1. Hours Test. The first safe harbor requires that at least 50% of the services performed (as determined by hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the Qualified Opportunity Zone.
2. Payment of Services Test. The second safe harbor provides that if at least 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the Qualified Opportunity Zone, based on amounts paid for the services performed, the business meets the 50% gross income test.
3. Property & Management Test. The third safe harbor provides that a trade or business may satisfy the 50% gross income requirement if: (a) the tangible property of the business that is located in a Qualified Opportunity Zone and (b) the management or operational functions performed for the business in the Qualified Opportunity Zone are each necessary to generate 50% of the gross income of the trade or business.
4. Facts & Circumstances Test. Fourth, taxpayers not meeting any of the other safe harbor tests may satisfy the 50% requirement based on a facts-and-circumstances test if, based on all pertinent information, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the Qualified Opportunity Zone.
Reinvestment of Proceeds
Ninety percent of the assets of a Qualified Opportunity Fund (“QOF”) must be “qualified opportunity zone property.” Pursuant to the Proposed Regulations, a QOF has 12 months from the time of the sale or disposition of Qualified Opportunity Zone property or the return of capital from investments in relative stock or partnership interests to reinvest the proceeds in other Qualified Opportunity Zone property before the proceeds would not be considered Qualified Opportunity Zone property with regards to the 90% asset test.
Non-Opportunity Zone Real Estate
The Proposed Regulations provide that a business that purchases real property straddling multiple census tracts where not all of the tracts are designated as a Qualified Opportunity Zones may still be able satisfy the relevant business requirements as long as the unadjusted cost of the real property inside a Qualified Opportunity Zone is greater than the unadjusted cost of real property outside it.
Post – Death Treatment
The Proposed Regulations additionally address the treatment of a QOF investment in the event of an investor’s death. Specially, the Proposed Regulations provide that neither a transfer of the QOF investment to the deceased owner’s estate nor the distribution by the estate to the deceased owner’s legatee or heir would result in the loss of the QOF investment benefit.
Please see the Proposed Regulations in full here.
Tax Court Held Microcaptive Arrangement Not Valid Insurance
In a recent memorandum opinion, Syzygy Insur. Co., Inc. v. Commissioner, T.C. Memo 2019-34 (Apr. 10, 2019), the U.S. Tax Court held that a microcaptive insurance arrangement and its fronting carriers did not constitute insurance for federal income tax purposes and payments through a microcaptive insurance arrangement were not deductible as insurance premiums.
I.R.C. § 831(b) provides an alternative taxing structure for certain small insurance companies, typically referred to as microcaptives. If the company meets the requirements and makes the I.R.C. § 831(b) election, the company is only taxed on its investment income and premiums received are not taxable income. For I.R.C. § 831(b) to apply, the company must transact in insurance.
In determining whether the transactions at issue constituted insurance for federal tax purposes, the Tax Court considered the four criteria of insurance, i.e., risk shifting, risk distribution, insurance in the commonly accepted sense and insurable risk, in addition to the recent case Avrahami v. Commissioner. The Tax Court found that the captive failed to meet both the risk distribution and the insurance in the commonly accepted sense criteria.
Although the captive argued that it distributed risks with the fronting carriers through the arrangements with the respective reinsurance pools, the Tax Court found that the arrangements did not qualify as bona fide insurance for a number of reasons: (1) net premiums paid by the manufacturer to the fronting carriers were nearly equal to the amount of premiums ceded to the captive from the fronting carriers; (2) contracts between the manufacturer and the fronting carriers were not arm’s length contracts; and (3) premiums for the policy were not actuarially determined.
Moreover, whether an arrangement is considered insurance in the commonly accepted sense depends on a number of non-exclusive factors, and the Tax Court found that most of these factors did not support a finding that the arrangement was insurance in the commonly accepted sense. Specifically, the captive was not operated as an insurance company, none of the policies were timely issued and the unreasonableness of the premiums and the inadequacy of the claims process weighed against the captive.
Having determined that the arrangement did not have adequate risk distribution and was not insurance in the commonly accepted sense, the Court concluded the arrangement was not insurance for federal income tax purposes. Because the Tax Court held that the arrangement was not insurance, the premiums paid by the operating company were not deductible and those same premiums received by the captive were taxable income.
Finding that the owners of the captive relied on the advice of their certified public accountant in good faith, the Tax Court determined the accuracy-related penalties imposed by the IRS did not apply.
Note, the Tax Court’s result mirrors recent I.R.C. § 831(b) cases. Although some of the facts presented in Syzygy are unique, there is no question that risks associated with I.R.C. § 831(b) microcaptives continue to increase.