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The Charitable LLC Tax Planning Strategy: What You Need to Know
November 10, 2022 •TaxPlanIQ Support team
Business owners and entrepreneurs are always looking for legitimate and easy ways to save on taxes. The "Charitable LLC" tax planning strategy is one way to do just that.
As a tax planner, this is an effective potential tool to use for your clients (among many).
In a nutshell, a Charitable LLC allows business owners to shelter a portion of their income from taxes by donating it to a 501(c)(3) organization. The idea is to form a Charitable LLC and donate 99% of non-managing member shares to charity or donor-advised funds and remain with 1%, which gives you control over the LLC as manager, allowing you to take advantage of massive tax benefits.
The beauty of the Charitable LLC is that it allows your tax clients to direct their own charitable giving, get an immediate tax deduction, and save on their overall tax bill.
It also helps:
- Eliminate much of the capital gains tax
- Create a large personal income tax deduction
- Enjoy generational tax-free growth
- Protect the assets from all creditors
How Does a Charitable LLC Work
The IRS allows the formation of Charitable LLCs as a mechanism for charitable organizations to pursue alternative modes of income generation without endangering their tax-exempt status. The LLC must be organized and operated exclusively for charitable purposes, with all profits going to the charity. The LLC can engage in a for-profit activity so long as it's related to the charity's exempt purpose.
A charitable LLC provides greater control and flexibility to the LLC managers as to how the company's income is distributed among its members. The IRS does not require that distributions be made in proportion to each member's ownership stake.
This flexibility can be particularly beneficial when a group of individuals manages the LLC, as it allows the LLC to make distributions in a way that furthers the organization's goals without running afoul of IRS regulations.
Additionally, the LLC can make riskier investments than a traditional charity, as it is not subject to the same stringent investment restrictions. There are no obligations to file the use of the charitable LLC funds, which inherently adds a layer of privacy.
As a business owner, you can take advantage of the Charitable LLC strategy by forming your own charitable LLC and then ceding 99% of your shares to charity or donor-advised funds. You will continue to have control over the LLC as a manager with 1% shares and 99% of the voting power while still enjoying an immediate tax deduction for the value of your donation.
Charitable LLC has no mandatory distribution requirements, self-dealing rules, jeopardy investments, excess business holding rules, and other rules and regulations that limit the activities of a traditional charity. This makes the Charitable LLC strategy an incredibly powerful tool for tax planning.
Benefits and Drawbacks
The primary benefit of this tax planning strategy is that you can deduct the full value of your donation from your taxable income. This can result in significant tax savings (up to 90%), especially if you are in a high tax bracket.
It also allows you to control how your donation is used by the charity and can direct them to high-value investments such as stocks, real estate, and other assets without crossing any legal lines.
Of course, there are some disadvantages to consider as well. First, this strategy can be complex and time-consuming to set up. You will need to engage the services of a qualified tax attorney or accountant to ensure that everything is done correctly and in compliance with IRS regulations.
You'll also need to be comfortable ceding a majority stake in your company to the charity. This can be difficult for some business owners, as it means giving up control over how the business is run.
Additionally, the Charitable LLC strategy is only beneficial if you are in a high tax bracket. If you are in a lower tax bracket, you may be better off taking the standard deduction or itemizing your deductions.
Finally, it is important to remember that charitable LLCs are subject to the same audit risk as any other LLC. If the IRS finds that you have not complied with charitable LLCs' rules and regulations, they can revoke your tax-exempt status and impose significant penalties.
To be eligible to form a Charitable LLC, you must have a $1M adjusted gross income (AGI) or $2M gain on appreciated assets from selling your company, real estate, crypto, stocks, art, or other investments.
If your AGI is below these amounts, you can still form a Charitable LLC but may not be able to deduct the full value of your donation.
If you have an adjusted gross income (AGI) of $1 million or less, you can only deduct up to 50% of your AGI in the form of a charitable donation. So, if your AGI is $500,000, the most you can deduct in charitable donations is $250,000.
