Opportunity zone penalties: What constitutes reasonable cause?

Editor: Michael Wronsky, CPA, MST

The Tax Cuts and Jobs Act (TCJA), P. L. 115-97, opened an array of opportunities in income and estate tax planning through the qualified opportunity zone (QOZ) provisions. However, an investor is able to benefit from the tax savings only when adhering to the regulations. Due to the rising costs of materials, capitalization rates, and interest rates, it has become increasingly difficult for fund managers to adhere to the rules and pass the testing requirements imposed by Regs. Sec. 1. 1400Z2(d)-1. Many investors have been forced to pivot from their original plans or halt or delay their construction. This is when investors and fund managers should reexamine the regulations related to reasonable cause for penalty abatement to determine if they are eligible for the relief.

If a qualified opportunity fund (QOF) fails the 90% investment standard under Sec. 1400Z-2(d)(1), a penalty is imposed under Sec. 1400Z-2(f)(1) for each month the QOF failed to meet the test. Although failing to meet the standard will not result in a QOF’s termination, the penalty can be substantial. The assessed penalty will be equal to the amount of the shortfall multiplied by the underpayment rate established under Sec. 6621(a)(2), which is the established short-term applicable federal rate plus 3%. However, a taxpayer may be able to avoid the penalty for failing to pass the QOF asset testing if the taxpayer can establish that it had reasonable cause for its failure.

Reasonable cause: Definition and penalty guidance

The Internal Revenue Code and Treasury regulations do not explicitly define “reasonable cause.” The Supreme Court has described reasonable cause in the context of Sec. 6651 as “ordinary business care and prudence” (Boyle, 469 U.S. 241, 246 (1985)). In contrast, the Court defines “willful neglect” as “a conscious, intentional failure or reckless indifference” (id. At 245).

The IRS’s Penalty Handbook in the Internal Revenue Manual (IRM) expands on what can constitute reasonable cause. “Reasonable cause relief is generally granted when the taxpayer exercised ordinary business care and prudence in determining their tax obligations but was nevertheless unable to comply with those obligations” (IRM §20.1.1.3.2(1)). The Penalty Handbook also establishes factors to consider in determining whether the imposition of a penalty is appropriate based on reasonable cause (IRM Part 20.1). The Handbook, for example, provides that a taxpayer establishes reasonable cause when there is a:

1. Death or serious illness of the taxpayer or a death or serious illness in the taxpayer’s immediate family. In the case of a corporation, estate, trust, etc., the death or serious illness must have been of an individual having sole authority to execute the return, make the deposit, or make the payment at issue or of a member of such individual’s immediate family (IRM §20.1.1.3.2.2.1(1)).

2. Unavoidable absence of the taxpayer. In the case of a corporation, estate, trust, etc., the absence must have been of an individual having sole authority to execute the return, make the deposit, or make the payment at issue (id.).

Furthermore, the Penalty Handbook states, “Penalties advance the mission of the IRS when they encourage voluntary compliance” (IRM §20.1.1.2.1(5)). Also, penalties cannot be imposed for the purpose of generating additional revenues: “Although penalties support and encourage voluntary compliance, they also serve to bring additional revenues into the Treasury and indirectly fund enforcement costs. However, these results are not reasons for creating or imposing penalties” (IRM §20.1.1.2.1(4)).

The QOF asset test: Reasonable-cause penalty abatement

The factors mentioned above should be considered when a QOF fails the 90% asset test. A QOF can request penalty abatement due to reasonable cause under Sec. 1400Z-2(f )(3). The need to request relief can arise from the many circumstances that cause a QOF to fail the 90% asset test.

One of these is by holding too much cash on hand, which could result from not finding a suitable investment within an opportunity zone within the six months of receiving an eligible gain investment. Holding excess cash at a QOF or QOZ business level can cause the entity to fail its asset testing requirements within a given year. Although these situations may be due to the economy and therefore out of the QOF’s control, in order to establish reasonable cause, the QOF would need to demonstrate that it exercised reasonable business care by pursuing multiple options.

For example, a QOF could demonstrate it exhausted all its efforts to find an appropriate investment in a QOZ property but was not able to invest due to the deal not making sound economic sense. Explaining the efforts (which might include hiring an adviser to search for high-quality opportunity zone investments, as not all such investments are the same) is one way to illustrate reasonable cause. This process should be documented and illustrate how every opportunity was analyzed to illustrate why the QOF ultimately did not invest in the project.

Additionally, a QOF could demonstrate reasonable cause if a key person experienced health issues that prevented them from carrying out an investment within the QOF where, due to absences and their inability to work related to health issues, the key person was unable to find a suitable investment in an opportunity zone within the testing period. The extended search to find a high-quality investment was not due to anything within the key person’s control and would demonstrate they exercised ordinary business care and prudence by exercising a thorough and diligent search.

The discussion above presents just a few of the many obstacles a QOF may face as the market continues to change. Tax advisers can aid clients to determine whether their QOF could be subject to a penalty and whether any tax planning considerations can be used to avoid such penalties.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.