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
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