O’Melveny Worldwide

Many Early-Stage Companies Could See Substantial Benefits from Opportunity Zone Tax Incentives

June 3, 2019

Proposed regulations issued in April 2019 provide substantial opportunities for investors in technology start-ups and other early-stage companies to take advantage of the federal tax benefits offered by the “qualified opportunity zone” (QO Zone) program implemented in the Tax Cuts and Jobs Act of 2017 (the “TCJA”).

As described in recent client alerts, the Treasury Department has released two sets of proposed regulations clarifying the QO Zone rules set out in the TCJA.1 Much of the initial interest in QO Zones was driven by real estate investors, and the first set of proposed regulations released in October of last year focused primarily on rules relevant to real estate development, leaving non-real estate investors on the sideline. The proposed regulations issued in April, however, expand the scope of guidance and provide a number of permissive interpretations that should facilitate investment by qualified opportunity funds (QO Funds) in businesses outside of real estate. This alert describes some of the key issues relevant to operating companies seeking to qualify as “qualified opportunity businesses” (QO Businesses) in order to incentivize prospective investors and QO Funds looking to expand their QO Zone investments beyond real estate.

Legal Framework

The QO Fund program is intended to promote investment in certain qualifying low-income communities designated as QO Zones.2 As described in more detail in our prior client alerts, taxpayers are provided several incentives to invest in QO Funds, including:

  1. temporary tax deferral of capital gains from the sale or exchange of assets reinvested in a QO Fund until the earlier of (a) the date on which the investor disposes of its investment in a QO Fund and (b) December 31, 2026;
  2. a permanent 10% exclusion of such deferred gains after five years;
  3. an additional permanent 5% exclusion of such deferred gains after seven years; and
  4. a complete exemption from federal tax for any future appreciation from investments in a QO Fund held for at least ten years.

To qualify as a QO Fund, a corporation or partnership must hold at least 90% of its assets (the “90% Tangible Property Requirement”) in “qualified opportunity zone business property” (QO Business Property) or equity investments in QO Businesses (i.e., “qualified opportunity zone stock” or “qualified opportunity zone partnership interests”). QO Business Property is property used in a trade or business of the QO Fund or a QO Business (a) acquired by purchase after December 31, 2017, (b) for original use or which is “substantially improved”, and (c) substantially all of the use of which is within a QO Zone during substantially all of the time held by the QO Fund or QO Business.

A QO Business must satisfy each of the following tests:

  • at least 70% of its tangible property must be QO Business Property (the “70% Tangible Property Requirement”);
  • at least 50% of its total gross income must be from the active conduct of a trade or business in a QO Zone (the “50% Income Requirement”);
  • at least 40% of its intangible property must be used in the active conduct of a trade or business in a QO Zone (the “40% Intangible Property Requirement”);
  • less than 5% of its assets3 can be non-qualified financial property (generally, debt, stock, partnership interests, options, futures contracts, and other similar property) other than “reasonable amounts of working capital” held in cash, cash equivalents or debt instruments with a term of 18 months or less (the “5% Financial Property Limitation”); and
  • it may not be engaged in certain specified businesses (i.e., private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other gambling facilities or stores primarily selling alcohol for consumption off-premises).

The legal framework described above is relatively straightforward when applied to real estate developments in QO Zones or to many types of retail or service businesses without a substantial online presence. Technology companies, however, have limited tangible assets and may seek to sell goods and services regionally, nationally, and internationally. Fortunately, the recent proposed regulations provide guidance that would make it easier for those companies to qualify as QO Businesses. The remainder of this alert discusses the key issues that are relevant to early-stage operating businesses and how those businesses might structure their operations to permit QO Fund investments.

Qualifying Income

Prior to the April proposed regulations, it was not clear whether companies that locate their headquarters or employees in a QO Zone, but have a regional, national, or global customer base, could be viewed as generating 50% of their total gross income from a trade or business within a QO Zone. While a hotel located in a QO Zone should easily satisfy the 50% Income Requirement, a software company leasing an office in a QO Zone was left in the dark as to whether licensing software to customers on the other side of the country or the world would disqualify it from being a QO Business.

The April proposed regulations provide three taxpayer-favorable safe harbors that will facilitate satisfying the 50% Income Requirement. Under these rules, the 50% Income Requirement would be met if either:

  • 50% of the services performed by employees and independent contractors (based on hours worked) are performed in a QO Zone;
  • 50% of the amounts paid for services performed by employees and independent contractors are for services performed in a QO Zone; or
  • the tangible property of the QO Business located in a QO Zone and the management or operational functions performed for the QO Business in a QO Zone are each necessary to generate 50% of the gross income of the QO Business.

With these safe harbors, a software start-up leasing an office in a QO Zone would be deemed to satisfy the 50% Income Requirement if its employees and independent contractors spend more than 50% of their working hours in that office (or if it otherwise met one of the other two safe harbors). This would be the case even where all of the company’s customers are located in Europe or otherwise outside of a QO Zone. Similarly, a company manufacturing parts in a plant located in a QO Zone that are sold to manufacturers in Germany or Japan could also satisfy the 50% Income Requirement.

