WHAT IS THE OPPORTUNITY ZONE?
The "Opportunity Zone Program" was introduced by the Congress in 2017 to stimulate investment in economically disadvantaged areas of the U.S. Geographically, opportunity zones refer to areas which are considered low-income communities for tax purposes. Across the U.S., state governors have designated over 8,700 areas as opportunity zones.
Although the program was meant to provide tax breaks to investors, there is significant potential for startups to capitalize on benefits that come from operating in an opportunity zone.
There are three distinct tax advantages of investing in a qualified opportunity zone:
- tax payments on any capital gains that are invested into a Qualified Fund can be deferred by the investors, either until December 31, 2026, or until they withdraw their investment - whichever event occurs earlier;
- as in incentive, the longer you hold your interest in a Qualified Fund for, the more tax you will be able to avoid. For example, investors who hold an interest for 5 years will be exempt 10% of the capital gains, whereas those investors who hold an interest for 7 years will be able to exempt an additional 5% of capital gains; and
- investors who hold their interest in a Qualified Fund for ten years or more will be able to completely avoid tax on the appreciation of their investment when they sell it.
It is important to note that these benefits are limited to capital gains alone. Interest purchased in the qualified fund from any source other than capital gains, or interest that accrues because of any services performed for the Qualified Fund, are not eligible.
What is a Qualified Fund?
Simply put, a Qualified Fund can be seen as a vehicle of investment which comes into existence as a partnership or corporation. The purpose of a Qualified Fund is to invest in a qualified opportunity zone property. A qualified fund needs to have 90% of its assets as qualified opportunity zone property. This can take the form of tangible property within a zone of opportunity or equitable interests in a company that is operating a qualified opportunity zone business (Qualified Business).
A Qualified Business is an active business which owns or leases 70% or more property in an opportunity zone. At least 40% of a company's intangible property must be utilized in actively conducting a business located in an opportunity zone. Out of the company's gross income, 50% must come from active business conducted within an opportunity zone.
Finally, certain business is excluded from this program and cannot be considered Qualified Businesses despite being in an opportunity zone.
Examples of such businesses include liquor stores, country clubs, golf courses, massage and spa related facilities, casinos, and racetracks.
Why become a Qualified Opportunity Zone Business?
The tax rules surrounding opportunity zones incentivize investment in Qualified Businesses as opposed to operating business in opportunity zones. Qualified Funds have only 6 months after they are formed to begin investment in a qualified property. Thus, many new funds that hope to qualify as Qualified Funds are on the lookout for Qualified Businesses to invest in. Founding members who own a Qualified Business are in a favorable position because their company is immediately made more attractive to investors.
Requirements of Becoming a Qualified Opportunity Zone Business
There are quite a few hoops that a business seeking to become a Qualified Business must jump through. Primarily, they must show that 50% of their gross income is derived from conducting business in an opportunity zone. At the time when the program was established, it was not clear how businesses could meet this requirement. Since then, the IRS has provided regulations containing three "safe harbor" tests. The requirements will therefore be met if:
- Greater than 50% of the service hours cumulatively worked by the company's employees or independent contractors occur in the qualified opportunity zone, or
- more than 50% of the compensation expenses are incurred within the qualified opportunity zone, or
- the Qualified Opportunity Zone Business situates both tangible property and management/ operations as necessary to meet the greater than 50% requirement.
A startup which has its headquarters in an opportunity zone can, in theory, satisfy the gross income test regardless of whether their gross income is generated inside or outside the opportunity zone. Likewise, a startup which has headquarters outside an opportunity zone could still meet the 50% requirement provided that its employees and contractors are situated inside the opportunity zone. The regulations cite the example of a tech startup that creates software which is sold globally. If most of the time spent by this startup's employees and developers is within the opportunity zone, they would still satisfy the 50% gross income test, notwithstanding the fact that most of their sales take place in regions distinctly outside the opportunity zone. A company's founders must therefore take the potential benefits of the Opportunity Zone Program into account before determining where to headquarter their company, or who to hire.
Apart from these requirements, there are several other issues which entrepreneurs need to consider, such as: (1) when and how to invest capital, (2) how to satisfy IRS tests with regards to valuation, (3) leasing, (4) third-party issues if the property is leased, and (5) tax reporting issues. With the right amount of planning and research, it is also possible to move an existing business into an opportunity zone.
Although the law surrounding opportunity zones is complex, the benefits are undeniable to both business owners and the underserved areas inwhich they operate. If you are considering starting a business in a qualified opportunity zone, be sure to contact The South Texas Business Lawyers so that we can assist you through the process.
Disclaimer: This article is made available for educational purposes only, to give you general information and a general understanding of the law, not to provide specific legal advice. By using this article, you understand and acknowledge that no attorney-client relationship is formed between you and The South Texas Business Lawyers, nor should any such relationship be implied. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
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