Since coming into effect in January 2018, Subchapter Z of the US Tax Code—also known as the opportunity zone provisions—has enabled investors to pour billions of dollars into a broad array of businesses, from real estate development companies to tech startups. Investments in qualified opportunity funds (QOFs) offer a number of distinct tax benefits, not the least of which is reduced capital gains tax liability. But the rules governing these investments are quirky, perplexing and—in some cases—severely restrictive.
In this eighth in our series of articles on qualified opportunity funds (QOFs), we discuss the working capital safe harbor (WC safe harbor) that applies to qualified opportunity zone businesses (QOZBs).
In our seventh article, we discussed the nonqualified financial property (NQFP) limitation, and the general exception to the NQFP limitation for reasonable amounts of working capital held in cash, cash equivalents, and debt with a maturity of 18 months or less (short-term debt). Areas of focus in this article are the more technical aspects of the WC safe harbor rules for taxpayers who wish to avoid the uncertainties of the general rule regarding working capital.
As we mentioned in the prior article, a QOZB must limit the portion of its property that is NQFP to less than 5%, measured by average aggregate unadjusted basis:
A taxpayer may exclude working capital assets from the numerator, however neither Subchapter Z nor the Treasury Regulations thereunder give explicit guidance on what characterizes an asset as working capital and whether the amount of such assets is reasonable, generally. Although we have analogized to other areas of the tax law (e.g., the accumulated earnings tax under Section 541 et seq.), in our experience the overwhelming majority of, if not all, QOZBs choose to qualify their working capital assets pursuant to the more narrow, but more certain, WC safe harbor if at all possible.
Primary Effect: Exclusion from NQFP
If the QOZB satisfies the technical requirements of the WC safe harbor with respect to a particular amount of cash, cash equivalents and/or short-term debt held by the QOZB, such amounts will automatically be treated as reasonable amounts of working capital. This last point is the key, because that is what permits the QOZB to exclude such assets from its NQFP.
Principally, the technical requirements of the WC safe harbor are three: The first two relate to when putative working capital assets are acquired, or shortly thereafter, and the third applies on a continuing basis until such assets are spent.
First, the QOZB must prepare a written plan for the use of the working capital assets in the trade or business within the QOZ. Second, in addition to or as part of the written plan, the QOZB must prepare a written schedule for the expenditure of the working capital assets which schedule must, ordinarily, cover no more than 31 months after the receipt of the working capital assets and must be consistent with the ordinary start-up of a trade or business. Third, the QOZB must actually use and spend the working capital assets consistent with the written schedule.
On a subsequent infusion of working capital assets, a QOZB may qualify this second (or later) amount under the WC safe harbor plan. All of the same technical requirements apply to this amount, including the need for a written plan and schedule and use substantially consistent therewith. In addition, however, the later infusion of working capital assets must have been contemplated in the original working capital plan, and the written schedule for the use of the new amounts must plan for the use of the working capital assets within a 62-month period beginning with the initial date of the first working capital plan.
Care should be taken and foresight used when preparing the written plan and schedule because the Treasury Regulations do not generally permit a QOZB to amend, revoke, or otherwise alter the written plan or schedule once put in place. This is a place where proper counsel and deft drafting can preserve future flexibility (and project value).
One narrow, but seemingly prescient, exception in proposed regulations is that a QOZB would be permitted to amend or rescind its written plan in the case that the QOZ in which it operates is within a federally declared disaster area. In that case, the QOZB would have until 120 days after the declaration lapses to alter its written plan. Under current regulations, such a QOZB is granted an additional 24 months in which to use its working capital assets subject to the written plan and schedule. Outside of this, the QOZB is bound by its own written plan and must stick to its schedule, at least up to the specificity of its plan and the standard of using the working capital assets substantially consistent with the written plan and schedule.
The tradeoff that a QOZB must make for the certainty of the WC safe harbor is that each time the QOZB receives working capital assets, it must prepare a new written plan and schedule for each infusion separately. Otherwise, with respect to that infusion, the general, and as yet unwritten, rules apply. In the case of a large cash contribution on formation or loan proceeds that the QOZB receives for major expansion, this may be no bother, but for more routine receipts of cash in the ordinary course of business, such as sales of inventory, this requirement practically forecloses the use of the WC safe harbor with respect to day-to-day transactions of the QOZB.
Secondary Effects: Easing Qualification for Start-Up QOZBs
In addition to allowing a QOZB to exclude working capital assets from the definition of NQFP, the WC safe harbor goes further and allows a QOZB engaged in the start-up of a business to more easily satisfy the general requirements to qualify as a QOZB.
While a QOZB is engaged in the start-up of a business and has working capital assets that satisfy the WC safe harbor, that QOZB is automatically treated as satisfying the tangible property test during the 31-month working capital period(s) (plus any extensions). Moreover, any tangible property acquired, leased or improved with those working capital assets and that is expected to be QOZB property as a result of planned expenditures under the written plan will be treated as such for purposes of the Tangible Property Test during any 31-month working capital period(s). Similarly, intangible assets acquired with such working capital assets are treated as used in the trade or business of the QOZB, and any income generated by such tangible or intangible property is counted favorably towards the requirement that at least 50% of the QOZB’s gross income be generated within a QOZ. Notwithstanding, no working capital assets themselves are treated as actual tangible property, intangible property or QOZB property for any purpose.
Click here for the previous article in the series: The Nonqualified Financial Property Limitation
View all articles in the Qualified Opportunity Funds OTS Series.