An Opportunity to Get Opportunity Zones Right

The 2017 OZ laws authorized states to designate selected census tracts with lower average-income levels. More than 8,700 opportunity zones were created, many of them in sparsely populated, remote locations where most entrepreneurs would be uninterested in starting up a new business and would never themselves want to live year-round. Fully 78 percent of all OZ investments have gone to just 5 percent of designated zones. There were probably three times the number of zones actually needed for meaningful results, many of them too isolated and others too small or unsuitable to be viable.

In practice, the tax benefits and structure of the OZ program were overwhelmingly tilted toward real-estate development. The incentives for businesses that actually make things were always a stepchild with their own separate rules. Most of the winning deals were construction projects already blueprinted and moving through the permitting stage. Those promoters and developers have now scored their windfall tax breaks, packed up and moved out after banking their profits and dismissing their work crews. Meanwhile, the perfunctory incentives and pickier rules for OZ businesses were so uncompelling in comparison that only a tiny fraction of the 2017-24 tax breaks actually went to operating companies still doing business today.

Despite these warts, some minor legislative surgery could sharply reduce the number of eligible zones while giving each state a per-capita-based right to designate a few other “bonus” census tracts where economic development makes the greatest sense. That could include selected downtown areas plagued with vacant office buildings begging for redevelopment. Governors could also use them sparingly as a discretionary tool to attract global manufacturers. Smarter rules would turbocharge companies that do more than sell burgers or wash cars. The crucial interlocking keys to OZ prosperity must be forged in Congress,but should then be handed off to empowered local officials who then follow a few discerning rules to certify a qualifying business and point it toward success.

Keeping in mind that the original purpose was to foster economic growth with sustained local employment, the first step for fixing the OZ laws is to tightly refocus the original IRS tax breaks for real-estate developers and partnerships. Congress should restrict these construction incentives to manufacturing, light industry and assembly-plant facilities; medical and scientific labs; and build-to-suit facilities anchored by qualified OZ businesses or small-business incubators. Moderate-income residential developments in these zones should also remain eligible for now, in light of national concerns about housing affordability.

Eligible projects should first be certified by a designated local agency as aligning with community economic development strategies. If approved under this system, insured municipal industrial revenue bonds to underwrite these new OZ-certified construction projects could thence be issued by the state or locality, with fully secured tax-exempt interest to be free of the federal alternative minimum tax. That would provide rock-bottom borrowing rates—with precious overhead-cost savings for OZ tenants—while also giving financial leverage to builders, business developers and OZ investors. Everything else should then become ineligible for these tax breaks except for operating OZ businesses.

A regulatory framework

Making that work will require some new rules. Here are some suggestions for a regulatory framework that could serve as the starting point for the inevitable legislative give and take:

To begin with, OZ tax breaks shouldn’t go to itinerant businesses without staying power or significant potential for long-term, well-paying employment. Eligibility should be focused only on incorporated companies with independent director majorities (not closely held companies, private partnerships or sole proprietorships) that must eventually pay federal corporate income taxes once they become profitable. Corporate subsidiaries must be ineligible; they are not independent small businesses and already have parental investment capital. Preferably, the qualifiers will also get a boost from their state’s or county’s own economic development programs and local startup incubators with help from the U.S. Small Business Administration; a legislative tie-in to strengthen local involvement is worth devising.

The new incentives should include only companies for which a substantial portion of the workforce—perhaps a third or more—will reside in the opportunity zone within two years, so that their paychecks are spent locally. After two years as an OZ company, most of the firm’s work products must be sold outside their own zone’s county. Their sales should be pulling nonresident dollars into their lower-income communities and not just recirculating local cash. No federal subsidies under these rules for local retailers and service firms.

To be eligible, a company should be certified by a qualified local or regional economic development agency using apolitical anti-fraud criteria. Companies’ owners must be disqualified from simply re-incorporating a business to sell themselves cheap stock and gain tax exemption; local officials would be better situated to sniff out such scams than Washington bureaucrats. Then, a 10-year package of new federal tax incentives can be provided that will attract entrepreneurs, investors and local workers.

