In private letter ruling (PLR) 202249005, Dec. 9, 2022, the Internal Revenue Service (IRS) held that gain from the sale of one of two parcels of land by a qualified opportunity zone business (qualified OZ business) during the startup working capital safe harbor period is good income for purposes of the qualified OZ business’ 50% gross income test.

In the ruling, the IRS conditioned this conclusion on the qualified OZ business amending its working capital plan (in accordance with the proposed regulations that permit such changes within 120 days after the end of the COVID-19 pandemic) and that the amended working capital plan requires the sale proceeds (net of tax distributions) to be used in the qualified OZ business’ remaining development project within the originally allowed  31-month period (as extended by up to 24 months due to COVID). In reaching this conclusion, the IRS relied on the qualified OZ business’ representation that the COVID-19 pandemic significantly impacted and delayed the project.

This article provides a general overview of the ruling, commends the IRS for issuing this important guidance, and points to two ambiguities resulting from the legal analysis in the ruling.

Facts of the Ruling

The ruling describes two separate qualified OZ businesses that were created to develop and construct a new retail and multifamily housing unit. Each qualified OZ business acquired a separate parcel of land for the project. Each qualified OZ business also adopted and maintained working capital plans and expenditures were expended in a manner substantially consistent with such working capital plans and written schedules. After a period of time, the two qualified OZ businesses merged under state law forming the taxpayer, a qualified OZ business. Subsequent to the merger, the qualified OZ business received an unsolicited offer to purchase one of the parcels and subsequently sold it to an unrelated third party in a taxable transaction at a gain. The sale occurred before the completion of the project and when the qualified OZ business was still in its construction phase. In this ruling, the taxpayer represented that it intends to amend the working capital plan of the qualified OZ business (which consisted of the working capital plans of both predecessor qualified OZ businesses) based on the proposed regulations permitting such amendment within 120 days after the end of the disaster declaration. The taxpayer further represented that the COVID-19 pandemic has significantly impacted and delayed the project, and that it intends to use the sale proceeds in the retained project (net of tax distributions) and also reduce the scope of the project to reflect the sold parcel.

The taxpayer requested a ruling that the gross income from the sale is “gross income derived from the active conduct of a trade or business in a qualified opportunity zone business” for purposes of satisfying the 50% gross income requirements, provided that the taxpayer uses the cash proceeds from the sale in a manner such that the completion of spending takes into account the originally allowed up to 31-month period (plus any COVID-related extension) and provided that the taxpayer revise its working capital plan within 120 days of the end of the COVID-19 pandemic, in reliance of the proposed regulations. The IRS granted the requested ruling.

Helpful Guidance

The ruling clarifies an important ambiguity qualified OZ businesses have been faced with when selling some of their real property during the construction stage before the qualified OZ business placed its assets in service. The question is whether gain from such sales, which may be the only gain the business has that year, qualifies as “gross income derived from the active conduct” of trade or business as required under Internal Revenue Code (IRC) Sections 1400Z-2(d)(3)(A)(ii) and 1397(C)(b)(2). The IRS ruled in the affirmative provided the sold parcel was purchased with capital that was treated as working capital and purchased pursuant to the working capital plan and written schedules of the predecessor of the qualified OZ business.

In its analysis, the ruling refers to the safe harbor under Treasury Regulations (Treas. Reg.) Section 1.1400Z2(d)-1(d)(3)(vi)(B), which provides that “if any gross income is derived from property that [the working capital safe harbor] treats as a reasonable amount of working capital, then that gross income is counted toward satisfaction of the 50-percent test” (in other words, it is treated as derived from the active conduct of a trade or business). The original intent of this safe harbor was to treat interest income on the working capital assets as income from a trade or business, permitting a qualified OZ business to satisfy the trade or business requirements and meet the 50% gross income test during the construction stage. The IRS in the ruling expanded this rule by concluding that because the sold parcel of land was purchased with capital that was subject to the working capital safe harbor plan, such capital was the “origin of the gross income” (presumably meeting the “derived from” requirement in the regulation) and that “the proceeds from the sale of such parcel may also be treated as working capital assets solely for purposes of satisfying the 50% [gross income] test.” This is very helpful, and much-needed, guidance.

First Ambiguity: Does Sale Reset 31-Month Period?

The IRS, however, appears to have taken its origin/tracing theory one step further in treating the sale proceeds as a successor to the original capital and conditioning the ruling on the use of such sale proceeds within the original 31-month safe harbor period (as extended by COVID-19 by another 24 months). In other words, if the sale took place in Month 20, the business would have had only 11 months to use that cash (assuming no COVID-19 extension). It is unclear whether this is the way the IRS interprets current law or whether it simply ruled this way because the taxpayer so represented its intent and there was no reason to deal with this issue. Certain language in the ruling may indicate the latter, but other language indicates the former. If this is the way the IRS interprets current law, then this restriction imposes a significant burden for a qualified OZ business that unexpectedly needs to downsize and sell assets due to unforeseen circumstances, especially once the 24-month COVID-19 extension is no longer available. Wouldn’t the policies behind the OZ rules have been better served if the sale reset the 31-month clock, thereby starting a new 31-month period? The authors believe that this would not have offended the core analysis in the ruling, as the gain from the sale of the parcel would have still been “originated,” or “derived from” the original working capital assets. Additionally, any concerns that such a ruling could be abused by taxpayers using assets to temporarily park cash so that they can start a fresh 31-month period at a later time can be mitigated by the OZ anti-abuse rules, the transaction costs associated with buying and selling property, and by allowing the 31-month period to reset only if the sale was unforeseen at the time the property was acquired as were the facts of the ruling. Moreover, the ruling may sometimes lead to nonsensical results, for example, if the same parcel was sold after the end of the 31-month period for cash proceeds, would that mean that the original working capital, now represented by the cash proceeds, retroactively did not satisfy the 31-month use requirement? We don’t believe that was the intent of the regulations.

