In the aftermath of the protests and marches of the past year or so, community wealth building has emerged as an often-discussed strategy of economic justice. Community wealth building is really another term for community capital, and it’s been at the core of our work at Cutting Edge Counsel since our firm’s founding. It’s also the focus of the National Coalition for Community Capital (NC3), where I’m on the board.
In particular, there is a growing interest in community investment funds as a tool for community wealth building – something we’ve been writing and talking about in recent years. In this blog, we wrote about why these vehicles represent the ultimate impact investment – in short, because instead of seeking to remedy the harmful impacts of the prevailing system, they represents a systemic change in who invests and where profits go.
In the conventional system, only the wealthy can participate in the most profitable investments, which means the wealthy can grow their wealth at a rapid clip. The rest of us are generally stuck with investment options that, on a risk-adjusted basis, pay less than inflation. So instead of growing wealth, these options tend to erode wealth, which means the non-wealthy are effectively penalized for investing while the wealthy are generously rewarded. Naturally, this system contributes to a widening wealth gap.
But community capital (and community investment funds in particular) represents an entirely different approach to moving capital that decentralizes it, democratizes it, and recognizes that wherever your investors are, that’s where your profits go. If you want to get profits into the hands of non-wealthy people in your own community, you need to source capital from those same people.
However, community investment funds must be structured to comply with the Investment Company Act of 1940 – a rather restrictive federal securities law that hasn’t been updated significantly in a very long time. Previously, we wrote about four ways of building a community investment fund under current law. These included a charitable loan fund, a real estate fund, a supplemental fund (aka diversified business fund), and a business development company. Then, in this blog, we added another to that mix, a pooled income fund – which is generally considered a planned giving device, but can also serve as a type of community investment fund.
Then last year, the National Coalition for Community Capital published this handbook on community investment funds, which I co-authored along with Michael Shuman, Amy Cortese, and fellow NC3 board member Janice Shade. The handbook covers a lot of territory that would be useful for anyone who is thinking about launching a fund in their own community. In the chapter on legal strategies, we dug into a number of ways it can be done – again, right now, under existing law – including those mentioned above and a few more.
And yet, despite all the legal strategies that are currently available, there is still a big gap, which we discussed in this blog. What’s still missing is a way to build a simple community-scale equity fund – meaning a for-profit fund that can take investment from the community (including, of course, non-accredited investors) and deploy it in debt, equity, or revenue share investments into local companies, with the profits distributed among community investors – and all this in a cost-effective vehicle with a minimal compliance burden under the securities laws.
NC3 has recently taken the lead on an initiative to expand the investment fund options under the 1940 Act – advocating both a legislative change by Congress and rulemaking by the SEC. We have already had discussions with key people in the SEC about this. While securities regulators will, of course, apply a healthy dose of skepticism to any new ways of doing things (that’s their job!), the SEC specifically reminded us that they have created new exemptions for new types of investment vehicles in the past and could do so again. The door was left open for us, and NC3 is continuing to push on this front.
In the meantime, if you want to launch a community investment fund as a wealth-building tool in your own community, there are great options available now. There’s no need to wait, though we hope the menu of options will expand soon. Don’t hesitate to reach out to us at Cutting Edge if you’d like to talk about what might work for you.
Finally, I want to give credit to the late Sam Cooke, who penned the song referenced in the title above. And if you haven’t seen the movie One Night in Miami, I recommend it. You’ll see the connection. The struggle for equal opportunities for all Americans clearly didn’t end in the 1960s. I see our work to expand community wealth building options as within the arc of change that Mr. Cooke foresaw all those years ago. It’s been a long time coming. But a change is gonna come.
Since 2015, a bipartisan coalition of lawmakers has advocated for tax incentives for those who invest in low-income communities, recognizing that the benefits from the economic recovery have largely bypassed those communities. Their efforts were rewarded when their proposed opportunity zone program was included as Subchapter Z of the 2017 tax law overhaul that was passed in December. While Subchapter Z wasn’t specifically tailored to community capital, it offers tax incentives that will apply to some kinds of community investment funds.
First, here’s how the new law works: A taxpayer with capital gains can defer capital gains tax if they sell their appreciated assets and, within six months, roll over the profits into a “qualified opportunity fund.”
But it gets better. Investors in the qualified opportunity fund who hold their investment for at least 5 years will have their basis bumped up by 10% of the deferred gain (thus reducing their capital gains tax), and by another 5% if they hold it for 7 years. In 2026, there will be a realization event (in which investors are taxed on the other 85% of the original profit invested in the fund, assuming the investment has been held for 7 years). But if they continue to hold their investment for at least 10 years, their basis is bumped up to the market value of their investment, which means any further capital gains tax is eliminated completely.
A qualified opportunity fund is a partnership or corporation with at least 90% of its assets consisting of qualified opportunity zone property (and acquired after 12/31/2017), which can include:
- Equity interests in a corporation or partnership that is an opportunity zone business (and issued directly by the corporation or partnership, not acquired in secondary sales); or
- Tangible property (real or personal) located in the opportunity zone that is either first used by the fund or is substantially improved by the fund (the latter meaning that additions to its basis exceed its original basis).