Cost-beneficial tax incentives

For starters, qualifying companies could be exempted from federal income taxes for, say, seven years or until cumulative operating profits exceed $5 million, whichever occurs first. That’s taking a page out of the Harris opportunity economy playbook, but with a more limited focus on targeted locations and a fair upside limit: Most startups will not achieve profitability for several years, so the federal tax revenue hit would be negligible, especially in light of tax-loss carry-forwards allowed by law. No personal tax write-offs to owners and partners for operating losses and depreciation.

Presently, OZ investors can score an unlimited tax break. For company founders, OZ funds, angel and venture investors and the funds they customarily set up, Congress should standardize key tax exemptions for OZ businesses with a defensible common cap. For example, the maximum “angel jackpot” limits on tax exemptions under Section 1202 of the tax code could be doubled uniformly for investors in an OZ company who own a single-digit percentage of its shares themselves or indirectly through an angel fund, a venture fund or a qualifying OZ fund. Family holdings beyond 10 percent of the company should be ineligible for these OZ tax breaks. These same upside limits should also apply to allowable real-estate developments. That puts a sensible and equitable ceiling on today’s unlimited capital-gains tax exemptions while still providing coveted upside tax incentives.

For an OZ company’s first 100 employees who reside in a qualifying zone, the firm could issue 1099 tax forms that qualify them for an income-tax exemption of their payroll earnings up to the national median salary (presently $59,000) for perhaps four years. Employees and executives who meet the residence test could also be given the same OZ tax exemptions as other investors for gains on qualified stock options and likewise for employer grants into their employee stock ownership plan accounts. Resident-employee tax perks will bolster both the community and the company’s lower-cost path to profitability.

These new twists on the OZ concept would give workers and managers a powerful incentive to reside inside an opportunity zone and stay put, spend their money locally and make the gamble that their startup employer can achieve sustainable profitability. The top brass of expanding companies will face strong pressure to remain OZ-compliant with its workforce and sales composition and with its facilities’ locations—or lose out. States with income taxes should be required to adopt these federal exclusions or forego their OZ eligibility.

Opportunities for retirement savers and pensions

Individual investors anywhere with IRAs and 401(a) or (k), 403(b) and 457 accounts could also participate: Gains on OZ investments coming from something like 10 percent or less of such tax-deferred savings should enjoy the same eligibility and tax breaks. Tax rules can require such distributions to go into qualifying custodial accounts or investment funds devoted exclusively to OZ companies where the appreciation becomes tax-free. Given the failure risks of startup businesses, I’d encourage personal limits on both individual-company and total investments. Some permissive SEC waivers would be needed, of course.

To further broaden the investment base, public pension funds could be allowed a larger indirect minority interest through a diversified qualifying OZ fund. As tax-exempt investors, new OZ rules could permit pension fund managers to cash out their winners and glean transferable tax credits from their appreciated OZ investments, with institutional limits triple those for individual investors. Such credits could be purchased and redeemed by private investors based on half their applicable tax rates. That could provide pension funds with a kicker of as much as 20 percent of realized capital gains on top of their intrinsic profits from an OZ investment. That’s a win-win for both the IRS and pension stakeholders, and ideal size-wise for many municipal systems.

Such a coalition package of stronger, reformulated rules and tax incentives—with friendly features for middle-class investors and pension funds—would invigorate the original OZ concept and should appeal to both political parties with very minor budgetary impact. This can empower state and local governments, but it will take coordinated action by key interest groups to assemble a viable fix of this lopsided tax law.

With the national election only a month away, it’s unrealistic to expect that these fresh ideas will make it into the candidates’ platforms. But once the election is over, public officials and associations with an interest in local economic development can add these concepts to their legislative agenda in preparation for the Super Bowl of taxes coming up next year. Long-term cost-benefit analysis will support their case.

Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.

ABOUT THE AUTHOR:

Girard Miller is the finance columnist for Governing. He is a retired investment and public finance professional and the author of “Enlightened Public Finance” (2019). Miller brings 30 years of experience in public finance and investments as a former Governmental Accounting Standards Board member and ICMA Retirement Corp. president.

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