INSIGHT: Issuance of Pro-Rata Debt to Investors in Qualified Opportunity Funds

Under the qualified opportunity fund (QOF) rules, the owners of equity interests in the QOF, which are associated with eligible gains derived by the owner in the preceding 180 days, (qualifying QOF equity interests), are entitled to exclude the gain derived from those qualifying QOF equity interests after 10 years of ownership. However, generally 90% of such eligible gains themselves become taxable in 2026.

These QOF rules may favor the sale to investors by a newly formed pass-through partnership QOF or subchapter S corporate QOF of a pro-rata combination of QOF debt and qualifying QOF equity interests, rather than solely qualifying QOF equity interests. That is because many prospective investors have enough cash available to make a significant combined debt and qualifying QOF equity investment, but lack the unrealized or recently recognized eligible gains needed to make such combined investment in the form of only a qualifying QOF equity investment. Even if they have such unrealized eligible gains to make additional qualifying QOF equity investments, many prospective QOF investors may lack the desire to pay 2026 tax on 90% of those unrealized gains.

Most investors probably view the major benefit of the QOF program to be the ability of the investor to exclude, after 10 years, the investor’s gain. If the debt service on the pro-rata debt issuance is immaterial, or if the QOF would, absent a pro-rata debt issuance, currently distribute almost all the cash used to make the debt service payments anyway, the magnitude of this 10 year benefit may not be significantly affected by whether the QOF is capitalized purely by common equity, or rather by common equity and pro-rata debt.

C Corporate Preferred Stock

Where a C corporate QOF is the issuer, that C corporation could also consider a similar strategy of issuing pro-rata preferred stock (rather than pro-rata debt), intended to be a QOF non-qualifying interest funded from other than eligible gains, and common stock. The common stock would be intended to be a qualifying QOF equity interest to be funded from eligible gains. However, the non-deductibility of preferred stock dividends by a taxable C corporation, as compared to the general deductibility of interest, often makes debt a more attractive alternative for C corporate QOFs.

Pass-Through QOF Preferred Interests

Such a pro-rata preferred stock approach would not be possible for an S corporation QOF. That is because, under the second-class-of-stock prohibition, issuance of preferred stock would disqualify the QOF’s S corporation status.

Such a pro-rata preferred return (or guaranteed payment on capital) partnership interest approach would also apparently likely not be feasible in the typical case of QOFs organized as partnerships (including multiple member LLCs). That is because Treasury Regulation Section 1.1400Z2(b)-1(c)(6)(iv) applies if a QOF partnership issues a QOF partnership interest in an amount in excess of the purchasing partners’ eligible gain. Under that regulation, the QOF partner is deemed to be holding two separate interests in the partnership for purposes of Section 1400Z-2, namely, a qualifying interest to the extent of eligible gain, and a non-qualifying interest for the remainder. However, under that regulation, irrespective of purported allocations of a preferred return to a portion of the partnership interest, and a common return to a portion of the partnership interest, all Section 704(b) allocations of income to the partnership interest between the qualifying interest and non-qualifying interest are apparently deemed to be made based on the relative capital contributions.

The preamble specifically rejects an allocation between the qualifying and non-qualifying interest based on each investment’s share of the partnership agreement’s allocation of the gain with respect to the property. That is, under Treas. Reg. Section 1.1400Z2(b)-1(c)(6)(iv), the portion of the consideration paid for the deemed separate preferred portion of the QOF equity investment attracts a pro-rata-share of the investor’s 10 year gain attributable to the common portion under the terms of the partnership agreement, and, if such preferred interest is not an acquisition from eligible gain, makes such portion ineligible for the 10 year gain QOF exclusion. Treas. Reg. Section 1.1400Z2(b)-1(c)(6)(iv) does not apply where the QOF partnership equity is entirely a qualifying QOF equity interest issued solely for eligible gain, even where the QOF partner owns QOF true partnership debt.

Example

For example, suppose a QOF is to be formed to invest $1 million in qualified opportunity zone property. Suppose there are four QOF investors, each of which has exactly $50,000 of eligible gain within the preceding 180 days, and each has $250,000, including $50,000 attributable to the qualifying eligible gain transaction, in cash available for the QOF investment. Suppose the QOF has one class of equity interest.

Under the mixed funds investment rules of Treas. Reg. Section 1.1400Z2(a)-1(f)(1), if the QOF issues, in exchange for $250,000, a 25% QOF equity interest, to each of the four investors, then 80% ($200,000 in excess of eligible gain / $250,000 total equity interests purchased) of each of the four investors’ 25% QOF interests will be non-qualifying. Thus, as to each investor, 80% of the potential benefit of the 10-year step-up in basis will be lost.

By contrast, if the QOF issues, in exchange for $250,000, a 25% QOF common equity interest for $50,000, the amount of each investor’s eligible gain, and a market rate interest- bearing $200,000 face note to each of the four investors, and which note is respected as debt for federal income tax purposes, then all the QOF common equity interests can be qualifying QOF equity interests. Thus, 100% of the 10-year step-up in value will be available.

Third-Party Debt

In lieu of using pro-rata shareholder debt, the QOF can achieve the same favorable tax results for its equity holders, with far more tax certainty, by issuing that debt to unrelated creditors. As a practical matter, however, third-party lenders will seek to recover their general overhead and specific due diligence and other costs, and so will charge interest rates exceeding the interest rates currently earned by the QOF investors on the funds they use to buy the pro-rata debt. In NA General Partnership v. Commissioner, the U.S. Tax Court indicated that the fact that an unrelated lender would have charged higher interest rates than were actually charged by a pro-rata equity lenders does not necessarily cause the pro-rata debt to be recharacterized as equity, so long as the terms of the pro-rata purported debt are not “a patent distortion of what would normally have been available to the debtor in an arm’s-length transaction.”

