By Mark Riedy, Partner and Head of Energy Team and Eddie Wang, Senior Associate, both from Kilpatrick Townsend & Stockton LLP
Special to The Digest
The recently-established Opportunity Zone Program offers developers, including start-up technology companies attempting to develop and commercialize new technologies in the energy, chemical, and infrastructure industries, an exciting, new opportunity to attract private placement investment funds into company-level business operations and project company-level equity, including working capital, for the construction of projects located in such Opportunity Zones.
It thus offers bioeconomy companies a new source of equity capital from which to secure the hardest-to-find initial funding to jump start business operations and projects. This new class of specialized equity investors otherwise may never have considered an investment of any kind into the bioeconomy, except that they may shelter and ultimately forego federal capital gains taxes on their recently acquired long term profits resulting from exiting other ventures.
The Tax Cuts and Jobs Act of 2017 (the “Act”) contained a tax incentive program (the “Opportunity Zone Program”) to encourage long-term equity investments into qualified low-income communities identified as “opportunity zones”. Such equity investments may be made into holding companies as private placements and/or project level companies as project equity and working capital if such companies are located in such zones. The Opportunity Zone Program provides preferential tax treatment for capital gains that are re-invested in qualified opportunity funds (discussed below).
The Department of Treasury and the Internal Revenue Service (“Treasury”), after comment and review periods, issued two sets of proposed regulations and guidance for the Opportunity Zone Program. We expect Treasury to issue another set of rules after a July 9, 2019 hearing to further clarify outstanding issues.
Any taxpayer that recognizes capital gains for federal income tax purposes is eligible under the Opportunity Zone Program. Capital gains that would otherwise be recognized for Federal income tax purposes before January 1, 2017 are generally eligible for deferral under the Opportunity Zone Program.
Qualified Opportunity Funds
A qualified opportunity fund (QOF) is any domestic corporation or partnership organized for the purpose of investing in qualified opportunity zone property (QOZ Property) that holds at least 90% of its assets in QOZ Property, calculated by averaging the percentage of QOZ Property held by the QOF every six months including the end of its taxable year.
Qualified Opportunity Zone Property
QOZ Property includes:
- QOZ Stock – stock held in a domestic corporation acquired by a QOF after December 31, 2017 at such stock’s initial issue solely in exchange for cash. The corporation must be a qualified opportunity zone business (QOZ Business) when the stock was issued and for substantially all of the QOF’s holding period.
- QOZ Partnership Interest – capital or profits interest in a domestic partnership that is acquired by a QOF after December 31, 2017 from the partnership solely in exchange for cash. The partnership must be a QOZ Business when the interest was acquired and for substantially all of the QOF’s holding period.
- QOZ Business Property – tangible property used in a trade or business of the QOF acquired by the QOF after December 31, 2017. During substantially all of the QOF’s holding period, substantially all of the use of such property must be in a QOZ. The original use of such tangible property in the QOZ must commence with the QOF or the QOF must substantially improve the property.
- Tangible property is substantially improved if within 30 months from the date of the acquisition, additions to basis to such property by the QOF exceed the adjusted basis of such property at the time of acquisition.
A QOZ Business is a trade or business:
- In which over 70% of the tangible property owned or leased by the taxpayer is QOZ Business Property, determined by substituting “QOZ Business” for “QOF” in the definition of “QOZ Business Property”;
- At least 50% of the gross income of such trade or business is derived from the active conduct of such trade or business in a QOZ;
- A substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business in a QOZ; and
- Less than 5% of the average of the aggregate unadjusted bases of the property of such trade or business is attributable to nonqualified financial property.
Preferential Tax Treatment
Capital gains that are properly invested pursuant to the Opportunity Zone Program are deferred from recognition and not included in income until the earlier of their disposal or December 31, 2026. The amount of gain to be included on such date is equal to the fair market value of the interest in the QOF attributable to the deferral of eligible gains, less the taxpayer’s adjusted basis in the qualifying QOF investment, up to a maximum of the total amount of gain deferred and invest in the QOF.
The taxpayer’s initial basis is zero. If the investment is held for at least 5 years, the basis is increased by 10% of the gain deferred. If the investment is held for at least 7 years, the basis is increased an additional 5% to 15%. Finally, if the investment is held for at least 10 years, the taxpayer may elect to increase the basis of his investment to its fair market value on the date such investment is sold or exchanged. Because QOZ Property must be acquired after December 31, 2017, this 10-year holding period necessarily must extend past December 31, 2026. Therefore, the step up in basis after 10 years will exclude from income only post-investment gains.
For example, if a taxpayer invests $100 of qualified capital gains into QOF in 2019, the taxpayer will be eligible for a 15% or $15 basis step-up in seven years. On December 31, 2026, the taxpayer will recognize $100 – $15 = $85 of capital gains (generally taxed at 20%) and increase his basis to $100. If the $100 investment appreciates to $2,000, and the taxpayer holds the investment for the full 10 years (i.e., 2029), then his basis is stepped up to $2,000 and the $1,900 gain is entirely tax exempt upon disposal.
As of April 1, 2019, 88 QOFs containing more than $26 billion have been established, with nearly $7 trillion of eligible capital gains still available. Funds that otherwise would not seek out bioeconomy investments may do so to take advantage of the preferential tax treatment.
For additional information on this significant funding opportunity, please contact the authors Mark J. Riedy (202-508-5823) and Eddie Wang (202-508-5813) at Kilpatrick Townsend & Stockton LLP.