How the Latest QOZ Proposals Affect Qualified Opportunity Zone Businesses

The new tax incentive added by the 2017 Tax Cuts and Jobs Act, which is designed to promote long-term growth in economically distressed areas known as Qualified Opportunity Zones ("QOZs"), is gaining interest among businesses and business owners who are considering starting or expanding businesses in QOZs (or moving existing businesses to QOZs).

Although real estate investments have been the main focus of QOZ-related investment activity to date, attention is now turning to investments in operating businesses located in QOZs, including such diverse investments as renewable energy, infrastructure, software companies, manufacturing, distribution centers and data centers.

This increased interest follows the issuance of the second set of proposed QOZ regulations[1] (the "New Proposed Regulations") on April 17, 2019, which provide guidance on a number of previously uncertain aspects of the QOZ provisions.

This bulletin provides an overview of the QOZ provisions and addresses certain aspects of the guidance provided by the New Proposed Regulations that specifically relate to investments in operating businesses, including a discussion of tax strategies that pertain to investments in such operating businesses.[2]

Tax Benefits Available for Investments in a QOF

The QOZ program extends special tax benefits to investors that would otherwise recognize taxable gain from a sale or exchange provided that the amount of such gain is reinvested into Qualified Opportunity Funds ("QOFs") that engage in economic activity in QOZs. If a taxpayer reinvests all or a portion of the taxable capital gain recognized on a sale or exchange into a QOF generally within 180 days of such sale or exchange, the taxpayer will thereby become eligible for the following tax benefits with respect to such reinvested gain. The investor will have a zero basis in its QOF interest with respect to the reinvested gain.

Deferral of Current Tax. Deferral of tax until the earlier of (i) the sale or exchange of the QOF or (ii) December 31, 2026. Unless the taxpayer disposes of its interest in a QOF prior to December 31, 2026, all deferred gains will be required to be recognized in 2026 (subject to the basis adjustment rules discussed below).

Partial Basis Step-Up. An increase in the taxpayer's tax basis (of 10% of the deferred gain) in the QOF after holding the QOF for 5 years, and an additional increase (of 5% of the deferred gain) after holding the QOF for 7 years. After the investor's deferred gain (reduced by such basis step-ups) is recognized, the basis is increased by the amount of the deferred gain recognized.

Exclusion of Gain From Income. If the QOF interest is held for 10 years or more, elimination of any taxable gain on ultimate sale of the QOF (i.e., no tax would be owed on the appreciation in value of the QOF interest after its initial acquisition by the taxpayer). For the gain to be excluded from the taxpayer's income, the ultimate sale must be of the QOF or gain from the sale of qualifying assets owned by the QOF including sale of a QOZ Business (but, under present guidance, not a QOZ Business's sale of its assets).

Relevant Definitions for Purposes of the QOZ Program

Qualified Opportunity Fund. A QOF is either a corporation or a partnership established for the purpose of investing in Qualified Opportunity Zone Property ("QOZ Property") (as defined below), other than another QOF. At least 90% of the assets of a QOF must be QOZ Property. The 90% test is applied by averaging the percentage of QOZ Property held by the QOF as of: (i) the last day of the first 6-month period of the taxable year of the QOF; and (ii) the last day of the taxable year of the QOF.

QOZ Property. QOZ Property is either (i) "QOZ Business Property" or (ii) stock or partnership interests in an entity that is a "QOZ Business" at the time such interest was acquired and during substantially all of the QOF's holding period for such interest.

QOZ Business Property. QOZ Business Property is generally defined as tangible property (i) used in a trade or business of the QOF; (ii) acquired by purchase from unrelated parties after December 31, 2017; (iii) substantially all of the use of which was in a QOZ during substantially all of the QOF's holding period for such property; and (iv) (a) the original use of which begins with the QOF or (b) to which the QOF makes substantial improvements. A property is substantially improved by a QOF if, during any 30-month period beginning after the date of acquisition, additions to basis with respect to the property by the QOF exceed the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF.

