Opportunity Zone Magazine Opportunity Zone Magazine Volume 1, Issue 1 | Page 24

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OPPORTUNITY ZONE MAGAZINE | VOLUME 1
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ISSUE 1
opportunity is located in a QOZ (or alternatively, when companies
seeking capital realize they are located in a QOZ), the quest for
a compliant Opportunity Zone structure begins. However, it is
important to note that the actual physical location of a business
in a QOZ is merely a prerequisite, and not the deciding factor,
in accessing the Opportunity Zone regime. In order to better
examine the requirements, let’s start at the level of the QOF
investment and work down to the holding of the underlying
private equity investment, examining the considerations at each
level of the investment.
While setting up a QOF
may appear rather simple,
exit from a QOF poses
certain challenges.
FORMATION OF A QUALIFIED OPPORTUNITY FUND
In order for an investor to avail itself of the capital gains deferral
and access the other QOZ benefits under the code, such investor
must invest in a QOF within 180 days of realizing the relevant
capital gain. Under the code, the QOF requirements are rather
straight-forward: the entity may be a partnership or a corporation
for tax purposes, and there are no particular governance
requirements applicable to the entity, other than that it file an
election to be treated as a QOF on Form 8996. As a result, the
subscription process for the fund is a relatively standard one,
and once the entity has filed its election, it may accept investors
which are seeking a deferral of their capital gains. Generally, the
investor’s timing considerations will require funds to use a capital
contribution subscription mechanism rather than the commitment
and drawdown mechanics more typical of private equity funds.
While setting up a QOF may appear rather simple, exit from
a QOF poses certain challenges. In particular, investment
funds are generally set up as pass-through entities, and as a
result, the sale of the underlying QOF property (when the
QOF is ready to exit) will result in taxable income being
passed through to the QOF partners (which income defeats
the purpose of having a tax-preferred structure to begin with).
That is, the investment involves two levels: the investors’
qualifying investment would be the partnership interests in
the fund, and the fund’s qualifying investment would be the
investment in the relevant private equity business. However,
if the QOF sells its stake in the business, it will realize income
which passes through to the investors, before the investors
have had a chance to liquidate their interests and take advantage
of the step-up in basis. In order to take advantage of the 10-
year exclusion of gain, managers of QOFs may be compelled to
conduct such a sale of the underlying property by selling the QOF
interests to the relevant buyer, so that the buyer indirectly acquires
the private equity assets through acquisition of the QOF interests.
For a fund which pursues multiple investments, this would require
a multi-class structure, with different classes corresponding to
different investments. This complexity is a key reason why QOFs
to date have generally focused on single-asset deals.
The foregoing, of course, is subject to potential change, in
the event the Treasury were to provide additional flexibility
for QOFs to liquidate investments without nullifying the tax
benefits provided under the code. Notably, in a recently letter to
the Treasury, the still-seated original Congressional sponsors of
the Opportunity Zones legislation have called for the Treasury
to provide exactly such a clarification, declaring, “Such fund-
level activity should in no way disallow the tax benefit to
the Opportunity Fund's investors, provided they do not take
distributions from the fund or sell their fund interest prior to
meeting the 10-year holding period.” No such clarification has to
date been provided.
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PRIVATE EQUITY INVESTMENT IN A QOZ BUSINESS
Beyond the structural considerations of a fund, a QOF must
also meet an eligible assets test which requires that it invest at
least 90 percent of its assets in one of three types of holdings:
stock in a QOZ Business, interests in a qualified opportunity
zone partnership or directly-held QOZ business property.
Such private investments in a company (whether structured
as a partnership or a corporation) involve both transactional
and qualitative company-level requirements.
TRANSACTION REQUIREMENTS FOR QOZ BUSINESSES
The transactional requirements applicable to investment in a
QOZ Business include that: the acquisition of QOZ Business stock
or QOZ Partnership interests must occur in cash transactions after
Dec. 31, 2017; and the issuer of the stock or interests must qualify
as a QOZ Business on the date of issuance and for substantially
all of the holding period thereafter. The latter requirement that
the business qualify “on the date of issuance” poses a commonly
overlooked challenge to investments in Opportunity Zones.
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