Family LLC or Family Foundation: How Can My Family Benefit?

Families can use several advanced planning tools to achieve their values, goals, and objectives.  Along with preserving family wealth, many families are interested in reducing taxes, effectively transferring wealth across multiple generations, protecting assets from catastrophic loss, and making impactful charitable gifts.  A Family Limited Liability Corporation (LLC) or a Family Foundation are two worthy options for you to consider.

FAMILY LIMITED LIABILITY CORPORATIONS (FAMILY LLC)

A Family LLC is a legal entity that enjoys the limited liability of a corporation and the operational flexibility of a partnership. Most people who set up Family Limited Liability Corporations are typically larger estates, looking to minimize state and federal estate taxes and avoid paying gift taxes. A Family LLC can benefit from owning rental properties, brokerage accounts, or a family business. Having a Family Limited Liability Corporation can protect your family members from creditors, help with estate planning, and divide income among the members.

You will want to have an operating agreement that limits and defines ownership and transfer rights. Some Family LLC could provide significant discounts from estate and gift tax.

ADVANTAGES OF A FAMILY LLC

One of the main benefits of a Family LLC is that you can transfer a family business with ease to the next generation. A Family Limited Liability Corporation acts as a pass-through for income tax purposes, minimizing federal gift and estate taxes.  

For successful business owners, a Family LLC can reduce income taxes by spreading business income across multiple family members and generations that may be in lower income tax brackets.    

Owners retain control over the assets and can protect younger members from financial decisions.

A Family Limited Liability Corporation can be an excellent vehicle to protect the assets against claims by creditors, divide income among generations, and facilitate multi-generational wealth transfer and estate planning.

DISADVANTAGES OF A FAMILY LLC

You cannot blend personal and business assets in a Family Limited Liability Corporation.

A Family LLC must meet IRS requirements; there could be consequences if you form a Family Limited Liability Corporation only to avoid paying taxes.  Also, the general partners of a Family LLC can be vulnerable to some risk, so it is a good idea to work with an elite wealth manager and a team of experienced and knowledgeable professionals in this area.

The members of the Family LLC pay taxes on their share of the entity’s profits, and there will be initial and annual fees associated.

FAMILY FOUNDATIONS

A Family Foundation, also known as a private foundation, is a not-for-profit organization mainly funded by a person, corporation, or family. The assets within the private foundation will generate income, which is used to support the foundation’s operations and make charitable grants to other nonprofit organizations. In addition, a family foundation can help foster family connections and instill family values for the younger generations.

ADVANTAGES OF A PRIVATE FOUNDATION FOR YOUR FAMILY

A private foundation gives you control over the choice of charitable organizations to which you want to support. In addition, you and your wealth manager can choose how to invest the assets in the foundation.

With a private foundation, succession possibilities are endless. With your family involvement, you will create a legacy and bond as a family around something meaningful.  You can have a clear vision of how you want to make a difference in the world and which causes you to want to support.

Family Foundations provide significant tax benefits.  You can avoid paying capital gain taxes on appreciated assets, including private business shares, public stocks, real estate, etc., by donating the assets to your foundation and then selling.  Since the Private Foundation is a tax-exempt entity, the sale incurs no capital gain tax. 

Additionally, you can claim a significant charitable deduction for the total market value of the assets donated to the Family Foundation, which can help offset taxes on other income sources.  The tax deduction can be carried forward for several years to continue providing tax benefits years after the donation. 

When you transfer assets to a Family Foundation, they are usually not subject to estate taxes; this can provide three types of tax savings combined with the tax benefits described above.

DISADVANTAGES OF A PRIVATE FOUNDATION FOR YOUR FAMILY

Setting up a Family Foundation is time-consuming, and there will be legal, and accounting fees associated with the setup and ongoing maintenance of the foundation.  There are regulatory and other reporting requirements, usually completed by your accountant and attorneys each year.

Assets transferred into a Private Foundation from you are irrevocable. You can’t change your mind once the transfer is complete.

There are annual excise tax payments; most foundations pay a 1 to 2% annual excise tax on their net income. This percent depends on the foundation’s annual grantmaking.

Family Limited Liability Corporations and Family Foundations are two effective strategies to help achieve what’s important to you and your family.  They can help you live a life of significance, accomplish your aspirations, and leave a multi-generational legacy. 

Both of these tools have significant advantages for the right family.  However, both have their share of disadvantages too.  If a Family LLC or a Private Foundation is not a good fit for your situation, there are many other options to consider.  It would be best to consult with your wealth manager and other advisors to determine the best solutions for your circumstances.

DISCLOSURE & ACKNOWLEDGEMENT

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.

Comparing 1031 Exchanges vs. Qualified Opportunity Funds

While both strategies can help real estate investors reduce taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method.

