Tax Law Insights

Congress enacted the Opportunity Zone (“OZ”) investment incentives in late 2017 as part of the Tax Cuts and Jobs Act.  Since then many investors, fund managers, and community development professionals have devoted significant time and resources to locating and underwriting investment opportunities.  The legislation left many unanswered questions – largely limiting investments to obvious qualifying businesses.  The first set of proposed regulations, released October 29, 2018, provided further guidance but not enough to answer many remaining questions.

The 50% Gross Income Rule

Perhaps the most important unanswered questions related to the treatment of operating businesses under the so-called “50% Gross Income Rule.”  This rule generally requires that at least 50% of a qualified OZ business’s gross income come from active business in the zone.

But how should a business source its income inside and outside of the zone?  Many wondered whether this rule limited OZ operations to smaller local businesses, like restaurants operating solely within the zone.

Yet even simple examples like restaurants with OZ brick-and-mortar locations can become potentially complicated, especially if they grow and begin earning non-OZ income.  For example, could a restaurant whose non-OZ food truck income surpasses the home location’s income still qualify?  Must that restaurant decide between its growth prospects and qualifying as an OZ business?  If so, should potential high-growth technology startups with customers outside the zone simply not apply?

In response, the latest proposed regulations (issued April 2019) provided the following three safe harbors and a fallback facts and circumstances test.  Each logically requires a physical location of sorts in the OZ, and businesses with headquarters and management located in an OZ are most likely to qualify.

Three Safe Harbors for the 50% Gross Income Rule

1. The Hours Worked Safe Harbor.

The Hours Worked Safe Harbor measures the total hours worked for the business in all its locations (“Everywhere Hours”) against the total hours worked within the OZ (“OZ Hours”).  If the OZ Hours make up at least 50% of the Everywhere Hours, then the Hours Worked Safe Harbor applies and the business qualifies under the 50% Gross Income Rule.

Hours worked for these purposes include employee hours, of course.  Perhaps surprisingly to some, hours worked also include independent contractor (and independent contractor employee) hours as well.  For this reason, a would-be OZ business using a large independent contractor workforce of the “side-hustle” variety (think food delivery or ridesharing) may have trouble meeting this safe harbor if those contractors render their services mostly outside the OZ.

That said, as noted in the preamble to the proposed regulations, technology companies such as software development startups should be able to meet this safe harbor.  Why?  Because while such companies often have customers all over the world (and therefore outside of the OZ), the vast majority of their worker hours are often spent developing software on the company’s campus, which could be in an OZ.

2. The Compensation Paid Safe Harbor.

The Compensation Paid Safe Harbor is similar to the Hours Worked Safe Harbor except that, instead of hours worked, it uses total compensation paid as the workforce qualifying measure.  Thus, if total compensation paid for services performed within the OZ (“OZ Comp”) is at least 50% of the business’s overall worker compensation (“Everywhere Comp”), then the business qualifies under the 50% Gross Income Rule.  Total worker compensation includes employees and independent contractors (and independent contractor employees).

Like the Hours Worked Safe Harbor, the Compensation Paid Safe Harbor may also help certain technology startups.  The preamble to the proposed regulations use the example of a startup with an OZ headquarters that uses a non-OZ service (or call) center.  The total headquarters compensation likely includes highly compensated officers, coders, and software engineers, and the service center includes lower compensated workers.  As such, the startup’s OZ Comp could, in theory, equal at least 50% of the Everywhere Comp, allowing it to qualify under the 50% Gross Income Rule.

3. The Property & Management Safe Harbor.

The Property and Management Safe Harbor does not include a fraction or equation, and is therefore perhaps more ambiguous and open to interpretation, and more difficult to calculate.  This safe harbor requires that (1) the business’s management or operational functions performed in an OZ, and (2) tangible property (including leased property) located in the zone must each be “necessary” to generate 50% of the business’s total gross income.  As provided in one of the examples, these two business inputs must, when taken together, be a “material factor in the generation of the income of the business.”

These concepts are easier to grasp theoretically than practically.  The proposed regulations do not clarify whether management functions can account for, say, 45% of the OZ income, and tangible OZ property can account for the remaining 5%.  Would that 5% be either necessary or a material factor?

The preamble uses the example of a landscaping company with its management located in the OZ, and its equipment also stored in the OZ.  Even though the company provides services outside the zone, because its management and equipment, together, account for more than 50% of the company’s gross income, it will qualify for the Property and Management Safe Harbor.  This safe harbor may also be helpful to construction and similar equipment-intensive businesses.

But would the software startup used as an example in the other two safe harbors also qualify here?  The Property and Management Safe Harbor explicitly requires that certain tangible property must be located in the zone and be “necessary” or a “material factor” in producing company income.  It therefore follows that the startup must first own or lease tangible property (i.e., property other than its intangible software) that would, when taken together with its management services, be a material factor in generating 50% or more of its income.  Perhaps the startup could qualify for this safe harbor if it owned physical servers at its headquarters that, along with its OZ management team, were instrumental in running, servicing, or selling its software.  Or perhaps the facts and circumstances fallback test is better suited for this situation.

4. The Facts and Circumstances or Fallback Test.

Any business not meeting a safe harbor may still qualify under the 50% Gross Income Rule if, based on all facts and circumstances, it derives at least 50% of its gross income from actively conducting a trade or business in an OZ.  This Fallback Test essentially takes us back to the original rule/concept provided prior to the latest proposed regulations.  It also might provide cover for businesses that meet one or more of the above safe harbors in most, but not all, taxable years.

At a minimum, the Fallback Test provides a potential reporting position for businesses with physical headquarters in an OZ who can somehow source at least 50% of their gross income to the zone.  This test is also consistent with the stated intent of the OZ incentives:  to spur development and create jobs in OZs around the country.  For that reason, businesses that can illustrate OZ job creation may consider relying on the Fallback Test.

Conclusion

The proposed regulations provided both helpful safe harbors and examples that we expect will provide comfort for many operating businesses seeking to qualify for OZ incentives.  The first two safe harbors allow would-be OZ businesses to manage their labor inputs in ways that can assure OZ business treatment.  The Property and Management Safe Harbor likewise provides a path for equipment-intensive businesses to take advantage of OZ incentives.

As with other tax regimes that provide similar safe harbors along with a facts and circumstances test (such as IRC § 302 redemptions), taxpayers will likely gravitate first to the safe harbors, and perhaps only in rare circumstances or unique tax years will they rely on the Fallback Test.  But given the clear Congressional, and Presidential, intent to spur OZ development and job creation, taxpayers with successful businesses headquartered in OZs may be more willing to rely on this Fallback Test than to use it as a last resort.  A few forgiving IRS Rulings on the scope of the Fallback Test could even fully open the OZ floodgates.  Yet such rulings often trickle out slowly, and as we noted in prior OZ-related posts, time is running out.