CRYSTALLIZATION OF THE PROMOTED INTEREST : A STRATEGY FOR OPPORTUNITY ZONE SPONSORS
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By crystalizing the promoted interest , the distribution waterfall is changed from a layered hurdle approach to a straight up percentage interest between the investors and the sponsor .
paying off the debt ). If the sponsor made the crystallization election at such time , then the distribution waterfall would result in the sponsor having a percentage interest of 10 %, and the QOF investors having a percentage interest of 90 %. In the eleventh year , the property has decreased in value to $ 26 million . If the property were sold at such time without a crystallization election having been made , then the sponsor would receive $ 1.2 million of liquidation proceeds ( after the loan is paid off ), but would receive $ 1.6 million had a crystallization election been made .
The same analysis can be undertaken with respect to refinancing the asset and distributing the excess proceeds . Assume that the asset was refinanced in the sixth year after the crystallization election was made in the fourth year , and the excess proceeds for distribution are $ 4 million . Without the crystallization election , all of the excess proceeds would be distributed to the QOF investors . With the crystallization election , the sponsor would receive $ 400,000 of the $ 4 million of excess proceeds .
The Treasury Regulations provide a specific set of circumstances allowing for a revaluation of assets ( resulting in a book-up of the capital accounts ). It remains unclear as to whether the making an election to crystalize the promote allows for such a book-up of the capital accounts of the members / partners . As a result , a sponsor should consider negotiating with the investors for a book-up of capital accounts , or to manufacture a transaction , such as a small redemption at the time of the crystallization election , where it is clear that a book-up of the capital accounts can occur . At the very least , the sponsor should negotiate a provision to receive mandatory distributions in an amount so that its direct and indirect equity holders can satisfy their income tax obligations from an allocation of taxable income from the entity .
Because of the required 10 Year Holding Period , sponsors should consider negotiating with investors for an election to crystalize the sponsor ’ s promoted interest . This freezes the value of the promoted interest to reduce the impact of the fluctuations that could occur during the 10 Year Holding Period . Still , investors may push back on this request for a number of reasons including with respect to having a revaluation of the assets ( and a corresponding book-up of capital accounts ). In any event , the sponsor should make sure that it obtains tax distributions from the entity because of the potential for phantom income .
TAX ISSUES
The negotiation between a sponsor and an investor with respect to crystallization election often involves the resolution of an income tax issue . This tax issue depends upon whether the assets of the QOZB can be revalued ( resulting in a corresponding book-up to the capital accounts of the partners / members ) as a result of the crystallization election .
Sponsors often use forced allocations in their applicable limited liability company or limited partnership agreements . This means that profits or losses generated in each year of the entity will be allocated in a manner to each member / partner , after taking into account any distributions and contributions , so as to bring the capital accounts for each member / partner to the amount that such member / partner would receive in a hypothetical liquidation of the entity each year . Without a revaluation of assets ( and the booking-up of the capital accounts of the members / partners ), ordinary income could be disproportionately allocated to the sponsor over the 10 Year Period to increase its capital account to the amount of cash it would receive under a hypothetical liquidation of the entity . However , a book-up of capital accounts could also result in more ordinary income being allocated to the QOF investors during the same period .
Marc Schultz ' s practice is concentrated in federal , local and state taxation matters . Schultz chairs Snell & Wilmer ’ s Tax Credit Finance Group and Renewable Energy Group , and founded and co-chairs the firm ’ s Opportunity Zones and Funds Industry Group . He is a regular speaker and panelist on the subject of tax credit finance and the Opportunity Zone incentive , has written numerous articles and been quoted in various publications with respect to these subject areas . Schultz is currently representing investors , fund sponsors , and developers with respect to the Opportunity Zone program . He was involved in the advising and drafting of a number of comment letters submitted to the U . S . Department of the Treasury and the IRS regarding the Opportunity Zone proposed regulations .
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