Keystone Opportunity Zones: Deep Tax Knowledge Can Offer Unique Benefits

by Drew VandenBrul, CPA, and Dan Giorgio, CPA | Dec 02, 2019

Mark Twain once said, “The report of my death was an exaggeration.” Similarly, the Pennsylvania Keystone Opportunity Zone (KOZ)1 program lives on and remains a driving force in Pennsylvania’s economic development, with some tax benefits extending out to 2035.

The benefits and complexity of KOZs derive from the wide array of state and local taxes on which the program is based. Unlike other economic development and incentive programs based on singular activities such as job creation, capital investment, or geographic location, capitalizing on the benefits of the KOZ program requires an underlying knowledge of each of the taxes to which it applies. The chart below lists the taxes for which KOZ credits, exemptions, deductions, or abatements are available.

Background

KOZs, established in 1998, originally were more limited in scope, but the program has evolved and expanded to include additional taxes, more locations, and a wider variety of tax benefit periods. The Pennsylvania Department of Community and Economic Development (DCED) refers to the KOZ as “one of the nation’s boldest and most innovative economic and community development programs.”2 According to DCED, by Dec. 31, 2017, the KOZ program had led to the creation of 7,278 jobs and $2.6 billion in private investment.3 Many of the businesses that received KOZ benefits have since continued to operate in Pennsylvania beyond the expiration of the initial benefits, with the largest numbers expiring after 2013 and 2018. The scope and popularity of the program has so expanded that in 2017 there were 1,060 qualified KOZ businesses, 512 KOZ property owners, and 218 approved KOZ residents. Of the qualified businesses, approximately 620 saw their benefits expire after 2018 and at least another 240 will face expiration by the end of 2023.4 It is critical for these businesses to optimize their available KOZ benefits and plan for taxes post-KOZ.

The following overview is applicable to a broad spectrum of current, potential future, and former beneficiaries of the KOZ program.

How KOZ Works

There are essentially five steps for accessing and benefiting from the KOZ program.

Step 1: Geography – KOZ locations have been designated and approved through a combination of political subdivision applications and approval by DCED, which maintains an interactive map of the approved KOZ locations on its website.5 While all zones carry the same Pennsylvania tax benefits, they vary in terms of the local taxes imposed and the expiration date of the tax benefits. These locations are dispersed across the state, covering a majority of counties. KOZ coordinators are assigned to each of 12 regions to assist with program administration.

Step 2: Qualification – Potential beneficiaries of the program can be a KOZ-qualified business, a KOZ resident, and/or a KOZ property owner. A resident must be domiciled and reside in a KOZ for at least 184 consecutive days. Residents can obtain benefits that include abatement of personal income tax (PIT) on additional classes of income and local wage tax abatements.6

Businesses and property owners make up the vast majority of qualified KOZ applicants. To qualify, they must own or lease real property in a KOZ from which they actively conduct a trade or business and must apply to DCED annually by Dec. 31 to obtain certification.

Existing Pennsylvania businesses seeking to expand or relocate to a KOZ must satisfy an additional one-time relocation requirement to qualify. These relocating businesses must do one of the following:

  • Increase full-time employment by at least 20% in the first full KOZ year.
  • Make a capital investment in the KOZ of at least 10% of its prior-year gross revenues.
  • Enter into a lease for the duration of the KOZ with aggregate lease payments of at least 5% of its prior-year gross revenues.

The relocation provisions are designed to prevent businesses from simply relocating within Pennsylvania to obtain KOZ tax advantages. However, application of these provisions can be complex. Careful consideration is needed to ensure that KOZ benefits will be available. DCED, in consultation with the Department of Revenue (DOR), has the statutory authority to waive or modify the relocation requirements. In practice, modifications often focus on the time frame for employment qualification, what is considered a “capital investment,” and how to measure prior-year gross revenues for the capital investment and long-term lease tests.

Step 3: Quantification of benefits – Quantification is where CPAs really get to show their stuff. To gain a full view of KOZ benefits, you first need to understand each of the underlying taxes, how they are applied, and how the KOZ impacts these calculations. An effective tax model will consider the projected tax impacts for each tax and each location over the duration of the KOZ.

Only certain KOZ-eligible taxes will align with each taxpayer, so the first step is to determine which may apply. For example, a C corporation would consider the corporate net income tax (CNIT) benefits, whereas a partnership, S corporation, and many limited liability companies (LLCs) would consider the PIT benefits, including the state of residency of the partners, members, or shareholders.7 Certain specialized industries are subject to separate taxes with their own KOZ calculations, including banks, mutual thrifts, insurance companies, and transportation companies.

Regardless of the form of legal entity involved, most businesses could obtain benefits associated with sales and use taxes on the tangible personal property and services purchased for exclusive use, consumption, and utilization in the KOZ.