QOZ Business. A QOZ Business is a qualifying trade or business in which:

  • substantially all (more than 70%) of the tangible property owned or leased by the taxpayer is QOZ Business Property;
  • at least 50% of the total gross income of such trade or business is derived from the active conduct of such trade business within a QOZ;
  • a substantial portion of the intangible property of such trade or business is used in the active conduct of such trade or business in the QOZ; and
  • less than 5% of the average of the aggregate unadjusted bases of the property of such trade or business is attributable to nonqualified financial property.

The proposed Treasury Regulations contain significant exceptions and clarifications to these rules, which are discussed below.

Application of QOZ Program to Investments in Operating Businesses

Before the New Proposed Regulations were issued, there had been significant uncertainty about how the basic requirements for qualification as a QOF would apply in a variety of common fact patterns. The New Proposed Regulations provided helpful guidance on a number of these issues, eliminating much of the uncertainty with respect to how to structure QOFs and QOZ Businesses to qualify for the benefits of this program, particularly for investments in operating businesses.

Requirement that 50% of the Gross Income of a Business Earned Within a QOZ.

With respect to the requirement in the definition of QOZ Business that at least 50% of the total gross income is derived from the active conduct of a trade or business within a QOZ, prior to the issuance of the New Proposed Regulations, there were no rules for determining (i) what constitutes the "active conduct" of a trade or business or (ii) where income is deemed to be earned (inside or outside a QOZ). For businesses that sold goods or provided services to customers located outside of a QOZ, it was unclear whether these businesses would qualify.

With respect to the income requirement, the New Proposed Regulations provide a facts and circumstances test and the following three safe harbors for purposes of determining whether at least 50% of the total gross income of the trade or business is derived from within a QOZ. Notably the safe harbors include services performed by independent contractors and the employees of independent contractors retained by the business (as well as the business's own employees) but do not address how to determine the source of income for businesses that do not have their own employees or independent contractors. The safe harbors are as follows:

  • at least 50% of the services performed (based on hours) for such business by its employees and independent contractors are performed within the QOZ;
  • at least 50% of the services performed (based on amounts paid for the services performed) for the business by its employees and independent contractors are performed in the QOZ; or
  • both (i) the tangible property of the business that is in a QOZ and (ii) the management or operational functions performed for the business in the QOZ, are each necessary to generate 50% of the gross income of the trade or business.

An illustrative example in the New Proposed Regulations of the application of these rules focuses on a technology company. It involves a startup business that develops software applications for global sale in a campus located in an Opportunity Zone. In the example, a majority of the total hours of the startup's employees and contractors developing software applications are located in the Opportunity Zone. The New Proposed Regulations conclude that the business satisfies the income test even though the business makes the vast majority of its sales to consumers located outside of the Opportunity Zone where its campus is located.

Another example in the New Proposed Regulations involves a landscape company with (i) officers and employees who manage the daily operations of its business from headquarters located in a QOZ, (ii) employees who perform services for customers both inside and outside the QOZ, and (iii) all of its equipment and supplies stored at the business headquarters. The New Proposed Regulations provide that because the management activity, equipment and supplies reside within the QOZ, the 50% gross income requirement is satisfied.

The New Proposed Regulations clarify that inventory (including raw materials) of a trade or business does not fail to be used in a QOZ solely because the inventory is in transit from a vendor to a facility of the trade or business that is in a QOZ, or from a facility of the trade or business that is in a QOZ to customers of the trade or business that are not located in a QOZ.

"Substantial Portion" of Intangible Property Be Used in a Business in the QOZ.

One area of uncertainty that continues to exist and was not meaningfully clarified in the New Proposed Regulations is how an operating company that uses a significant amount of intangible property satisfies the requirement that it use a "substantial portion" of its intangible property in the conduct of an active trade or business in a QOZ.

While the Proposed Regulations do provide that "substantial portion" means for this purpose at least 40%, there is no guidance on where use of intangible property occurs. It is not clear if this would be based on where servers are located, where employees that are developing the intangibles are performing services, where revenue related to the intangible property is derived from, or many other similar sourcing rules.

Nonqualified Financial Property.

Nonqualified financial property generally includes stock, debt, partnership interests, options, futures, forward contracts, notional principal contracts and other similar property but does not include reasonable amounts of working capital.

