As investor interest in qualified opportunity zones (“QOZ”) grows, both qualified opportunity funds (“QOFs”) and investors should be aware of the benefits of organizing QOFs as C-corporations. C-Corporation QOFs may take advantage of the reduced corporate income tax rate of 21 percent and the benefits under Section 1202 of the Internal Revenue Code (the “Code”).
Section 1202 allows non-corporate taxpayers, to exclude from gross income 100 percent of eligible gain from sale of so-called “qualified small business stock” (“QSBS”) if certain requirements are met. The gain to be excluded on sale of QSBS must not exceed the greater of: (a) $10,000,000, or (b) 10 times the aggregate adjusted basis of QSBS. Since the limitation applies to each taxpayer/investor, the aggregate amount of gain excluded from gross income of all the shareholders may be substantial. Additional requirements for QSBS gain exclusion include: (i) the gross assets of the corporation must not exceed $50,000,000, (ii) at least 80 percent (by value) of the corporation’s assets must have generally been used in the active conduct of qualified trade or business while the taxpayer held such QSBS, (iii) the QSBS must be issued by a qualified small business at original issue (directly or through an underwriter) and (iv) the taxpayer must hold the stock for more than five years.
Investors in QOF stock that also qualifies as QSBS may have the following benefits:
- Capital gain deferral, as commonly available for QOFs.
- A step up in basis in deferred capital gains of 10 percent to 15 percent based on the holding period of QOF stock from five to seven years, as commonly available for QOFs.
- Investors that desire to exit a QOF prior to the statutory 10-year holding period may exclude from their gross income capital gains of up to $10,000,000 or 10 times adjusted basis of QSBS. This gain exclusion is available solely due to the QOF stock qualifying as QSBS under Section 1202. Otherwise, investors that exit a QOF early will be subject to tax on any gain realized from the sale of the QOF interest. In some cases, it may be more beneficial to exit the QOF prior to the December 31, 2026, QOF recognition date and benefit from the generous gain exclusion provisions of Section 1202.
- A flat corporate income tax rate of 21 percent. Although investors would be subject to double tax, investors may choose not to receive distributions on a regular basis, thus avoiding tax on dividend distributions and later take advantage of Section 1202 gain exclusion.
- Given Section 1202’s original issue requirement, subsequent purchasers of QOF stock will not benefit from Section 1202 gain exclusion. However, such subsequent purchasers may still obtain benefits commonly available to QOF investors, assuming they meet all applicable requirements.
Based on the foregoing, developers and investors should consider the benefits of organizing QOFs as C-corporations. QOFs organized as C-Corporations provide attractive investment opportunities for cash investors and investors with deferred gains, flexibility with early exits if so desired, significant tax savings on early exists and possibly easier exits on sale of QSBS stock, which could still offer various QOF benefits to potential buyers. As with any investment, investors should consult their tax advisors prior to investing in a QOF.