We are forming an Opportunity Fund, an LLC with a corporate manager is the plan. If we set aside a reserve to pay the capital gains tax, is that taxable? Can we structure around this?
Such a reserve probably doesn't work. The QOF has to have at least 90% of its assets as qualified opportunity zone property and the reserve would not qualify. Probably best to consider some type of refinance at the project or business level to allow for distribution to pay taxes if the facts would allow that. This is probably best discussed live.
Remember that the fund must have 90% of its assets invested in qualified opportunity zone business property. There are some cases where cash and cash equivalents may be held but certainly not for 7 years. Any income derived from the reserve( interest) may or may not be taxable depending on the source.
To the extent that you do not roll the capital gains in a QOF, they will be taxable in the year recognized.
I would recommend a limited partnership, not an LLC for the Fund and use one or more LLCs for the Q Biz in which the fund invests. So you are raising extra capital with the intent to make distributions in 2026 for the investors to pay their deferred capital gains. Partners generally pay tax on distributions of profits. Most funds are providing for minimum annual tax distributions to pay tax on the profits. In any partnership, a distribution in excess of taxable profits is a return of capital that is not taxable income.
I’m not sure I follow your thought process. Please email me at pcardwell@jmslawyers.com. And we will set up a time to speak. Sent from my iPhone
A reserve set aside would not be taxable within or outside the fund but would not reduce the original cap gain.
The working capital safe harbor is for a 31 month period, so the 2026 tax will extend beyond that period. In addition, the liability is not technically with the QOF, but with the taxpayer who realized the gain, so you will not be able to set up a reserve for the 2026 liability.
It's impractical to build a reserve because you'll fail your compliance testing. It's not so much about whether the reserve itself would be taxable, but more about the idea of whether the reserve constitutes a bad asset for all the rules under the program. My suggestion would be to have each investor build a reserve him/herself, or alternatively, cash-out refinance assets shortly before the 2026 recognition date arrives.
The reserve to pay the tax on the gain deferred until 2026 should be outside the QOF. Because only gain is rolled into a QOF and the purchase price representing a return of basis is not invested (or taxed), I generally advise clients to set aside the return of basis and keep the amount in safe, fairly liquid investments, to pay the tax
If the reserve fund is created from taxable income rather than a capital contribution then it would be taxable when earned and of course, the earnings on the fund would also be taxable. Since the payment of the tax would not itself be deductible then an accrual would not be deductible to offset these income items.
Remember that 90% of a QOF's assets must be qualified OZ business property, so if the required cash can stay within that framework, you could do it. With a 20% tax rate, I'd think that you would fall short by only holding 10% in cash. On the flip side, you'd also be losing the ability to have some slippage afforded by the 90% rule if you already came up with a specific use for the 10%. You could push this a bit farther by holding up to 5% at the subsidiary entity level, ready for a distribution up in 2026. Of course, investors were otherwise going to pay the tax currently, so it's not clear why they need the fund to make the cash available to them. It would be somewhat less efficient, but certainly, investors could set aside the money themselves. With a $1M gain, either set aside ANOTHER $200K in anticipation of 2026, OR set aside $200K of the $1M today, and only invest $800K in the fund. Of course, you would now use $40K of your $200K to pay the tax on the $200K that you didn't invest. But the remaining $160K would cover the tax bill on the $800K that was deferred. Finally, a fund could anticipate BORROWING the $200K in 2026 and making distribution at that time, which would come out tax-free (presuming that the debt was allocated to the investor under the tax rules), and could be used to pay the deferred tax bill.
Setting aside a reserve by itself is not a taxable transaction. What would be taxable is the delta between your gains realized if greater than the amount invested via deferral into an opportunity zone fund. So if you sold stock for $100 of which the basis was zero, there is a $100 realized gain. Assume you only invested $60, then $40 of the gain would be recognized as taxable today. Conversely, if you sold stock for $100 of which the basis was $40, there is a $60 realized gain. Assuming again that you only invested $60, then $0 of the realized gain would be recognized as taxable today. Basis, or original cost, is clean money and can be set aside as a holdback should you wish.
It may cause you to fail the working capital test. Best to set up a line of credit and borrow before time of distribution.
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