As mentioned above, it may be the case that the IRS simply did not need to deal with this issue in the ruling because the taxpayer agreed to use the cash proceeds from the sale within the original 31-month period (as extended by the 24-month COVID-19 relief). The ruling may therefore be read as being silent with respect to situations where the cash cannot be used within the original 31-month period.

Second Ambiguity: Are the Working Capital Safe Harbors Restricted to Startup Businesses?

Absent any special rule, before the property being placed in service, it is unclear whether a building being constructed and not yet placed in service is treated as qualified OZ business property for purposes of the 70% asset test, as it is not yet “used in a trade or business” as required under IRC Section 1400Z-2(d)(2)(D)(i). For most developments, Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(D)(1) and (2) provide for a solution in the form of turning off the 70% asset test for 62-months for startup businesses and for treating the work in process as qualified OZ business property even before it is placed in service. Other than treating certain working capital assets as reasonable amounts of working capital, the working capital safe harbor also includes two additional safe harbors, the one discussed in the first part of this article, treating gross income from the working capital assets as income from a trade or business, allowing the qualified OZ business to satisfy the 50% gross income test, and another safe harbor concerning the use of intangibles.

In the ruling, unrelated to the analysis necessary to reach its conclusions, the IRS appears to conclude that, except for the safe harbor treating certain working capital assets as reasonable amounts of working capital, all the other safe harbors described above are only applicable to startup businesses stating in the Law and Analysis section of the ruling that Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(A) “only applies to startup businesses.” We believe this to be an overly restrictive reading of the regulations and not supported by their text.  For example, under their terms, disregarding the heading of Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(A), none of the other safe harbors for gross income under Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(B), for use of intangibles under Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(C), and for property acquired with working capital assets under Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(D)(2), are restricted to startup businesses. The only safe harbor that by its terms is specifically restricted to startups is the one that turns off the 70% asset test under Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(D)(1). The ruling appears to question this conclusion and appears to hold that all the above safe harbors mentioned above only apply to startup businesses.

We note that support for the IRS position may be found in the heading to that particular regulation, calling it “Maximum 62-Month Safe Harbor for Startup Businesses,” in the examples in the regulations generally dealing with new businesses, and in the preamble to the final regulations (that was not supported by the text of regulations accompanying such preamble at the time, and by the text of the regulations as they were later amended by technical corrections as described below).

Except with respect to the safe harbor that turns off the 70% test for startup businesses, that is specifically limited to “startup” businesses, the operative text of the other safe harbors and generally of that regulation is not so restricted. In fact, as described below, the word “startup” does not appear anywhere else in those safe harbors. Furthermore, at least one of the safe harbors clearly does not apply to startup businesses. Specifically, the main difference between Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(D)(1) and (2) is that the former deals with startup businesses, turning off the 70% asset test during those 62-month period, and the latter deals with any eligible business treating property in the construction stage as qualified OZ business property for purposes of the 70% asset test during the same 62-month period. It is clear that Treas. Reg. Sections 1.1400Z2(d)-1(d)(3)(vi)(D)(2) does not apply to startup businesses because it would not have been needed given that the 70% asset test is completely irrelevant for startup businesses during the same time period. Moreover, limiting all the safe harbors to startup businesses could lead to unreasonable results because of the former mentioned regulation, for example where an existing qualified OZ business wants to build a new building but during the construction phase is unable to benefit from the safe harbors described above resulting in all work in process as bad property for purposes of the 70% asset test. Further, even though  Treas. Reg. Section 1.1400Z2(d)1(d)(3)(vi)(A) are called “Maximum 62-Month Safe Harbor For Start-Up Businesses,” we believe that this, in of itself, would not preclude such regulation from also applying to non-startup businesses as it is well settled law that that the title of a statute and the heading of a section cannot limit the plain meaning of the text. It would therefore be helpful if the IRS clarified their position on this matter.

Dr. Daniel Altman is a partner in the tax group of Sidley Austin LLP in New York and a member of the advisory board of the Opportunity Zones section of the Novogradac Journal of Tax Credits. Dan is also an active participant in the Novogradac Opportunity Zones Working Group and has extensive experience advising clients on opportunity zone investments. He can be reached at [email protected].

Andrew Smith is a managing associate in the tax group of Sidley Austin LLP in New York and has extensive experience advising clients on opportunity zone investments. He can be reached at [email protected].