Finally, local taxes must be considered in the benefit calculation, including property taxes. The KOZ quantification is especially significant in Philadelphia due to its business income and receipts tax (BIRT), net profits tax (NPT), additional 2% sales and use tax, and realty use and occupancy tax (U&O).

When a business is evaluating site selection and potential relocation options, quantification of the KOZ benefits should consider taxes within Pennsylvania, both within and without the KOZ. If a business is considering multiple potential states, a tax comparison should be made to the other states and local jurisdictions.

Step 4: Application – DCED requires submission of an annual online KOZ application8 by Dec. 31, but it is advisable to submit the application as soon as possible to ensure any issues are resolved and to more quickly receive the sales tax exemption for use in conjunction with KOZ purchases.

Following the initial application, DCED will request two additional pieces of information: a written business synopsis explaining the general characteristics and operation of the KOZ-located business, and proof that real property is owned or leased in the KOZ. For most businesses, this requirement is satisfied by providing copies of the lease or sublease for the property. Keep in mind, this requirement applies to each legal entity seeking KOZ approval, so subleases may be required if the business is conducted through a number of related or affiliated entities that are each seeking KOZ approval.

The initial application will be reviewed by state and local agencies to ensure compliance with all tax reporting, filing, and compliance requirements. If approved, the secretary of DCED will issue an approval letter.

Step 5: Reporting – When it comes to figuring out how the KOZ tax benefits are claimed, the complexity ranges from the property tax abatement, to issuance of a sales tax exemption certificate, to potentially complex calculations of income tax credits and abatements.

Sales and use tax exemption benefits are claimed by issuing an exemption certificate to vendors and suppliers. When a business receives its annual KOZ qualification, DOR will issue an exemption number to be provided to vendors and construction contractors. If sales and use tax is erroneously paid on purchases that are deemed KOZ-exempt, normal refund procedures should be followed to obtain refunds.

Reporting for business taxes, such as the CNIT and Philadelphia’s BIRT and NPT, operates as a credit against the tax. The tax is calculated without regard to the KOZ, then a KOZ credit is computed based on apportionment attributable to the KOZ. Pennsylvania and Philadelphia provide Form RCT-101 KOZ and Schedule SC/worksheets, respectively, to support the apportionment and credit calculations. These credit forms are then attached to the business tax filings. For CNIT and Philadelphia’s BIRT and NPT purposes, the KOZ apportionment (i.e., percentage of credit allowed) is based on a two-factor formula representing the average ratios of KOZ property and payroll to Pennsylvania property and payroll.

Reporting of KOZ benefits for PIT purposes can become complex, as most of the benefits are derived from pass-through entities operating in a KOZ. These pass-through businesses report income to partners, members, and shareholders net of the KOZ benefits, as computed on Pennsylvania Schedule P-S KOZ. This reporting must take into account disparate KOZ treatment between residents and nonresidents, business income and losses, and the distinct classes of income reported for PIT purposes.

In addition to the tax-specific KOZ reporting, Philadelphia KOZ businesses with $2 million or more in gross revenues must also complete an annual Subsidy Self-Reporting form, which is due by May 1 of the following year.9

KOZ Opportunities and Planning

The KOZ program provides a wide array of potential tax benefits, but specifically precludes claiming certain other tax credits, including research and development, neighborhood assistance, enterprise zone, and job creation tax credits. However, within the KOZ program there are many opportunities to ensure all available benefits are claimed and tax benefits maximized. Since the program and its benefits are completely tax-based, many aspects of state and local tax planning come into play.

Entity structuring and transfer pricing – If a KOZ-eligible business has multiple locations or operates multistate, opportunities exist to review the legal entity structure, segregation of activities between entities, and intercompany transfer pricing. It is likely that the business will benefit from having its higher-margin, income-producing activities conducted in the KOZ at arm’s-length pricing to affiliated entities and third-party customers. This may include segregating the business located in a KOZ into a separate legal entity to maximize the income and apportionment aligned with KOZ credits. The tax-favored status of a KOZ business can be a significant component of tax rate management.

Accounting methods – Many federal tax accounting methods are elective and may impact recognition of income and deductions between entities and across tax periods. Businesses considering a move to a KOZ and existing KOZ businesses nearing the end of the benefit period should review their accounting methods and elections. For example, a method that accelerates income into a KOZ period may provide a permanent Pennsylvania tax benefit to an existing KOZ business, even after considering the timing impact in other states and for federal tax purposes. Conversely, accounting methods that defer income recognition may be attractive to those anticipating a move into a KOZ.