100 YEARS OF 1031 EXCHANGE

The 1031 Like-Kind Exchange, also known as 1031 Exchange, has been around for quite some time. Since its inception in 1921, it has become one of the most popular tax strategies used by taxpayers when relinquishing their real estate property. For generations, investors have used 1031 Like-Kind Exchanges to swap investment properties and defer taxable gains.

However, there is now a relatively new option that defers or even potentially eliminates a portion of capital gains for real estate investors. Created under the Tax Cuts and Jobs Act of 2017, the Qualified Opportunity Fund, or QOF, provides taxpayers an alternative way to postpone and eliminate certain taxable gains.

In addition, it allows individuals to invest their capital gains in real estate or business development projects within designated communities known as Qualified Opportunity Zones. Both strategies can be great tools for investors, but there are differences between the two. Let’s go over some of these differences that you should know before investing in either one of these options.

WHAT ASSETS ARE ELIGIBLE FOR EACH STRATEGY?

Only real estate held for investment purposes can qualify for a 1031 Exchange. Personal property is excluded because this specific asset class is not eligible for the exchange written in a set of rules determined by the Internal Revenue Service.

On the other hand, Qualified Opportunity Funds allow for potential capital gain tax deferral on a broader range of eligible assets, including stocks, bonds, real estate, collectibles, partnerships, and private business interests.

Essentially any investment whose sale would result in a taxable capital gain can qualify for a Qualified Opportunity Fund. It is important to note that for both strategies, only the profits accumulated from the disposition of the listed assets are eligible to receive the respective tax benefits of the 1031 Exchanges and investments in Qualified Opportunity Funds.

HOW ARE PRINCIPAL AND GAINS HANDLED?

1031 Exchanges require investors to swap both the principal (cost basis) and the gains accumulated. A Qualified Opportunity Fund only requires the gains to be transferred. The principal is not required to be rolled into the fund. This has the potential to free up assets and can be beneficial to those who need liquidity.

For example, suppose you sell an eligible asset worth $1 million with a $200,000 cost basis.  In this case, a 1031 exchange requires you to transfer the $1 million sale proceeds into a like-kind property to avoid all taxable gains in a 1031 exchange (you can exchange less, but you will have to pay capital gain taxes on the portion you withdraw).  However, you are only required to move the $800,000 gain into a Qualified Opportunity Fund to avoid a taxable gain.  The $200,000 cost basis can be withdrawn tax-free. 

WHAT ARE THE ELIGIBLE INVESTMENTS FOR EACH STRATEGY?

Sellers can swap into any qualifying investment property in a 1031 Exchange, meaning the replacement property does not have to be from the same asset class, adding diversity to your investments. Once again, this excludes personal property for the same reason as stated with eligible assets. In the case of QOF, individuals are investing in a Qualified Opportunity Zone or QOZ.

The IRS defines an opportunity zone as an “economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatments.” Generally, individuals invest in a pooled set of commercial real estate funds, housing, infrastructure, and businesses within a QOZ. The primary purpose is to spur economic development and job creation within the distressed community.

WHAT IS THE RULE ON REPLACEMENT PROPERTY?

To complete a 1031 Exchange, real estate investors must follow a specified time frame to purchase the replacement properties. You have 45 days to identify a replacement property after you sell the original investment property. Once identified, you must close on that property within 180 days of the sale. The rule on replacement property for a Qualified Opportunity Zone is different. You do not have to identify the replacement property; however, you must reinvest the capital gain in a QOF within 180 days.

WHAT HAPPENS WITH CAPITAL GAINS TAX?

1031 Exchanges provide tax deferral, not forgiveness. You defer the taxable gain until you sell the replacement property. You can eventually eliminate the capital gain if you continue to perform 1031 Exchanges up to the time you die. Your heirs receive a step-up in the cost basis to the date of your death, eliminating the capital gain tax.

With a Qualified Opportunity Fund, there are a few moving parts. First, you can defer the capital gain tax until you sell the Qualified Opportunity Fund or until December 31, 2026, whichever occurs first.  There is no limit on the number of gains that you can defer in this manner.

Qualified Opportunity Funds also have the potential to reduce capital gains through a step-up in cost basis. If you invest in a Qualified Opportunity Fund before December 31, 2021, and hold until 2026 you can receive a 10% step-up in your original cost basis.

Finally, Qualified Opportunity Funds provide you an opportunity to eliminate any additional capital gains on the new investment.  Specifically, if you hold the Qualified Opportunity Fund for at least ten years, you will not pay any capital gain on the new investment, regardless of the potential profit size.

While both strategies can help reduce your taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method. An elite wealth manager who understands the unique needs of real estate investors and what you want to accomplish moving forward can help lead you in the right direction.

DISCLOSURE & ACKNOWLEDGEMENT

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.