The New Proposed Regulations provide a working capital safe harbor for investments in QOZ Businesses that acquire, construct or rehabilitate tangible business property. As long as a QOZ Business has a written plan that identifies cash being held for a project and there is a written schedule for deployment of the cash that the business substantially complies with, the committed cash will be considered reasonable working capital for up to 31 months.[3]

This is a helpful clarification for operating businesses that need time to deploy invested capital and build out infrastructure (e.g., a retail store or new restaurant where the acquired or leased space needs to be redesigned).

Original Use and Substantial Improvement for QOZ Property.

The New Proposed Regulations define "original use" by reference to when the property first is placed in service by any taxpayer for depreciation purposes. As a result, if the property was ever placed in service by any person, it has been originally used, and if the original use was in a QOZ, that property must be substantially improved.

However, if the original use was not in a QOZ by the taxpayer, such property could still satisfy the original use requirement if purchased by the taxpayer from an unrelated party[4] and used in a QOZ. The New Proposed Regulations also clarify that improvements made to leased property satisfy the original use test and are treated as acquired by purchase.

The New Proposed Regulations provide relief from the original use requirement for property (including a building or other structure) that has been vacant or unused for at least 5 years before purchase by a QOF or QOZ Business by allowing the QOF or QOZ Business to satisfy the original use test by placing the unused or vacant asset into service in the QOZ without requiring that such property be substantially improved.

One less favorable clarification made by the New Proposed Regulations is that the substantial improvement test must be applied on an asset-by-asset basis.

For example, if a QOF or QOZ Business acquires two buildings within a QOZ and substantially improves only one of the two, only the building that has been substantially improved would be QOZ Business Property even if the total amount spent exceeded the cost for both properties.

Note, however, that the IRS and the U.S. Department of Treasury ("Treasury") requested comments as to whether future guidance should apply an aggregate standard for determining compliance with the substantial improvement test, whether property not capable of being substantially improved should be exempted from the substantial improvement rule, and whether the purchase of non-original use property together with items of original use property should be aggregated to determine whether the test is satisfied. This issue was discussed in many of the comment letters on the New Proposed Regulations that were submitted to Treasury, and was addressed repeatedly in testimony at a public hearing on the New Proposed Regulations that was held on July 9, 2019.

Applying the substantial improvement test on an asset-by-asset basis may pose particular challenges for an operating business that acquires tangible property located in a QOZ.

For example, suppose a QOZ Business acquires all of the assets of a manufacturing facility located in a QOZ. Technically the QOZ Business would be required to ensure that that 70% of the aggregate value of the assets of the business satisfy either: (i) the "original use" requirement, or (ii) the "substantial improvement" requirement, which, in the case of the assets of the manufacturing facility, may require an evaluation of whether each acquired asset of the facility including the building, each piece of equipment, and all of the personal property have been substantially improved.

Moreover, the asset-by-asset approach could be challenging for existing businesses that are already operating in a QOZ that would want to expand the business to take advantage of the QOZ program. It might be necessary for such businesses to form a new entity to do the expansion and lease certain shared property from the existing business. Additional complex structuring opportunities may be available, and business owners are advised to discuss with legal counsel early in the process.

Leased Property.

The New Proposed Regulations provide favorable guidance for property leased by a QOF or QOZ Business.

Leased tangible property is treated as QOZ Business Property for purposes of satisfying the 90% asset test and the requirement that substantially all tangible property be QOZ business property, so long as: (i) the leased tangible property is acquired under a lease entered into after December 31, 2017; (ii) substantially all of the use of the leased tangible property is in a QOZ during substantially all of the period for which the business leases the property; and (iii) the lease is a "market rate lease" (i.e., the terms of the lease must reflect common, arm's-length market practice in the locale that includes the QOZ).