A business is an opportunity zone business if:
- Substantially all of its tangible property is located in the opportunity zone;
- At least 50% of its gross income is derived from operations in the opportunity zone;
- A substantial portion of its intangible property is used in its operations in the opportunity zone; and
- Securities comprise less than 5% of its total assets by tax basis.
While this new law provides tax incentives to invest in funds that serve low-income communities, it does not provide any new strategies under the securities laws. It is probably inevitable that the vast majority of qualified opportunity funds will be open to accredited investors only, like nearly all private funds.
However, there are at least three strategies that allow a qualified opportunity fund to be open to its entire community, including non-accredited investors:
- Real estate fund: A fund whose primary business is investing in real estate and 90% of whose assets consist of real estate in an opportunity zone will be a qualified opportunity fund and will be exempt from the burdensome regulations of the Investment Company Act of 1940 (the “1940 Act”), which paves the way for the fund to raise capital via a direct public offering – making it a true community investment fund.
- Small business holding company: This type of fund is exempt from the 1940 Act if most of its assets comprise controlled or majority-owned subsidiaries – the idea being that the fund is in whatever business its subsidiaries are in, rather than in the securities investment business. Again, if 90% of its holdings are businesses in opportunity zones, it will also be a qualified opportunity fund.
- Intrastate fund: A closed-end fund of up to $10 million, all of whose investors reside in the same state, is eligible to seek an exemptive order from the SEC that allows it to raise community capital via a direct public offering and while avoiding all or most of the 1940 Act’s regulations. Such a fund could invest in either business or real estate in opportunity zones and thereby also become a qualified opportunity fund.
With any of these strategies, a community-scale fund can open up the opportunity for community ownership of community assets, with everyone able to participate on a level playing field, and everyone able to reap the profits from local ventures.
It should be noted that governors of each state had until late March to designate low-income census tracts as opportunity zones, but some have asked for a 30-day extension. However, only 25% of the low-income communities in each state may actually be designated as opportunity zones. It remains to be seen which communities will actually win that designation.
But community investment funds can be offered to the public in any community anywhere in the U.S. At Cutting Edge Capital we believe community investment funds are an effective way to significantly move the needle toward a more inclusive, democratic and decentralized economy.
If you would like to see this happen in your community, here are some steps you can take:
- Look at this map, which shows the census tracts that may be eligible for designation as an opportunity zone.
- If your community includes eligible census tracts, write to your governor, asking him or her to designate those tracts in your community as an opportunity zone.
- If you would like to see community investment funds serve your community, fill out our intake form to make an appointment with us to explore the kinds of funds that can be offered in your community.
What if your community can come together to fund local ventures? Watch our webinar with Kim Arnone and Brian Beckon to find out how to utilize community investment funds (CIFs). Get an in-depth look at the array of opportunities CIFs offer.
This is an immensely useful webinar for nonprofit organizations, coworking spaces, accelerators/incubators, community organizers, and economic development specialists.
WEBINAR: Economic Activism Starts at Home: The Impact of Community Investment Funds July 27, 2017 11 a.m. PT
Work for or operate a nonprofit organization, innovation hub, accelerator, or incubator? Are you a community leader or economic development specialist? Do you want to learn about community investment funds and community capital raising? Join Cutting Edge Capital’s webinar on July 27th at 11 a.m. PT with Kim Arnone and Brian Beckon to learn in depth about community investment funds and how they can propel your mission and community vision. Click here to save your spot now!
Vice President, Cutting Edge Capital
Kim specializes in developing community capital raising strategies for social enterprises, cooperatives and nonprofits. She works primarily on investment offerings that can be publicly offered and that are open broadly to community members. Kim has assisted a wide range of enterprises in successfully raising capital; from a worker-owned green waste recycling company to an organic farm, from a rural community development fund to an urban food coop. Kim has been with Cutting Edge for 5 years and has been practicing law for 20 years. She has her Juris Doctorate from Hastings College of Law, where she was editor-in-chief of the Women’s Law Journal. Kim lives, works, and plays in Oakland.
Vice President, Cutting Edge Capital
Brian is an attorney with over twenty-five years of experience working for nonprofits, start-ups, and publicly-traded companies. As a principal of both Cutting Edge Capital and Cutting Edge Counsel, Brian’s work is now focused on direct public offerings, corporate structuring, and strategies for community capital to help build a more equitable economy. Brian has served as General Counsel for RSF Social Finance, Clean Power Finance, and LendZoan; and before that as Corporate Counsel for Sybase and Catellus Development Corporation. He earned his J.D. from the University of the Pacific McGeorge School of Law and started his legal career with the North Bay law firm of Gaw Van Male. Brian is a member of the California Bar and serves on the boards of the Mount Diablo Music Education Foundation and the Neto Community Network.