Qualified Opportunity Funds: Inspector General Recommendations and the Response from IRS Management

With contributions by Auyon Rahman of Summit Consulting

In our first post of this series, we reviewed the watchdog report by the Treasury Inspector General for Tax Administration. In this post, we look at the eight recommendations made by the Inspector General, the response from IRS management, and the implications for Qualified Opportunity Fund administration.

Qualified Opportunity Zones have proven exceptionally popular as an investment vehicle since their inception in December 2017. The tax incentive has been so well received by investors that billions were invested even before final IRS regulations were issued, and investments continued during the global COVID-19 pandemic. In fact, almost 6,200 Qualified Opportunity Funds (QOFs) filed IRS Form 8996 by the end of 2020.

As sometimes happens with new tax regulations, the Treasury Inspector General for Tax Administration (TIGTA) conducted a recent audit and found areas for administrative and procedural improvements to ensure the tax incentive achieves its legislative goals. The report issued by TIGTA made eight recommendations to the IRS to improve Opportunity Zone compliance procedures.

What the Audit Found

The TIGTA report examined tax filings, both paper and electronic forms, for tax years 2018 and 2019. For the 2018 tax year, the first year that the incentive was available to investors and before IRS regulations were issued, the Inspector General examined 1,491 tax filings. For tax years 2019 and 2020, the TIGTA report showed significant deficiencies in properly completing Form 8996 and Form 8997. Below are the key findings of the TIGTA report in summary.

• For tax year 2018, 37% of the 1,491 tax returns from QOF partners or directors (filing Form 8996 along with their corporate tax returns) did not file Form 8996 in tax year 2019. To remain in compliance, Form 8996 must be filed annually throughout the active life of the QOF.
• A significant number of investors in QOFs either did not return Form 8997 with their annual individual tax returns or returned incorrectly completed forms. Form 8997 is intended for individual investors to list capital gains invested in each QOF.
• Form 8997 did not require individual investors to supply their tax identification number, which made the process of cross-checking these forms against individual returns unnecessarily difficult.
• Many QOFs invested in other QOFs. While this is technically permissible under the regulations, an investment from one QOF in another does not contribute to the QOF’s requirement to invest at least 90% of its eligible gains in Qualified Opportunity Zone Property. QOFs cannot invest in other QOFs as a means to preserve their tax benefit.

While the TIGTA report showed significant deficiencies among investor tax filings, it also showed that IRS systems and processes need improvement. For example, the TIGTA concluded that IRS staff erroneously added an internal compliance indicator to tax accounts when Form 8996 was attached in 98.7% of cases. This is likely a result of the IRS Code and Edit function. The guidelines are written to edit the indicator if Form 8996 is attached. However, the instructions do not state that the Code and Edit employee should only add this code if Line 2 of Form 8996 is marked “Yes.” Line 2 asks, “Is the taxpayer organized for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund)?” Essentially, the IRS suggests it cannot determine taxpayer intent as to why one would submit Form 8996 indicating they are not a QOF. Interestingly, the TIGTA believes intent is clear, as Form 8996 follows Line 2 with the statement, “No. STOP. Do not file this form with your tax return.” Ultimately, this is just one example highlighted by the TIGTA as an opportunity to improve IRS reporting processes. Below, we take a closer look at the TIGTA findings.

Recommendations and Response

As a result of these errors, the TIGTA made eight recommendations to the IRS. Of these eight, the IRS agreed with six. Here are the recommendations made by the TIGTA and the subsequent responses from IRS management.

Recommendation 1: Create Guidance for Intentional Noncompliance

While it cannot be certain that taxpayers made intentional mistakes, the TIGTA recommended that IRS management “work with the IRS Office of Chief Counsel, in consultation with the Department of the Treasury Office of Tax Policy, to develop guidance for QOFs that intentionally do not comply with program requirements.”

The IRS agreed. The IRS agreed to work with the Office of Chief Counsel and the Department of the Treasury Office of Tax Policy to develop procedures for dealing with QOF noncompliance. IRS management will update its guidance on handling QOFs that do not make an accurate return, fail to make any return, or otherwise intentionally do not comply with program requirements.

Recommendation 2: Develop a Decertification Process

The TIGTA report found 1,530 tax returns (28.8%) reporting potentially inaccurate investment information. Their second recommendation is to “develop processes and procedures to decertify QOFs that intentionally do not comply with program requirements.”