In some cases, you might have one huge return year that pushes you over the $1 million AGI mark. You can still form a Charitable LLC in that year, but you'll only be able to deduct 50% of your AGI as a charitable donation.
Applications Of A Charitable LLC
There are many ways to use a Charitable LLC for tax planning. Here are some of the most common:
- Sale of real estate, privately held business, crypto, or other capital assets
- Sale of a whole or fractional interest in LLC or Ltd partnerships
- 1031 Exchange exit strategy
- Liquidation of S-Corporation or C-Corporation
- Estate Planning upon death
- Generational Transfer Planning
Step By Step Process
If you're interested in using the Charitable LLC tax planning strategy for your clients, you’ll want to know the general workflow:
Step 1: Create A Charitable LLC And Separate Investment LLC.
The first step is to create a charitable LLC. This can be done by filing the Articles of Organization with your state's Secretary of State.
You will also need to create an Investment LLC, which will hold all of your company's assets. The Investment LLC will be owned by the Charitable LLC.
Consult with a qualified tax attorney or accountant to ensure that your LLCs are properly structured and in compliance with IRS regulations.
Step 2: Donate Share To The Charity.
Once your LLCs are set up, you'll need to donate a majority stake in your company to the Charitable LLC. The ideal scenario is to donate 99% of non-managing member shares to charity or donor-advised funds and only remain with 1%, giving you 100% control and voting right over the LLC as manager.
Step 3: Contribute Assets To The Charitable LLC.
As a donor, you will contribute assets to the single-member Charitable LLC. The assets can be in the form of cash, stocks, real estate, or other investments.
This donation then goes to investments within the Investment LLC or can be lent out as a collateralized loan to a 3rd LLC, allowing you to plow back the interests and gains from the collateralized loan note into the Investment LLC.
As the manager of the Charitable LLC, you'll get to direct where these investments go. This allows you to direct the investment strategy of the Charitable LLC.
But there needs to be a true separation between the donor and the charitable LLC, which means you cannot control the day-to-day operations of the LLC.
Step 4: Receive A Charitable Deduction.
You will be eligible to receive a charitable deduction of between 88 and 90% for the value of the assets you donated to the Charitable LLC.
This deduction can be taken in the year you make the donation or can be carried forward for up to 5 years. Note that the charitable deduction is only available if you itemize your deductions.
Step 5: Distribute Meaningful Gifts
While there are no legal requirements to distribute meaningful gifts, we always recommend the Charitable LLC makes significant distributions that align with the intent and purpose of the LLC. This will set you apart from those who abuse the system and ensure that the IRS does not question your motives for setting up the Charitable LLC.
A good rule of thumb is to distribute at least $5,000 per year per LLC member to a qualified charity. This could be done through grants to qualified nonprofits, scholarships, or other charitable causes.
The Charitable LLC can also make distributions to a donor-advised fund, a special type of account that allows you to make charitable donations and get an immediate tax deduction but gives you flexibility on when and how the money is distributed to charity.
What Are The Risks?
There are a few risks to be aware of when using the Charitable LLC tax planning strategy:
The biggest risk is that the IRS could classify the Charitable LLC as a sham charity and disallow the deductions taken. To avoid this, it's important to ensure that the Charitable LLC is truly a separate entity from the donor and that it is in compliance with IRS regulations.
Another risk is that the IRS could audit the LLC. While this is always a possibility, the IRS is more likely to audit an LLC if it suspects that the LLC is not being operated in compliance with IRS regulations.
The Charitable LLC strategy may save your tax planning clients a significant amount in taxes.
Even if clients experience trouble through an unexpected black swan event, the Charitable LLC strategy provides structures and asset protection for his family.
When used correctly, it can save your clients thousands of dollars in taxes each year.
However, doing it properly requires guidance. TaxPlanIQ gives you educational resources, helpful links, and tasks associated with this and dozens of other tax planning strategies.
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