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 seventh in our series of articles on qualified opportunity funds (QOFs), we discuss the nonqualified financial property limitation (NQFP limitation) that applies to qualified opportunity zone businesses (QOZBs).

A qualified opportunity zone business (QOZB) is subject to a number of requirements and limitations. One of these is the nonqualified financial property limitation (NQFP limitation), which states that the average of the aggregate unadjusted bases of the QOZB’s property attributable to “nonqualified financial property” (NQFP) must be less than 5%.

NQFP includes any of the following:

• Debt

• Stock

• Partnership interests

• Options

• Futures contracts

• Forward contracts

• Warrants

• Notional principal contracts

• Annuities

• Other similar property, as specified in relevant regulations (see below).

NQFP does not include either of the following:

• Reasonable amounts of working capital held in the form of cash, cash equivalents, or debt with a term of 18 months or less (short-term debt)

• Accounts receivable acquired in the ordinary course of business.

The purpose of the NQFP limitation is to prevent taxpayers from funneling financial investments in securities, debt and similar property through a qualified opportunity fund (QOF) and QOZB. An immediate consequence is that the most natural structure is a two-tier model where a QOF owns one or more QOZBs, none of which have subsidiaries (except for disregarded entity subsidiaries) because the subsidiaries would be treated as NQFP. The NQFP limitation does permit a small amount of unrestricted financial investment and, most importantly, excludes the working capital needed to start and run a business as well as the accounts receivable that naturally accumulate in an operating business.

There is a list of financial property that is explicitly included within the definition of NQFP and a provision that permits the expansion of the list by regulation. No such regulations have been promulgated under Subchapter Z nor Section 1397C. Moreover, in enumerating the list, the provision begins that NQFP means debt, stock, etc., which ordinarily indicates that a list is exclusive. In this case, this means that financial property not explicitly included in the list is not NQFP. This may be relevant for assets such as cryptocurrency (or in the IRS’s parlance, “virtual currency”) and other property that is not specifically listed.

In measuring the QOZB’s proportion of assets held in NQFP, the QOZB must use the average unadjusted cost basis of its property. Feasibly, the provision could be interpreted to mean that this average should be computed daily, monthly, annually, over the course of a ten-year (or more) holding period, or in any number of other ways. Neither Section 1397C nor Subchapter Z expound upon how such an average is to be computed. In the absence of guidance, the QOZB is left to choose some reasonable means of determining that average. A natural choice may be that the QOZB measure its assets and average semiannually, given the requirement that a QOF certifies for a given tax year based on two semiannual testing dates.

In most cases, especially for a new QOZB, the QOZB will be flush with financial property, specifically cash, because a QOF must acquire its interest in a QOZB at original issuance solely for cash. Thus, this creates an NQFP limitation issue for essentially all QOZBs. To solve for this, QOZBs nearly universally must appeal to the exceptions to the NQFP limitation for working capital.

There is a “working capital safe harbor” (the topic of a future article) that permits a QOZB to treat amounts of cash, cash equivalents and short-term debt as if those amounts were reasonable amounts of working capital so long as certain technical requirements are met.

Outside of the working capital safe harbor, there is no guidance specific to Subchapter Z regarding what constitutes a “reasonable” amount of working capital. For QOZBs that cannot check each of the boxes for the working capital safe harbor, they must appeal to a more general concept of working capital.

Under the accumulated earnings tax (AET) in sections 531-537, an analogous concept applies that allows a corporation which accumulates earnings and profits to avoid the AET on those earnings if the accumulation is for the reasonable needs of the business of the corporation. Included among those needs is necessary working capital. Courts have used a number of tests to measure the amount of necessary working capital in the AET context and include principally the liquid assets needed for a single operating or business cycle.

For example, the operating or business cycle of a manufacturing business is typically the period necessary to convert cash into raw materials, raw materials into inventory, inventory into accounts receivable, and accounts receivable back into cash. Thus, the working capital necessary to sustain the business through that cycle would be treated as necessary for purposes of the AET. In addition, liquid assets necessary to satisfy third-party obligations outside of the direct operations of the business (e.g., cash reserve requirements to satisfy lending arrangements) are also treated as necessary for purposes of the AET. For QOZBs that find themselves outside of the working capital safe harbor, the authorities underlying the AET may be helpful and persuasive to avoid violating the NQFP limitation when holding cash, cash equivalents, or short-term debt of 5% or more.