If the lease is with a "related party" (i.e., the entities have 20% or more common ownership taking into account certain constructive ownership rules), (i) the lessee cannot make any prepayments of rent for a period exceeding 12 months, (ii) if the leased property is tangible personal property and the original use of such property in a QOZ did not commence with the lessee, the lessee must become the owner of tangible property having a value at least equal to the value of the property leased from a related person within the earlier of (a) 30 months after the lessee receives possession of the leased property or (b) the end of the lease term, and (iii) there must be substantial overlap in the QOZs where the leased property and the property acquired in (ii) is used. However, if there is a plan, intention, or expectation that leased real property is to be acquired by the QOF or QOZ Business for other than the fair market value of such land, the property never will qualify as QOZ Business Property.

As is true of land acquired after December 31, 2017, land leased after December 31, 2017, is not required to be substantially improved. The IRS and Treasury requested comments on all aspects of the leased property rules.

The first set of proposed Treasury Regulations[5] provides two valuation methods for the QOF 90% asset test and the QOZ Business 70% asset test.

Property can be valued using either (i) the "applicable financial statement valuation method" where value is based on the book value (after depreciation and amortization) reported on an applicable financial statement or (ii) the alternative valuation method where value is based on the original cost basis for the property.

The New Proposed Regulations provide special rules for leased property. The lessee can use the "applicable financial statement valuation method" if the financial statement is prepared in accordance with GAAP and GAAP assigns a value to the leased property. Alternatively, the leased property may be valued by calculating the present value of the lease payments using the applicable federal rate as the discount rate.

The rules regarding the treatment of leased property are incredibly helpful, especially for operating businesses. For businesses that have few tangible assets, leasing property in a QOZ might allow a business to clearly satisfy the asset tests where there might otherwise be ambiguity. Similarly, leasing used property located in a zone may provide a way to utilize the QOZ program's tax incentives to expand an existing business.

For example, if you have a widget manufacturer with a factory in the zone and the factory has some floors that are vacant, owners of the widget factory might want to start an advertising business that promotes the widgets and products made by third parties.

If the widget business owner did this in the existing entity, the business would not qualify as a QOZ Business because most of its assets would be used and not substantially improved. However, if a newly formed entity also owned by the owner of the widget manufacturer were to engage in the advertising business, it could satisfy the asset tests through leasing space in the factory.

Working Capital Safe Harbor.

The first set of proposed Treasury Regulations provides the following safe harbor for "reasonable working capital": (i) the working capital is designated for the acquisition, construction and/or improvement of tangible property in a QOZ; (ii) there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital; (iii) the working capital is spent within 31 months of the receipt of the funds; and (iv) the working capital is used substantially consistent with the foregoing.

The New Proposed Regulations expand the safe harbor to include costs and expenses of developing a trade or business. This clarification will be extremely helpful for operating businesses that are start-ups. The New Proposed Regulations also clarify that the safe harbor can be applied serially to each capital contribution made by a QOF to a QOZ Business (rather than applying a single 31-month period), and further provide that the safe harbor will not be violated if the 31-month period is exceeded due to delays in receiving governmental approvals. Questions remain, however, concerning the consequences of other types of business disruptions that do not involve governmental delays — such as labor stoppages, natural disasters and other economic forces — as they are not enumerated within the New Proposed Regulations as providing an exception to the 31-month period.


While a number of questions remain with respect to how the requirements of the QOZ program apply to operating businesses, the New Proposed Regulations provide helpful guidance and have piqued interest in locating operating businesses in QOZs and in creating and structuring QOFs to invest in operating businesses in QOZs. It remains to be seen whether Treasury will issue any further guidance with respect to the application of the QOZ program and what issues such guidance, if any, will address. However, the existing guidance including the New Proposed Regulations should be sufficient for many operating businesses to proceed with structuring their QOZ-activities as good QOZ Businesses.


[1] REG-120186-18.

[2] For a more comprehensive discussion of both sets of proposed Treasury Regulations, see "Stroock's Take on the New 'Qualified Opportunity Zone' Guidance," available at; and "They're Out! Stroock's Take on the Second Set of Proposed QOZ Regulations," available at

[3] The New Proposed Regulations also provide that the safe harbor will not be violated if the 31-month period is exceeded due to delays in receiving governmental approvals.

[4] "Relatedness" for this purpose is generally determined by a 20% or greater common ownership test taking into account certain constructive ownership rules.

[5] REG-115420-18.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.