Possible IRS Attacks

Most QOFs are probably formed as partnerships. One possible IRS attack on the use of pro-rata debt by a partnership QOF could be to seek to recharacterize the debt as partnership interests under traditional thin capitalization and similar analyses. Treas. Reg. Section 1.1400Z2(a)–1(b)(12)(i), through a cross-reference to the time-value-of-money regulations, refers to such general tax doctrines to determine whether an instrument issued by a QOF at original issue is debt. If the purported debt instrument issued to the partner, who also is investing in a qualifying QOF equity interest, is itself also viewed as a partnership interest, Treas. Reg. Section 1.1400Z2(b)-1(c)(6)(iv) will correspondingly dilute the 10 year gain benefit. The IRS has had some success in recharacterizing partners’ advances to partnerships as equity.

Other QOFs may be organized as S corporations. Promissory notes they issue pro-rata to their stockholders will typically qualify for the S corporation straight debt safe harbor. Treas. Reg. Section 1.1361-1(l)(5)(iv), although predating the QOF rules, indicates that such a safe harbor note is “generally treated as debt and when so treated is subject to the applicable rules governing indebtedness for other purposes of the Code.”

Moreover, outside of situation where the QOF is classified as a partnership and correspondingly governed by Treas. Reg. Section 1.1400Z2(b)-1(c)(6)(iv), even if the QOF notes are recharacterized as QOF equity, there is some doubt as to whether that recharacterized non-qualifying equity interest would dilute the 10-year step-up of the designated QOF equity interest. The QOF notes, as recharacterized, would be a preferred, limited fixed distribution right, equity interest. If there were no accrued but unpaid returns, they would ordinary be valued at about their face, and therefore not detract from the 10 year step-up in the designated qualifying QOF equity interests

Economic Substance and Anti-Abuse

The IRS might argue that capitalization of a pro-rata combination of debt and equity violates the economic substance doctrine of Section 7701(o)(1). The IRS could note that its principal purpose is to reduce the proportion of the QOF’s initial funding, from investors seeking a full 10 year step-up on the appreciation generated from the funds they supply to the QOF, which must be sourced from eligible gains.

The 2010 Joint Committee Technical Explanation of Section 7701(o), although issued before the QOF rules, states that Section 7701(o) does not apply to alter the tax treatment of “certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages [including] the choice between capitalizing a business enterprise with debt or equity.”

The application of the general QOF anti-abuse rule, Treas. Reg. Section 1.1400Z2(f)-1(c)(1), is uncertain. That general rule describes the purposes of Section 1400Z-2 in terms of generating investments in QOFs, and does not list as a purpose of Section 1400Z-2 unlocking eligible gains for federal taxation of 90% of such gains in 2026.

However, a special QOF anti-abuse rule, Treas. Reg. Section 1.1400Z2(f)-1(c)(2), and illustrative Example (1) of Treas. Reg. Section 1.1400Z2(f)-1(c)(3), does describe as a violation of the anti-abuse rule the creation of eligible gains by a partnership from appreciated property contributed by foreign partners whose direct gain would not be eligible gain. This suggests that the IRS does indeed view unlocking eligible gains by 2026, and triggering 2026 recognition of 90% of such eligible gains used for a qualifying QOF equity investment, as a purpose of Section 1400Z-2, which purpose would arguably be thwarted by the QOF issuing pro-rata debt rather than qualifying QOF equity investments. Thus, the IRS willingness or ability to seek to treat the creation of pro-rata debt as an abuse is uncertain.

Further, in situations where the owners of the qualifying QOF equity interests could demonstrate the likelihood that an unrelated lender could have been located to buy the QOF debt, the actual issuance of the debt pro-rata to the qualifying QOF equity interests instead creates no additional QOF tax benefits that would have been available in that hypothetical unrelated lender situation.

A related issue is whether, if ineligible preferred partnership interests in a QOF partnership are held pro-rata among QOF partners who are related to, but different from, the QOF partners owning the common partnership interests, the IRS could view this as an abusive circumvention of the rule in Treas. Reg. Section 1.1400Z2(b)-1(c)(6)(iv), applicable where the common and preferred partnership interests are both held by the identical QOF partner.

Other Consequences of Pro-Rata Debt

To the extent the QOF would not, absent a pro-rata debt issuance, distribute a material amount of cash used to make the debt service payments anyway, but rather would reinvest at the QOF level, an evaluation would have to be made as to the after-tax effects of such reinvestment by the QOF as compared to the after-tax effects of such debt service being used by the QOF’s creditor-investors. Further, the use of pro-rata debt rather than equity creates a QOF level interest cost and an equal amount of QOF equity investor interest income. QOF investors must consider any potentially adverse timing or characterization mismatch of their QOF interest income and their share of the QOF’s interest expense, as mitigated by any applicable “self-charged interest” regulations.

Conclusion

In structuring a QOF which seeks to raise money from investors who have sufficient cash, but too little eligible gain, to entirely satisfy the QOF’s cash needs, organizers could consider a pro-rata issuance of qualifying QOF equity interests and debt. The potential application of the QOF anti-abuse rules to this approach is uncertain.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.