Opportunity Zone Magazine Volume 1, Issue 3 | Page 13

HOW DO I START MY OWN QOF? 13 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 The entity may elect for QOF status to begin in the month of the entity’s choice. 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 OPPORTUNITYZONE.COM