The IRS disagreed. The IRS said that it would first need to develop guidance on addressing QOFs that do not comply with program requirements before it can commit to developing a decertification process.

Recommendation 3: Address Noncompliance

There were no established processes or procedures for addressing ineligible QOFs or those that filed inaccurate forms. The third recommendation is for IRS management to review the 699 QOFs that the TIGTA identified from tax year 2019 returns and take action to address noncompliance.

The IRS agreed. The IRS agreed with this recommendation and plans to notify the 699 QOFs identified by the audit.

Recommendation 4: Identify and Address Inaccurate Calculations

The IRS does not yet have a complete set of necessary processes or procedures to identify and address QOFs that do not meet program requirements or report false information. For example, the TIGTA report identified 341 tax returns that reported investments totaling over $1.3 billion made in another QOF (which puts the receiving QOF at risk for not meeting the 90% standard).

The TIGTA recommends the IRS “review the 341 QOFs that reported investments in another QOF or their own TIN [tax identification number] on tax year 2019 tax returns and address QOFs that include these investments in their total QOZ property when calculating their investment standard (Form 8996, Part II).”

The IRS agreed. The IRS agreed with this recommendation and plans to notify the 341 QOFs identified.

Recommendation 5: Automate Internal Processing Codes

Form 8997 accounts for deferred gains invested in QOFs during the year. A specific processing code is added to the taxpayer’s account when a return shows a deferred gain. The code is used to verify all annual filing requirements were met for that and future tax years; however, it is not yet an automated process.

The TIGTA recommends “as part of the compliance initiative project, [IRS management should] review the 5,141 investor returns and address any ineligible deferred capital gains.”

The IRS agreed. IRS management agreed with the recommendation and plans to notify the 5,141 investors identified.

Recommendation 6: Eliminate Erroneous Internal Codes

The TIGTA report identified some potentially erroneous IRS indicators on tax accounts when the business did not self-certify as a QOF. This may be due to technical issues with tax preparation software.

The TIGTA recommends the IRS “develop interim processes and procedures to identify and track accounts identified with erroneous QOF indicator codes.”

The IRS disagreed. IRS management disagreed with this interpretation and offered a different administrative solution. Management contends the codes are not erroneous; they are applied when Form 8996 is filed, regardless of what is reported on the form. Management has worked with software vendors to resolve such issues and implemented a process to track accounts that may not be a QOF. CapZone is currently building compliance software to address these gaps.

Recommendations 7 and 8: Increase Electronic Transcriptions

The final two recommendations follow a heavily redacted section of the TIGTA report titled, “Additional Key Data Fields to Identify Qualified Opportunity Fund and Investor Noncompliance Are Needed.” The TIGTA advocates that additional electronic data must be transcribed from paper-filed Forms 8996 and 8997.

The IRS agreed. The IRS agreed with these recommendations and has requested the transcription of this information. It plans to continue to submit annual requests for the transcription of this information, including in tax year 2022.

The Consequence for QOF Administrators and Investors

The upshot of this audit is that it will encourage a more vigilant approach from the IRS to respond to poorly completed QOF paperwork, as well as help develop processes for noncompliance, including decertification as a QOF.

Although the IRS has exercised leniency with noncompliant funds and investors to date, this should be considered a by-product of growing pains with the administrative aspects of the program. Furthermore, although the IRS will not be decertifying QOFs in the short term, it should be assumed that the decertification of ineligible funds will be enacted eventually, perhaps soon. According to the report, IRS management has drafted an Opportunity Zone Compliance Plan (dated November 2, 2021) but does not offer any indication as to when this information will be released.

In the future, it seems likely that this popular form of capital gains investment will require closer scrutiny from accountants and investors alike, particularly when annual IRS returns are due. For QOFs, compliance with the Opportunity Zone tax incentive is also likely to become even more complex with the emergence of legislation aimed at establishing greater levels of transparency for QOFs and impact metrics for the Qualified Opportunity Zone Businesses they invest in. The Opportunity Zones Transparency, Extension and Improvement Act would reinstate and expand reporting requirements across the country.

For more information about evolving QOF compliance and reporting requirements, QOFs may reach out to CapZone at info@capzonegroup.com.

Photo by Hyoshin Choi on Unsplash