QOFs: Essential Takeaways for Founders and Investors in Startups
Qualified Opportunity Funds (QOFs) offer investors a range of potentially massive tax benefits, but this tax regime is far from simple. Passed as part of the 2017 Tax Reform, QOFs were originally viewed as primarily for real estate investors. However, that changed with the latest set of regulations released last week: QOFs can have even bigger potential tax benefits for startups and established FinTech companies.
Sponsored by a bipartisan group, Congress passed the QOF rules to stimulate investment in economically challenged regions. Under this legislation, each state earmarks certain “census tracts” as Qualified Opportunity Zones (OZ). Detailed maps showing OZs for each state are available online.
As I’ve discussed, the QOF tax benefits can be simplified into three categories: (i) defer any tax paid on capital gain until as late as December 31, 2026; (ii) reduce capital gains tax by as much as 15% when the QOF investment is held at least 7 years; and (iii) exclude any capital gains from a QOF investment if held for at least 10 years. Below, I summarize the most important takeaways for investors in FinTech companies and startup founders. I also compare the QOF rules for another potentially big tax benefit that can be particularly valuable for founders: the exclusion of gain from small business stock under Section 1202.
A. QOF Rules for Startups
You must have capital gain.
The QOF tax benefits are only available if an investor has capital gain. The investor must realize the capital gain before making the investment. But there is no need to trace the capital gain proceeds to the cash or property used to make the QOF investment. It can be long-term or short-term capital gain and, importantly, it need not be net capital gain. You can invest capital gain you realize on the sale of an investment even if, in the same year, you recognize a capital loss that offsets the gain.
After realizing the capital gain, investors have 180 days to invest in a QOF. If an investor invests more than their capital gain, the investment will be bifurcated. The investor gets the QOF tax benefits up to the amount of capital gain, while the excess is not treated as a QOF investment.
Founders, beware. Even if you have capital gain, if you receive stock as compensation for services, the stock will not qualify for the QOF tax benefits. The stock (or other equity) must be purchased for cash or property.
- The business must be in an OZ.
With the latest set of regulations, we have guidelines to determine what it means for a business to be in an OZ. There are several safe harbors:
- Over 50% of all services are provided from a location in an OZ, based on service hours.
- Over 50% of all services are provided from a location in an OZ, based on the amount paid for services.
- The business generates at least 50% of its gross income from operations conducted in an OZ.
Under these rules, a qualified business can easily operate both inside and outside the OZ. The location of the business’s customers and clients doesn’t matter. One example in the preamble is a software startup in a campus in an OZ, which sells its software product through the internet to customers across the country and internationally.
Besides satisfying one of the safe harbors, the business must also use at least 40% of its intangible property in an OZ. It’s unclear how the IRS will locate use of intangible property. However, by setting the threshold so low, this will not be a significant hurdle for many businesses.
A business must also satisfy certain requirements for tangible property, but these requirements will be easy for many startups to satisfy by newly purchasing or leasing office equipment and other equipment and property that the startup uses in its business.
- Holding Period
To qualify for excluding gain from an investment in a QOF, the investor must hold the investment for a full 10 years. There is nothing stopping an investor from selling a QOF investment early. But if the investor sells before the 10-year mark, any gain from the QOF investment will be taxable.
B. Comparing QOFs with the Small Business Stock Exclusion
Under Section 1202, investors and founders of startups can potentially qualify for excluding gain from the sale of small business stock. This Section 1202 exclusion can be a powerful tax benefit, particularly for founders of startups. There is a potential overlap in the QOF gain exclusion and the Section 1202 gain exclusion. Which one is better? What follows is a description of some of the key differences founders and investors need to remember, summarized below in the table.
- Type of Business. The exemption from capital gains tax for small business stock is not available for certain types of businesses. Many services don’t qualify, including engineering, accounting, law, and health. Financial services are also excluded, including banks, insurance, leasing, investing and brokerage businesses. By comparison, QOF benefits are only restricted for a handful of “sin” businesses: gambling, liquor stores, massage parlors and golf courses. Given the restrictions under Section 1202, the QOF tax rules will be of particular interest for FinTech startups, financial services and health businesses excluded from Section 1202 but that potentially qualify for QOF.
