In 2017, Congress created the Opportunity Zone program to encourage investment in economically distressed parts of the United States. While the Opportunity Zone program is primarily focused on providing tax breaks for investors, emerging companies may be able to capitalize on the program as well.
The Opportunity Zone program
Opportunity Zones are census tracts that qualify as “low-income communities” under the tax code and which state governors have designated as beneficiaries of the Opportunity Zone program. There are over 8,700 Opportunity Zones scattered throughout all 50 states, the District of Columbia and U.S. territories.
The Opportunity Zone program provides three tax benefits to investors who invest capital gains into a qualified opportunity fund (“Qualified Fund”) within 180 days of the sale or exchange giving rise to such gains.
- Investors can defer paying taxes on the capital gains they invest into a Qualified Fund until they sell their interest in the Qualified Fund or December 31, 2026, whichever is earlier.
- Investors who hold their interest in a Qualified Fund for five years can eliminate 10% of the capital gains that they invested from tax, and investors who hold their interest in a Qualified Fund for seven years can eliminate an additional 5% of the capital gains from tax.
- Investors who maintain their investment in the Qualified Fund for at least 10 years do not have to pay tax on the appreciation of their interest in the Qualified Fund when they sell that interest.
Importantly, these tax benefits are limited to investments of capital gains (e.g., proceeds from the sale of stock in excess of basis) in the Qualified Fund. Investors who purchase an interest in a Qualified Fund with cash or other property that isn’t from capital gains, or who receive an interest in a Qualified Fund by performing services for the Qualified Fund, are not entitled to these tax benefits.
A Qualified Fund is an investment vehicle that has at least 90% of its assets as qualified opportunity zone property (“Qualified Property”). Qualified Property is tangible property located in an Opportunity Zone and/or equity interests in a U.S. company that is engaged in a qualified opportunity zone business (“Qualified Business”). To be engaged in a Qualified Business, in addition to other requirements, at minimum (i) 70% of a company’s tangible property must be used in an Opportunity Zone, (ii) 40% of a company’s intangible property must be used in the active conduct of a business in an Opportunity Zone, and (iii) 50% of a company’s gross income must be derived from the active conduct of a business in the Opportunity Zone. Golf courses, country clubs, massage parlors, hot tub or suntan facilities, racetracks, gambling facilities, and liquor stores cannot qualify as Qualified Businesses.
Why it makes sense to become a Qualified Opportunity Zone Business
The tax rules generally encourage Qualified Funds to invest in Qualified Businesses rather than to operate businesses in Opportunity Zones directly. Moreover, because Qualified Funds have until 6 months after formation to begin investing in Qualified Property, many new funds that intend to qualify as Qualified Funds are in a rush to find Qualified Businesses in which to invest. This presents a significant opportunity for founders— other things being equal, qualifying as a Qualified Business could make a company more attractive to investors.
How to become a Qualified Opportunity Zone Business
Generally, the primary hurdle to becoming a Qualified Business is the requirement that at least 50% of a company’s gross income be derived from the active conduct of a business in an Opportunity Zone. When the Opportunity Zone program was established, it wasn’t clear how companies could demonstrate this. However, the IRS has established “safe harbors” that provide that this requirement will be met if either:
- the management, operations and tangible property needed to generate 50% or more of the gross income of the business are located in an Opportunity Zone; or
- 50% or more of the services performed for the business by employees and independent contractors (based on either hours worked or compensation paid) are performed in an Opportunity Zone.
Thus, a startup that locates its headquarters in an Opportunity Zone could satisfy the 50% gross income test regardless of whether its income is generated inside or outside of the Opportunity Zone. Alternatively, a startup headquartered outside an Opportunity Zone could meet the 50% gross income test if its employees and independent contractors spend most of their time inside the Opportunity Zone. While there are other requirements a company must meet to qualify as a Qualified Business, founders should consider the potential benefits to the company of the Opportunity Zone program and consider these safe harbors in determining company headquarters or planned hires.
A video on this topic is available on Cooley’s Taxplaining page.
Last reviewed: March 2, 2023