While these rules are a welcome development for companies hoping to qualify as QO Businesses, those companies will nevertheless need to keep a number of issues in mind before locating in a QO Zone in order to so qualify. For example, an early stage company with few employees would need to consider whether it can attract sufficient employees with the necessary skills to meet future expansion goals. Given the substantial benefits of a QO Fund investment, a QO Fund investor may require assurances that the company maintain its status as a QO Business even where the company may seek talented employees outside of a QO Zone. It will be important for a company seeking to qualify as a QO Business to weigh these issues carefully against the improved ability to attract capital through QO Fund investments.

Tangible and Intangible Property

Early-stage companies, particularly services and technology businesses, may only require limited use of tangible property in their operations. The flexibility of the rules set forth in the April proposed regulations, however, permit these types of businesses to meet the necessary requirements with proper planning. For example, a technology company may have tangible assets that consist only of leased office space and business equipment. If the office equipment is purchased new (or leased) after December 31, 2017 (or purchased used from a person that has not previously used the equipment in a QO Zone), then the office equipment would count toward the 70% Tangible Property Requirement.

The proposed regulations also clarify that leased property within a QO Zone would be treated as QO Business Property provided the lease is entered into after December 31, 2017 even if the company is neither the first user of such property nor substantially improves the property. Thus, a leased office building used in the company’s trade or business and meeting these basic requirements would be treated as QO Business Property.4 These more relaxed proposed rules are expected in many cases to provide service and technology businesses with significant opportunities to satisfy the 70% Tangible Property Requirement.

Of course, for many companies similar to those described in the previous paragraph, the most valuable property used in their business tends to be intangible property. Under the QO Fund statute, “substantially all” use of intangible property must take place within a QO Zone. The April proposed regulations, while helpfully setting this “substantially all” bar at just 40%, do not provide much detail as to what it means for intangible property to be used in a trade or business. Thus, for example, it is unclear whether a software company that develops a line of software for license, then moves on to focus on developing a second line of software while collecting license fees from the first line would continue to be able to count that first software line as being used in an active trade or business. Nevertheless, the April proposed regulations, which include examples that feature software companies, suggest that the Treasury Department is pursuing a broad interpretation of the statute that should permit many service and technology businesses to meet the 40% Intangible Property Requirement.

Working Capital

The statutory framework provides a strict limitation on the amount of “non-qualified financial property” that can be held by a QO Business, excepting a “reasonable” amount of working capital. This may present a challenge to early-stage operating companies that hold relatively small amounts of tangible property relative to cash invested to fund current and future operations. The proposed regulations released in October 2018 recognized this issue with respect to real estate development businesses by treating financial property (e.g., cash) as reasonable working capital for a period of up to 31 months if such businesses create and follow a written plan for the use of such financial property for the acquisition, construction, or substantial improvement of tangible property in the QO Zone. The April proposed regulations extend this safe harbor to cover financial property used for the development of a trade or business in a QO Zone. This addition provides needed relief that is expected to permit many companies outside of the real estate world to raise the capital needed to fund their business while still meeting the 5% Financial Property Limitation.

Structuring and Single-Use QO Funds

The statute and guidance released thus far clearly allow for the establishment of large-scale QO Funds to seek a diverse array of investments in QO Businesses. There are no restrictions on structuring an investment on a non-diversified basis; in fact, a start-up company that is located in a QO Zone could attract additional investors seeking to defer the recognition of capital gains even where the investor is not necessarily already a QO Fund. From a structuring perspective, to qualify as a QO Fund, such a company would need to satisfy the 90% Tangible Property Requirement.

It may be more advantageous, however, for investors in such circumstances to acquire interests in an entity that qualifies as a QO Fund that in turn invests solely in equity in a partnership or corporation that itself qualifies as a QO Business. Under such a structure, the underlying partnership or corporation would need to meet the less stringent 70% Tangible Property Requirement to qualify as a QO Business and for its equity to constitute qualifying property, which in turn would make it easier for the QO Fund to meet the 90% Tangible Property Requirement.


In its recent QO Zone proposed regulations, the Treasury indicates a willingness to interpret the QO Zone statute in a broad, taxpayer favorable manner. These rules therefore provide welcome news and a significant opportunity for early-stage operating companies to secure investment from taxpayers seeking to avail themselves of the tax benefits associated with an investment in QO Funds. While significant questions remain about how certain rules will ultimately be interpreted or amended, the flexible and accommodating approach taken by the proposed regulations suggest that early-stage operating companies of all stripes may want to consider whether they would benefit from qualifying as a QO Business.

1 The October 2018 proposed regulations are described here and the April 2019 proposed regulations are described here.

2 Information about where QO Zones are located can be found here.

3 For this purpose, the value of the assets is measured by the aggregate unadjusted bases of the relevant property.

4 The value of the leased building for this purpose would generally be the value of the property on an “applicable financial statement” (as defined in Treas. Reg. section 1.475(a)-4(h)), or by calculating the present value of the payments required to be made under the lease.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Luc Moritz, an O’Melveny partner licensed to practice law in California, Billy Abbott, an O’Melveny counsel licensed to practice law in California and New York, Alexander Roberts, an O’Melveny counsel licensed to practice law in New York, and Dawn Lim, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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