- Type of Investor. The section 1202 exemption is not available for C-Corporations. The QOF tax benefits are available for C-Corporations, S-Corporations, LLCs, and partnerships.
- Type of Issuer / Investment. The small business stock gain exclusion is only available for stock of a C-Corporation. There is no restriction for the QOF tax benefits. QOFs may invest in stock, LLC member interests, and partnership interests.
- Gain Limit. The small business stock exemption is limited to the greater of 10x the investment or $10 million. There is no such restriction under the QOF rules.
- Business Size Limit. The small business stock exemption is only available if the business has less than $50 million of gross assets. There is no such limitation under the QOF rules.
- Holding Period. The small business stock gain exclusion requires a holding period of at least five years compared to 10 years for the QOF tax exclusion.
- Originally issued. The small business stock gain exclusion is not available for stock acquired in secondary transactions. The stock must be “originally issued” by the C-Corporation. There is no such restriction under the QOF rules.
- Issued for Services. The small business stock gain exclusion is available for founders who receive stock in exchange for services. However, equity issued in exchange for services does not qualify for the QOF tax benefits. Instead, the stock or partnership interest must be acquired for cash or property in an amount equal to the investor’s deferred capital gain.
- Geographic. In contrast to the requirement that businesses be in an OZ to qualify for the QOF tax benefits, there are no such geographic constraints for the small business stock exclusion.
Comparison of Qualified Opportunity Fund and
1202 Small Business Stock Gain Exclusion
Qualified Opportunity Fund
|Type of Business||Many services (law, health, engineering, accounting, financial services, banks, insurance, leasing, investing, brokerage) are restricted.||Only “sin” businesses are restricted (liquor stores, gambling, massage parlors, golf courses).|
|Type of Investor||C-Corps cannot benefit.||No restriction.|
|Type of Issuer / Entity||Only stock of C-Corp.||No restriction.|
|Limit on Gain Exclusion and Business Size||Up to greater of $10 million or 10x investment is excluded; at time of investment, business must not have more than $50M of gross assets.||No limit.|
|Original Issuance of Stock vs. Secondary Purchase||Only originally issued stock qualifies.||No restriction.|
|Holding Period||5 years||10 years|
|Equity Compensation||No restriction.||Only investments for cash or property, not services.|
|Geography||No restriction.||Must be located in OZ.|
In many respects, the QOF tax benefits are more flexible than the rules for excluding gain from small business stock. They are available for virtually any business and there is no limit on the amount of gain to be excluded or the size of the business at the time of the investment. The benefits are available for stock of C-Corps and S-Corps and partnership interests. And investors need not acquire newly issued equity: the benefits are available for stock or partnership interests acquired through secondary transactions.
The QOF tax rules are of particular interest for FinTech companies. There is no size restriction or requirement for stock to be originally issued under the QOF rules. And the QOF benefits are available for C-Corps. This makes the QOF tax benefits flexible enought to apply to established FinTech companies, and not just startups.
Many FinTech startups won’t qualify for the small business stock gain exclusion under Section 1202 because the benefit is not available for financial services. No such exclusion applies to QOFs. And just like many software and tech startups, FinTech companies have considerable flexibility on their physical location. But the disadvantages of QOFs are significant.
First, you need to be in an OZ. While the rules provide flexibility to set up offices both inside and outside an OZ, the geographic constraint remains.
Second, no capital gain, no QOF.
Third, the QOF capital gain exclusion requires a ten-year holding period, compared to five years for the small business stock gain exclusion. That’s a very big difference in the world of startup investing.
Fourth, with QOFs, founders need to exercise extreme caution. The QOF benefits are not available for equity compensation. To qualify as an investment in a QOF, the stock, LLC membership interest or partnership interest cannot be received in exchange for services.
Investors in startups, and particularly in FinTech, need to consider the QOF rules. For investors and startups with enough flexibility to take advantage, this could be the opportunity of a lifetime.