In the midst of the excitement surrounding the Opportunity Zone (OZ) program, the first question taxpayers often ask after being educated about the basics is how to start a Qualified Opportunity Fund (QOF). The acronym might be a bit intimidating, but the process could be surprisingly simple, depending on facts and circumstances. Nevertheless, taxpayers should be cautioned to install the right group of professionals to shepherd them through the process of establishing a QOF, and communication among those professionals will prevent mistakes and better ensure an optimal outcome.

Let’s explore two varieties of QOFs: the “Personal QOF,” in which between one and three taxpayers will contribute substantial sums toward a project; and the “Syndicated QOF,” in which a sponsor accepts capital from a sizable group of investors.

WHAT TO CONSIDER REGARDING ENTITY FORMATION

For both types of QOFs, the default choice of entity is an LLC taxed as a partnership. In a Personal QOF, even if only one taxpayer is providing capital, the introduction of a second member with a very small percentage of equity (0.1%, or perhaps even 0.01%) will render the entity a partnership for tax purposes and suffice for eligibility as a QOF. The only common scenario calling for a smaller QOF to be a corporation is if the taxpayer wishes to take advantage of both the OZ program and the Qualified Small Business Stock (QSBS) program at the same time; otherwise, corporations are simply less flexible than tax partnerships (i.e., multi-member LLCs) for smaller investments.

When taxpayers set up QOFs, they and their non-tax advisers typically make some elementary and avoidable mistakes. The first is that the QOF’s organizing documents as filed with the Secretary of State must contain a clause indicating the exclusive purpose of the entity is to serve as a QOF; if this requirement remains unmet by the end of the QOF’s first taxable year, the IRS could take adverse action upon examination, which may include decertification. The second is that the QOF’s governing agreement must contain a similar clause and supplemental provisions to better ensure continued compliance with the OZ program. The third is misunderstanding the timing behind QOF setup. Many taxpayers believe the QOF entity must elect for QOF status to begin upon the first month of the entity’s existence. On the contrary, the entity may elect for QOF status to begin in the month of the entity’s choice; similarly, the Treasury Regulations allow a pre-existing entity to elect QOF status beginning in the month a taxpayer selects on IRS Form 8996. To avoid the possibility of inadvertent timing failures, taxpayers should form QOF entities as early as practicable and customize the QOF election according to actual capital inflows.

SUPPORTING DOCUMENTATION FOR QOFs

When establishing both Personal QOFs and Syndicated QOFs, taxpayers would do well to include the right supplemental documents alongside the governing agreement and formation paperwork for the QOF itself. Typically, these documents include Subscription Agreements and routine corporate consents. While the OZ rules and regulations do not explicitly require them, Subscription Agreements and corporate consents help imbue the legitimacy of the QOF and the associated investment transactions, and this protection may make a significant difference in the event of a disagreement between the equity holders. The documents also provide a more thorough paper trail to better illustrate the nature and sequence of transactions before an objective observer, such as a lender or an auditor.

For Syndicated QOFs, another essential document is the Private Placement Memorandum (PPM). For Personal QOFs with multiple substantial investors, a Subscription Agreement typically includes some of the risk disclosures one might find in a PPM, but the provisions are not nearly as extensive. In a Syndicated QOF, the PPM must contain the traditional descriptions of the nature and perils of the various planned investments, but the document must also include entire sections devoted to the OZ program. The first of these sections would be a stand-alone description of the general history, intent, and policy behind the OZ program. The second would be an addendum to the narrative detailing the features of the QOF’s planned investment(s) laying forth how the OZ tax benefits could potentially enhance the after-tax returns and, concomitantly, the QOF’s ability to secure equity capital. The third would be a subsection of the risk disclosures, which would be further divided into two general categories: specific risks of deploying capital into QOZs, which are most often economically depressed areas of the United States; and unique risks posed by the tax rules and regulations of the OZ program itself, which requires careful compliance discussed in more detail below.

The aim of lining up all of the proper legal documents is to protect the QOF sponsor (for a Syndicated QOF) or the equity investors (for a Personal QOF) from lawsuits, adverse tax consequences, and unnecessary legal costs to correct prior mistakes. The old saw “an ounce of prevention is worth a pound of cure” rings as true for QOFs as it would in almost any other imaginable context. Once the attorneys have finished the paperwork required for initial setup, the spotlight shifts to the accountants and other tax personnel tasked with keeping the QOF in compliance with the program’s various requirements.

ONGOING COMPLIANCE FOR QOZBs AND QOFs

The first compliance hurdle is usually the deployment of invested QOF capital. The Treasury Regulations are quite generous with this topic, in keeping with the general theme of the Trump Administration’s desire for as much capital as possible to flow into OZs. The Regulations allow QOFs an extension of time to place contributed capital into QOZP. Even so, taxpayers should form and capitalize QOFs with their minds on a specific investment so as to avoid two adverse outcomes. The first and most obvious is the inability to find a suitable investment, which may not result in significant adverse consequences, depending on when and how the investment is unwound. The second is making a decision based not on the quality of a given project but the time constraints a QOF may face under the compliance requirements; cognitive biases can delude taxpayers into believing a certain proposition may be a better idea than it actually is, which would be a dangerous path in a tax program requiring profitability for taxpayers to be successful.

The easiest way to avoid any mishaps with compliance testing at the QOF level would be to form a QOZB in advance of a cash contribution (recall that QOZBs cannot be initially capitalized with property). If timed correctly, a QOF can extend the schedule for required deployment of capital by waiting out the duration of the new cash safe harbor and investing into a QOZB with the required business plan in place to toll the working capital safe harbor. For example, suppose a QOF is fully capitalized with cash investments on Jan. 1, 2021. The safe harbor allows a QOF until Dec. 31, 2021 to achieve 90% investment in QOZP. If the QOF forms a QOZB and invests all of its cash on hand into the QOZB on Dec. 30, 2021, the QOZB can claim the working capital safe harbor if the QOZB has a qualifying business plan on the date of receipt. The working capital safe harbor lasts 31 months, so the QOZB would have until as late as July 31, 2024 (and perhaps another 31 months if certain conditions apply) to fully spend down the capital contributions the parent QOF accepted more than 3 years earlier. This example illustrates why using a QOZB as the vehicle to hold any QOZ investment allows taxpayers to take advantage of a more favorable compliance regime for QOZBs than QOFs.

The only essential element that must be in place before funding a QOZB is the business plan detailing how and when the incoming cash will be spent. Once the QOF has formed and capitalized at lea