As we enter into the third year of the federal Qualified Opportunity Zone (QOZ) program we have a slightly clearer picture of how taxpayers are using this flexible and impactful program.
Not surprisingly, the vast majority of early Qualified Opportunity Funds (QOFs) formed through Dec. 31, 2019 are focused on real estate projects as they begin directing their investments into Qualified Opportunity Zone Businesses (QOZBs). Preliminary reports in 2019 indicated that only about 5% of public QOFs were focused on operating businesses. However as the Treasury Department provided more guidance through new sets of proposed and final regulations, taxpayers and the OZ community have come to realize that using the OZ program for operating businesses can yield even greater long-term benefits for both OZ communities and investors compared to real estate projects alone.
OZ PROGRAM PARTICIPATION
To participate in the QOZ program, the taxpayer must generally roll all or a portion of their short-term or long-term capital gain into a QOF within 180 days of the taxpayer being required to report the tax gain. The Final Regulations further liberalized when the 180-day period begins for various types of gains and the entity type generating the gains. The QOF must invest the deferred gains into undeveloped or developed real estate, a new or existing QOZB, or directly into other qualified QOZ Business Property (QOZBP).
Effective Jan. 1, 2018 through Dec. 31, 2026, Individuals, C and S Corporations, REIT’s, partnerships and other pass-through entities can sell their appreciated capital assets and elect to reinvest the resulting capital gain income into a QOF, in order to defer the tax on those gains for up to seven years (Dec. 31, 2026 when the deferred gain is reported) and also permanently exempt up to 15% of the original federal gain (after 7 years) and 100% of the post-reinvestment gain (after holding the QOF interest for at least 10 years).  QOF’s established after 2019 will not meet the seven-year holding period by Dec. 31, 2026 and will therefore only receive a 10% tax basis step-up. It is also worth noting that taxpayers residing or investing in certain states, including: California, Mississippi. Massachusetts (non-corporate taxpayers) and North Carolina must factor in their state tax exposure due to non-conformity with the federal OZ rules. Where possible, Section 1031 transactions may be preferable, or installment sales, with an election out of installment sale treatment for federal purposes to allow OZ reinvestment for federal and for state an installment sale deferral.
UTILIZING THE OZ PROGRAM FOR ACTIVE BUSINESSES
From the OZ investor perspective, operating business investments offer benefits above those available to OZ real estate investments, including the following: less entitlements, less capital outlay, arguably less risk, quicker path to revenue generation, ability to alter business plan, mobility and often a higher multiple upon exit.
As a result, serial entrepreneurs and investors with connections to successful business operators should consider operating businesses as a highly attractive OZ business investment.
While the initial OZ statute and first set of Treasury Regulations focused primarily on real estate projects as re-investment options, the second set and final regulations certainly clarified that operating businesses are appropriate re-investments for deferred gain. The regulations also provided more liberal reinvestment periods and other more flexible provisions as compared to real estate projects.
Let’s analyze the various ways an OZ investor might acquire an operating business. We will compare the three general ways for qualifying a business under the OZ rules in order of easiest to most complex.
Keep in mind the core requirements for a business to qualify as a QOZB:
1) At least 70% of the QOZB’s assets must be QOZBP  primarily used in OZ census tracts 
2) At least 40% of all QOZB intangibles must be used in OZ census tracts 
3) At least 50% of the QOZB income must be OZ-sourced income, determined under a three “safe harbor” set of rules, or an alternative facts-and-circumstance test, contained in the second set of regulations. 
There is no minimum amount required to invest in an operating business, and taxpayers can invest both qualified deferred gain and after-tax money into the business; however, only the qualified deferred gains invested into the QOF/ QOZB are eligible for the various OZ tax benefits.
ESTABLISHING A NEW BUSINESS WITHIN AN OZ CENSUS TRACT
Establishing a new business (or starting a new division which offers a new product or service) within a single or multiple OZ census tracts is the most straightforward way to qualify an operating business under the code and regulations.
The reason that a new start-up business is the cleanest way to meet the OZ qualifications is that the tangible property acquired for use in the new business will generally be treated as QOZBP unless the property had been used in an OZ census tract before acquisition or was acquired from a Related Party (over 20% common ownership).
Leased assets, even if acquired from a related party, are treated as first used by the acquiring taxpayer, however, special Related Party lease rules (which are much less onerous than the Related Party rules applicable to purchased assets) must be followed to ensure QOZBP classification. Another possible method for getting assets into a new business is for the QOF investor to contribute qualifying assets into the QOF, in which case the Related Party rules are not applicable. The downside of a contribution of assets (in lieu of cash) to a QOF is that no eligible gain is triggered for OZ reinvestment and the contributing taxpayer’s eligible QOF reinvestment is limited to the lower of their tax basis in the property contributed or the fair market value. The difference between fair market value and tax basis creates a “Mixed Fund”. The secondary problem is that the contributed asset is not treated as QOZBP since it was not “purchased” after 2017.
In virtually all cases, the operating business will be owned by the QOZB rather than the QOF. This is to allow the operating business to obtain the favorable general 31-month or the newly introduced 62-month “start-up” business Working Capital Safe Harbor, and also secure the more liberal 70% QOZBP requirement vs. the more stringent 90% requirement for QOF’s. This means the QOZB can hold up to 30% non-QOZBP – or “bad assets” without subjecting the QOF to penalties for failing the semi-annual qualification testing. 
ACQUIRING OR RELOCATING AN EXISTING BUSINESS INTO AN OZ
Moving an existing business into an OZ census tract can offer a number of complexities, but with proper planning it can be done.
If the business is owned by more than 20% of the QOF equity owners, then the assets brought into the QOF or QOZB will be non-QOZBP. This is not fatal to qualifying the business provided the investors plan on investing material amounts into the transferred business.
For example if the QOZB acquires business assets not previously used in an OZ census tract from a related party for $500,000, such assets are non-QOZBP, but provided this amount remains less than 30% of total QOZB assets, the QOZB can