in the Opportunity Zone
- Business functions and tangible property: Both the business’ management and operational functions, and tangible property, both located within the Opportunity Zone, are independently necessary to derive at least 50% of the business’ gross income
III. The 5% Test
No more than 5% of the average of the aggregate unadjusted basis of the business’ property must be attributable to nonqualified financial property (i.e. financial assets). Unadjusted basis refers to the original cost to purchase an asset. A reasonable amount of working capital held in cash or cash equivalents with a term of less than 18 months is not treated as financial assets or nonqualified financial property. To better understand how your business meets this test, it is highly recommended that you consult a tax lawyer or accountant because of the highly technical nature of this analysis. It may be most beneficial for a business owner to know that this criteria exists and to establish a high-level understanding of such criteria.
An amount of working capital is considered reasonable if:
- the amount is designated in writing for the development of a trade or business in a QOZ
- there is a written schedule for the use of the funds within 31 months of the receipt of the working capital
- the working capital is used in a manner substantially consistent with the written description and schedule. Delays caused by slow government action (i.e. zoning approvals) will not violate these. A business can use this reasonable working capital provision more than once such that subsequent funding may also rely on the safe harbor, provided that these requirements are met.
- The 40% test
A substantial portion of the business’ intangible property (at least 40%) must be used in the active conduct of a qualified business in a QOZ. It is possible for the use of intangible property in contiguous property that is not in an Opportunity Zone to count toward this test. The ownership, operation, and leasing of real property can be the “active conduct” of a business if the activity is not merely entering into a triple net lease.
- Not a disqualified business
Your business may not be engaged in a “sin” business (i.e. liquor store, race track, etc.)
As the IRS releases guidance to interpret the requirements of the Opportunity Zone program, business owners should understand the opportunity it may present for their businesses. Access to capital is a fundamental issue for growing small businesses and the Opportunity Zone Program may provide a new capital resource for QOZBs. PIDC recognizes that accessing Opportunity Zones equity investment can be very challenging for small businesses. If you are a business-owner looking for capital to grow your business, we have a variety of business lending products to assist that may be more suited to your needs. One particular resource is our Commercial Mortgage Loan which supports small businesses and nonprofits that need financing to purchase buildings that they either currently occupy or intend to relocate to.
Download a full PDF of How to be a QOZB infograph.
Discover other AZ-OZ Fund tools to help Arizona businesses gain access to capital.
** Special thanks to PIDC’s Tarik Brooks and Efraim Burle for contributing this article.
*** DISCLAIMER: This article has been prepared and published for informational purposes only and is not offered, nor should it be construed, as legal or accounting advice on any specific facts or circumstances. The contents of this article are intended for general informational purposes only and you are urged to consult Tax Accountant Professional or Tax Attorne concerning any particular question that you may have.