By Richard Shamos and Paul Marino

As the federal government’s opportunity zone program has taken form, the path forward for private equity investors that wish to utilize the favorable tax regime has likewise become more certain. The deployment of private equity strategies in qualified opportunity zones (QOZ) may present significant benefits to investors in such strategies. However, investments in qualified opportunity funds (QOFs) entail a number of cascading requirements and potential trip-wires, which managers and investors alike should carefully consider when structuring a fund and deploying capital. Notably, QOFs employing a private equity strategy must invest their capital in a company that qualifies as a qualified opportunity zone business (QOZB), which entails meeting certain locational and operational requirements under the statute. Let’s examine these requirements, as well as their implications for a private equity investment structure in Opportunity Zones.

As is the case with most investments, deals involving companies located in Opportunity Zones start with the identification of an investment opportunity. When investors realize that the opportunity is located in a QOZ (or alternatively, when companies seeking capital realize they are located in a QOZ), the quest for a compliant Opportunity Zone structure begins. However, it is important to note that the actual physical location of a business in a QOZ is merely a prerequisite, and not the deciding factor, in accessing the Opportunity Zone regime. In order to better examine the requirements, let’s start at the level of the QOF investment and work down to the holding of the underlying private equity investment, examining the considerations at each level of the investment.


In order for an investor to avail itself of the capital gains deferral and access the other QOZ benefits under the code, such investor must invest in a QOF within 180 days of realizing the relevant capital gain. Under the code, the QOF requirements are rather straight-forward: the entity may be a partnership or a corporation for tax purposes, and there are no particular governance requirements applicable to the entity, other than that it file an election to be treated as a QOF on Form 8996. As a result, the subscription process for the fund is a relatively standard one, and once the entity has filed its election, it may accept investors which are seeking a deferral of their capital gains. Generally, the investor’s timing considerations will require funds to use a capital contribution subscription mechanism rather than the commitment and drawdown mechanics more typical of private equity funds.

While setting up a QOF may appear rather simple, exit from a QOF poses certain challenges. In particular, investment funds are generally set up as pass-through entities, and as a result, the sale of the underlying QOF property (when the QOF is ready to exit) will result in taxable income being passed through to the QOF partners (which income defeats the purpose of having a tax-preferred structure to begin with). That is, the investment involves two levels: the investors’ qualifying investment would be the partnership interests in the fund, and the fund’s qualifying investment would be the investment in the relevant private equity business. However, if the QOF sells its stake in the business, it will realize income which passes through to the investors, before the investors have had a chance to liquidate their interests and take advantage of the step-up in basis. In order to take advantage of the 10-year exclusion of gain, managers of QOFs may be compelled to conduct such a sale of the underlying property by selling the QOF interests to the relevant buyer, so that the buyer indirectly acquires the private equity assets through acquisition of the QOF interests. For a fund which pursues multiple investments, this would require a multi-class structure, with different classes corresponding to different investments. This complexity is a key reason why QOFs to date have generally focused on single-asset deals.

The foregoing, of course, is subject to potential change, in the event the Treasury were to provide additional flexibility for QOFs to liquidate investments without nullifying the tax benefits provided under the code. Notably, in a recently letter to the Treasury, the still-seated original Congressional sponsors of the Opportunity Zones legislation have called for the Treasury to provide exactly such a clarification, declaring, “Such fund-level activity should in no way disallow the tax benefit to the Opportunity Fund's investors, provided they do not take distributions from the fund or sell their fund interest prior to meeting the 10-year holding period.”1 No such clarification has to date been provided.


Beyond the structural considerations of a fund, a QOF must also meet an eligible assets test which requires that it invest at least 90 percent of its assets in one of three types of holdings: stock in a QOZ Business, interests in a qualified opportunity zone partnership or directly-held QOZ business property. Such private investments in a company (whether structured as a partnership or a corporation) involve both transactional and qualitative company-level requirements.


The transactional requirements applicable to investment in a QOZ Business include that: the acquisition of QOZ Business stock or QOZ Partnership interests must occur in cash transactions after Dec. 31, 2017; and the issuer of the stock or interests must qualify as a QOZ Business on the date of issuance and for substantially all of the holding period thereafter.2 The latter requirement that the business qualify “on the date of issuance” poses a commonly overlooked challenge to investments in Opportunity Zones.

In order to be a QOZ Business, a company must meet one of two qualitative, company-level tests applicable to “substantially all” (meaning 70 percent, according to the Treasury’s proposed interpretation) of its tangible assets. Such assets must be acquired after Dec. 31, 2017 and either have an “original use” in the zone or be “substantially improved” by the investment. An existing business will likely contain substantial existing tangible assets which themselves do not qualify as QOZ business property, and so these assets are likely to cause the company as a whole to fail the QOZ Business test on the date of issuance. The failure of the target company to meet the QOZ Business test on day one, in turn, could potentially compromise the entire tax structure.

There are a number of ways that investors in private equity can address this issue through effective acquisition structuring. The company or the investors may set up a new entity to act as an acquisition vehicle or to ring-fence the new investment opportunity, and which entity thereby would itself qualify as a QOZ Business. For example, such an entity could acquire and/or manage a new operating business of the target company or a holding company for new tangible assets such as machinery which satisfy the original use test or the substantial improvement test. Similarly, such an entity could be used to acquire a business located outside of any Opportunity Zone and move it into a zone. The key concept to be aware of here, is that qualitative requirements apply to the company and its tangible assets, and so simple capitalization of an existing company located in the zone does not alone satisfy the requirements of an eligible asset.


As noted above, any private equity target of a QOF must qualify as a QOZ Business, which involves a number of requirements. In particular, the Opportunity Zone regime is designed to spur investment in tangible assets located in QOZs. As a result, a QOZ Business must be able to show that “substantially all” of its tangible property meets the original use or substantial improvement test, as well as certain operational requirements. These operational requirements are incorporated into the Opportunity Zone statute by reference and include portions of Code sections 144(c)(6)(B) and 1397C(b). The former provision provides an exclusion for certain types of sin businesses, such as liquor stores, casinos and massage parlors. Section 1397(C)(b), on the other hand, imposes certain qualitative