Capital expenditures and other purchases – The KOZ program incentivizes purchases for exclusive use in the KOZ by providing sales and use tax exemptions. As businesses prepare capital expenditure budgets for the years leading up to locating in a KOZ and the final years before the end of their KOZ periods, they must consider the timing of significant KOZ-based purchases. For example, a large equipment purchase while in a KOZ yields a 6% to 8% sales and use tax savings when compared to making the same purchase immediately before or after the KOZ period. There may be depreciation impacts to these purchases as well, but those are generally timing differences and are less impactful since Pennsylvania doesn’t follow federal bonus depreciation rules.

There is a flip side to capital expenditures to be considered. Dispositions of assets will also impact KOZ benefits, depending on the timing and whether gain or loss results. Ideally, gains should be recognized during the KOZ period and losses deferred to post-KOZ, after taking into consideration the timing effects for other state and federal tax purposes.

Apportionment – For income tax purposes, KOZ apportionment is based on a two-factor formula representing the average ratios of KOZ property and payroll to Pennsylvania property and payroll. Therefore, the higher this percentage, the greater the apportionment and credit or abatement. While it is unusual to think of tax planning in terms of increasing apportionment, that’s exactly the objective when it comes to KOZ factors. This approach both encourages investment in KOZ property, rent, and payroll, and discourages investment in these factors elsewhere in Pennsylvania. This is especially true for the CNIT and Philadelphia’s BIRT and NPT because the underlying taxes are apportioned using only the receipts factor. These factors can often be managed independently of the tax to which the credit applies.

Post-KOZ planning – KOZ-qualified businesses eventually will reach the end of the benefit period. As suggested above, businesses should plan for this well in advance of the expiration date in terms of capital expenditures and divestitures. Some businesses may have significant enough employment and capital expenditure growth to consider requesting an extension within their existing zone10 or qualifying as a relocating business into a new zone. Others will view this as an opportunity to revisit their site-selection criteria and determine if the existing location or another best suits their needs going forward.

After years of KOZ benefits, other state and local tax planning may not have occurred and should be revisited by the business and its tax advisers. Numerous state and local tax changes will have taken effect during a KOZ period, including single sales factor apportionment, elimination of the capital stock/foreign franchise tax, changes to net operating loss limitations, and enactment of market-based sourcing for service receipts, to name just a few. Businesses that continue in their current location post-KOZ should reconsider their legal entity structure, apportionment factors, and transfer pricing to make sure they will be aligned without the benefits of the KOZ. Also, consider other Pennsylvania tax credits that were previously unavailable (e.g., research and development). Finally, businesses will need to review the financial statement reporting of their current and deferred state taxes to ensure they properly reflect expiration of the KOZ benefits.

Conclusion

For the past two decades, Pennsylvania has successfully used the KOZ as one of its most powerful economic development tools to promote investment and job creation, support job retention and in-state expansions, and revitalize areas of economic distress. The program has evolved over time to suit differing industries and types of entities in support of the original legislative findings that these areas “require coordinated efforts by private and public entities to restore prosperity and enable the areas to make significant contributions to the economic and social life of this Commonwealth.”11

The KOZ program has been built on Pennsylvania's complex state and local tax structure. Businesses and CPAs who are either already in a KOZ, or are considering entering one, must weigh the full breadth of the tax savings and opportunities available. 

1 The term KOZ collectively includes Keystone Opportunity Zone, Keystone Opportunity Expansion Zone, and Keystone Opportunity Improvement Zone.

2 KOZ Program Guidelines, DCED, April 2018.

3 “Keystone Opportunity Zone (KOZ),” Pennsylvania Department of Community & Economic Development. http://dced.pa.gov/business-assistance/keystone-opportunity-zones

4 Pennsylvania Department of Community and Economic Development.

5 http://dced.maps.arcgis.com/apps/opsdashboard/index.html#/c2bfa12d1a0a4d2bb816647bdcd3c5b3

6 In 2017, KOZ residents were located across 11 cities.

7 In 2017, C corporations represented just 11% of the qualified businesses, whereas partnerships, S corporations, and LLCs represented 84% of the qualified businesses. The balance were nonprofits and sole proprietorships.

8 https://apps.dced.pa.gov/koz

9 https://business.phila.gov/tax-subsidy-self-reporting

10 72 Pa. Stat. Section 8912-D(b)(2) requires at least 2,500 Pennsylvania employees and prior capital investment of at least $300 million to extend the state tax benefits. Local tax benefits are not eligible for extension.

11 73 P.S. Section 820.102(2).

Drew VandenBrul, CPA, is managing director at Grant Thornton LLP in Philadelphia. He can be reached at drew.vandenbrul@us.gt.com.

Dan Giorgio, CPA, is senior tax associate at Grant Thornton LLP in Philadelphia. He can be reached at dan.giorgio@us.gt.com.

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