Opportunity Zones: Establishing and Maintaining Compliance

Published by Matt Kelley on Friday, August 2, 2019
Journal cover thumb August 2019

Since the federal opportunity zones (OZ) incentive was introduced during 2017 tax reform and was codified in Internal Revenue Code Sections 1400Z-1 and -2, the Treasury Department and Internal Revenue Service (IRS) published 243 pages of regulatory guidance (including preamble material), Revenue Procedure 2018-16, Revenue Ruling 2018-29 and IRS Form 8996 with instructions.

In addition to this guidance, the IRS released and continues to update, a Frequently Asked Questions webpage. All this, as well as the state-level guidance and legislation, continues to evolve. Even with this guidance, questions remain and taxpayers participating in the OZ incentive must be diligent in ensuring compliance with the OZ rules throughout the life of the investment.

Most OZ investors carefully consider compliance requirements before and during the deal closing, whether a real estate deal or an operating business startup.

In the following paragraphs, we will address post-closing compliance and diligence–practical measures to monitor and ensure compliance with the OZ rules on an ongoing basis and compliance with IRS Form 8996. 

Practical Measures

Qualified opportunity fund (QOF) sponsors expend significant resources (time and money) to review the details of the OZ investment for compliance before and during the closing stage. Attorneys are retained to form the QOF, and often a qualified OZ business, and to review and opine on the compliance with OZ regulations. Accountants are retained to assist in the structuring of investments, the development of pro forma models, the development of a written working capital plan, the valuation of assets and calculations of other key metrics to support a reasonable expectation that QOFs will comply with the rules–including the 90 percent asset test, the 70 percent tangible property test, the nonqualified financial property test, etc.

The importance of this pre-closing diligence cannot be overstated. However, too little consideration may be provided to reviewing these same tests and OZ requirements in the weeks and months following the closing. 

QOF sponsors should develop and implement practices to review and monitor OZ compliance to avoid costly penalties. A simple but effective practical measure to help track and monitor ongoing compliance is for OZ investors to develop an OZ compliance checklist that can be reviewed consistently and regularly to ensure that all of the OZ requirements continue to be met, as well as to review proposed changes in the investment (e.g., distributions, debt refinancing, sale or transfer of interest in a QOF, sale or transfer of QOF or qualified OZ business property) and understand whether and how these changes affect OZ compliance.

The compliance checklist generally should include all of the relevant OZ requirements, but can be customized to each QOF or to each investor in a QOF. The checklist either should include inputs to quantify the mathematical tests (90 percent asset test, 70 percent tangible property test, 50 percent business activity, 5 percent nonqualified financial property threshold, etc.) or should reference a separate source that calculates these percentages. How often the checklist is reviewed against the facts of the OZ investment should be determined by how frequently the facts may change. For most OZ investments, the checklist should be reviewed at least quarterly and for others, a monthly review may be necessary. 

Finally, ongoing diligence is required for investors taking advantage of the working capital safe harbor within a qualified OZ business structure. Not only must the working capital plan be in writing, but the taxpayer must demonstrate that use of the working capital substantially complies with the plan during the 31-month period. While the Treasury has not clarified what may be considered less-than-substantial compliance, the taxpayer should frequently refer to the written plan and make efforts to comply as closely as possible.

QOF investors should be wary of actions that can trigger an inclusion of deferred gain. Because an investor has a zero basis at the onset of their investment, the most common inclusion event is likely to be a distribution from a QOF partnership to partner investors in excess of partner basis. Therefore, in order to avoid inclusion of deferred gain, it is wise for QOF investors to carefully track their outside basis throughout the life of the QOF investment. In addition, certain transfers and reorganizations of investments can result in the inclusion of deferred gain. Investors are wise to understand what events can trigger this recognition.

IRS Form 8996

A corporation or partnership uses Form 8996 to certify that it is organized to invest in OZ property. In addition, a corporation or partnership files Form 8996 annually to report that the QOF meets the 90 percent asset test or to calculate the penalty if it fails to meet the 90 percent test. The good news is that if the proper due diligence and consistent monitoring recommended above is followed, completing Form 8996 and satisfying the 90 percent asset test should not present an insurmountable challenge. The form is filed annually by the QOF and is due with the QOF’s federal income tax return, including any extensions.

The form has four parts. Part I is a self-certification. The purpose of Part I is primarily for the QOF to self-certify as a QOF and identify for the IRS the first month in which the fund chooses to be considered a QOF. Identifying the first month is important, as this will determine the timing of the first 90 percent asset test. The example in the form instructions makes clear that existing entities are eligible to be certified as a QOF. For example, an entity that is formed in January may elect to be certified as a QOF in April, when the QOF receives an investment eligible for deferral under the OZ incentive. 

Parts II and III are used to determine whether a QOF satisfies the 90 percent asset test, by computing the average ratio of the total value of OZ property to the total value of all assets (including nonqualified OZ property) held by the QOF on the last day of the first six-month period, as well as the last day of the year. If this ratio is less than 90 percent, then the QOF is directed to use Part IV to calculate the penalty.

Significantly, the 90 percent asset test is determined based on the annual average of the two testing dates described above; however, if the QOF happens to be below the 90 percent standard, the penalty is calculated on a monthly basis for each month that a QOF did not satisfy the standard. This penalty calculation reinforces the point made previously that monitoring compliance monthly is a wise strategy to avoid unexpected penalty exposure. In addition to Form 8996, the recent Request for Information issued May 1 by the IRS, indicates that additional reporting requirements will likely be forthcoming.

This topic was addressed as recently as July 9, during the IRS hearing on the second tranche of regulations. Multiple testimonies at the hearing expressed the importance of more detailed reporting to ensure the OZ incentive is achieving its intended purposes of providing economic stimulus to underserved communities. The exact data that will be required by the IRS is unclear, but the Request for Information indicates the IRS is interested in data to determine the types of OZ investments, job creation, the type of businesses operated by a qualified OZ business, etc. This additional reporting requirement may or may not be burdensome to the QOF, but the QOF investors should be aware of the potential requirement and develop a plan to address it. 

Rules governing the OZ incentive are new and can be complicated. Taxpayers must be vigilant in structuring investments and in monitoring ongoing compliance. Taxpayers are wise to adopt procedures for continual monitoring and should not hesitate to lean on professionals who have the necessary expertise to assist them.