Working Capital Safe Harbor: The Rules Are Clearer–But Still Complicated
Published by Dan Kowalski , Jill Homan , and Joseph B. Darby III on Tuesday, April 5, 2022
In the opportunity zones (OZ) world, the significance of the working capital safe harbor (WCSH) cannot be overstated: It is arguably the single most important concept–and single most valuable tool–found in Treasury Decision 9889, the final regulations under Internal Revenue Code Section 1400Z-2.
After lots of twists and turns, the current WCSH is at least coherent and can be easily applied in simple or “vanilla” situations. But the OZ world tends to be “spumoni”–real-world transactions tend to be complicated and messy and are not always easily squeezed into the relatively basic WCSH categories.
This article will look at how the WCSH may–or may not–work when applied to real-world OZ transactions.
An Evolving Provision
The WCSH is not found in the statutory language that created the OZ incentive. However, Treasury recognized in the first set of proposed regulations that the WCSH needed to be invented. The OZ incentive is all about encouraging taxpayers to invest substantial amounts of capital in OZs and that capital cannot be deployed instantly in projects–the cash, after all, does not spend itself. For the OZ incentive to function successfully, it needed a mechanism whereby cash could be held and deployed by qualified OZ business in a managed and intelligent manner over a time period that was long enough to be reasonable, but short enough to satisfy the time limits baked into the incentive. Hence, the WCSH.
However, the WCSH had lots of teething problems and became the most frequently modified provision in the regulations. The WCSH went through at least four iterations, including two sets of correction after the final regulations were issued in January 2020. The first correction, issued in April 2020, was well-intentioned but had blatant errors. The most recent correction, issued in August 2021, provides a set of rules that at least are internally consistent and relatively clear–but are also much narrower than many practitioners hoped.
What the Corrections Do and Do Not Clarify
The 2021 corrections clarified that subparagraph (1) unequivocally “turns off” the 70% tangible property standard for startup businesses, but at the same time creates a new kind of uncertainty because that rule applies only to “startup businesses” and not to all businesses.
The new uncertainty starts with the fact that the term “startup business” is not even defined in the regulations. Arguably, this new term means a prospective business activity that has not yet attained the status of an IRC Section 162 trade or business–that is, an activity that does not yet rise to the level of “carrying on” a business for which expenses may be deducted–but this will almost certainly be the subject of spirited debate in some future IRS audit.
The next potential problem is that, while the 70% test is turned off for a startup during the WCSH period, it is still far from a complete free pass. The 50% gross income requirement, for example, still applies, and could be problematical in many real-world situations. Take the following example:
A qualified opportunity fund (QOF) plans to invest $10 million in a qualified OZ business formed to acquire minimally improved land (currently leased on a triple-net basis to a tenant for $20,000 per month and operated as a parking lot) for $2 million, and then plans to spend $8 million to build a new residential apartment complex. The qualified OZ business, not unreasonably, would like to continue the existing lease until construction starts. This development project should qualify as a startup business, but here’s the rub: The legacy parking business is not part of the qualified OZ business’s intended future business of operating a residential facility and is also a triple-net lease, and therefore does not even qualify as a trade or business under the final regulations.
Following the purchase, the continuing rental stream of $20,000 a month is almost certainly “bad” income and the qualified OZ business will initially have relatively little “good” income to count toward the 50% gross income test. If the qualified OZ business fails the 50% gross income requirement for the QOF’s first testing year, then the QOF will not have an eligible investment because the erstwhile qualified OZ business fails to meet all the qualifications of a qualified OZ business. Also, the QOF will likely be subject to penalty under the 90% investment standard. There is no apparent relief under the WCSH rules since those merely provide a safe harbor for the 70% tangible property standard.
New Life to Subparagraph (2)
As a result of IRS corrections, subparagraph (2) now has both a clearer purpose and a sharper focus. Subparagraph (2) now provides that if an “eligible entity” (not just a “startup business”) has a working capital written plan that is “expected” to satisfy the 70% tangible property standard when completed, then as that tangible property is “purchased, leased, or improved by the trade or business,” it is treated as qualified OZ business property, satisfying the requirements of IRC Section 1400Z-2(d)(2)(D)(i), during that and subsequent working capital periods the property is subject to, for purposes of the 70% tangible property standard in IRC Section 1400Z-2(d)(3). In effect, as tangible property is purchased with WCSH cash or leased, or improved (including as property is created through new construction), it is treated as meeting the definition of qualified OZ business property for purposes of the 70% tangible property standard, even though the applicable property has not yet been placed in service.
Is Subparagraph (2) a huge safe harbor? It depends on the transaction. Under Subparagraph (2), the 70% tangible property standard is definitely not turned off–it is just made easier to satisfy, so long as tangible property is actually being purchased, leased or improved. But this provision makes it clear that timing, and dare we add haste, becomes an important part of the WCSH for nonstartup businesses. The nonstartup qualified OZ business needs to get its tangible property purchased, leased or improved quickly so that the qualified OZ business can meet the 70% tangible property standard at the end of the QOF’s first-year testing period or else face penalties under the 90% investment standard.
Moreover, the QOF also needs to be mindful of the 90% qualified OZ holding period, which provides that in order for an erstwhile qualified OZ business to qualify as qualified OZ business property (i.e., “good property”) in the hands of a QOF, it must meet all the qualifications as a qualified OZ business for at least 90% of the QOF’s cumulative holding period for that equity of the qualified OZ business entity (i) beginning on the date the QOF’s self-certification as a QOF is first effective and (ii) ending on the last day of the qualified OZ business entity’s most recent taxable year ending on or before the semiannual testing date of the QOF.
A nonstartup qualified OZ business that fails to meet the 70% tangible property standard during its first-year testing period can come back into compliance for purposes of the 90% qualified OZ holding period only by using the six-month cure period provided in Treas. Reg. Section 1.1400Z2(d)-1(d)(6). But if the QOF remains out of compliance for longer than that, it means the qualified OZ business now has as much as 18 months of nonqualified status in the hands of the QOF. Thus, the QOF not only fails initially the 90% investment standard but, to thereafter satisfy the 90% qualified OZ holding period, the qualified OZ business would need to become qualified and held by the QOF for something like the next 13.5 years. Needless to say, the penalties in that situation would be prohibitively expensive–it figuratively blows up the QOF.
Another unanswered issue–also important in real-world transactions–is how to define “startup” business when a single qualified OZ business is engaged in multiple business or development activities. Assume a qualified OZ business wants to acquire two parcels of undeveloped land located 10 miles apart in separate OZs and turn each into residential apartments. The first project will be completed in 18 months, and the second project will be completed in 30 months. Assume the first project will not meet the 70% tangible property test by itself (e.g., because the land is purchased from a related person) and therefore the qualified OZ business desperately needs to count the “good” property in the second project as part of a single business in order to meet the 70% tangible property standard. Can the two projects be combined into a single “startup” business? Can the qualified OZ business use the WCSH to “turn off” the 70% test for the first project until the second project is completed?
These are questions that are not answered by the current final regulations and that pop up with surprising regularity in the real world.
So give the IRS kudos for getting the WCSH to a much better place than it was–but there are still a lot of important questions that remain to be answered.