Choice of Entity & Tax Considerations

Choice of Entity & Tax Considerations

Choice of Entity & Tax Considerations. In Arizona, the types of entities used to hold real estate are:

  1. the general partnership,
  2. the limited partnership,
  3. the trust,
  4. the corporation, and
  5. the limited liability company.

1.1 General Partnership. In a general partnership, all partners are fully, completely, totally liable for the debts and obligations of the general partnership. Unless formed specifically as a limited partnership, a partnership defaults to a general partnership, and the statutory authority for general partnerships is at Chapter 5 of Title 29, of the Arizona Revised Statutes, Revised Uniform Partnership Act, ARS § 29-1001 et seq.

1.2 Limited Partnership. Chapter 3 of Title 29, ARS § 29-301 et seq. controls limited partnerships in Arizona. Limited partnerships were the favored entity of choice in Arizona and throughout the country until the widespread of acceptance of limited liability companies. Before Arizona adopted its LLC statute in 1992, the limited partnership (“LP”) was the entity of choice to hold real estate and the corporation was the entity of choice to operate a business. The primary reason of the demise of limited partnerships was that the general partner of a limited partnership–and there had to be at least one general partner–had general liability. Weighing the value of control versus the general liability exposure as a general partner in limited partnerships, syndicators and other general partners in the business of real estate opted instead for the ease and limited liability of limited liability companies.

1.3 Trust.

1.3.1 Formation. In Arizona, the Trust Code is at ARS § 14-1101 et seq. and trust administration is set forth at ARS § 14-7401. An Arizona trust need not file any formation documents with any Arizona governmental agency, pay any formation filing fees or publish any documents in a newspaper. To form a trust, the trust creator (also called trustor or settlor) names a trustee to hold legal title to property conveyed by the trustor to the trustee for the benefit of one or more beneficiaries designated by the trustor. The trustor may be the trustee and a beneficiary. A trustee of a trust owes fiduciary duties to all the beneficiaries of the trust. Property must be conveyed or assigned to the trustee of the trust before the trustee can manage the property according to the trustor’s instructions. While trusts may be created by an oral agreement, but if a trust involves assets with more than nominal value, the trust should be in writing. Trusts may be revocable, irrevocable, simple or complex, but most trusts are revocable when first created. A revocable trust is a trust that can be amended or terminated at any time by the trustor. Every trust involving valuable property should be evidenced by a good written trust agreement that instructs the trustee on exactly what to do with the trust property.

1.3.2 Land Trust. A “land trust” or “Illinois land trust” is a special type of trust used by some owners of real property owners to hide the owner’s identity or owners’ identities. A land trust is usually revocable, so the trustee exerts power and control over the trust assets and, if distinct from the trustee, the beneficiaries. Arizona does not have any land trust statutes or court cases.

In some states, the identity of the beneficiaries of the land trust can be hidden from the public. ARS § 33-404, however, requires that every deed post-June 22, 1976 that conveys an interest in Arizona real property: (i) identify the trust that is a grantor or a grantee, and (ii) disclose the names and addresses of the beneficiaries of the trust. If the deed does not satisfy these requirements, the deed is voidable by the other party to the conveyance within a 2-year statute of limitations. ARS § 33-404 [E]. Therefore, a person who acquires an interest in Arizona real estate and places the property in a land trust of which the person is a beneficiary using a deed that does not disclose the name and address of the person/beneficiary has created a situation where the grantor/seller has the legal right and power to void the deed. This statute is the reason title insurance companies will not insure title obtained by a deed that has a trust as a grantor or a grantee unless the deed satisfies the requirements of the statute. A typical purpose of a ‘land trust’ or a ‘business trust’ is to hide assets owned by the beneficiaries. But every asset protection plan must have a business purpose. This does not include the ability to hide bona fide debts from creditors. So these types of trusts are not well-recognized for use in Arizona. That one cannot create a trust to defeat creditors is codified in ARS § 14-10505[A][1] that states, “During the lifetime of the settlor, the property of a revocable trust is subject to claims of the settlor’s creditors.” ARS § 14-10505 [A][2] states, “…with respect to an irrevocable trust, a creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit.” So a creditor may claim satisfaction against the trust’s assets unless the debtor can show the business purpose behind the plan. Violating ARS § 33-404 to create a land trust to hide ownership of Arizona real estate to prevent creditors from being paid the amount owed on a lawful debt is not a qualified business purpose.

1.4 Corporation. Chapter 3 of Title 29, ARS § 10-120 et seq. controls corporations in Arizona.

1.4.1 Corporation Types to Hold Real Estate. All for-profit corporations created under Arizona law have the same legal structure, rights and powers. Arizona recognizes that corporations may be formed for profit or not for profit, but not as C or S corporations. A corporation is called a C corporation if it is taxed under Subchapter C of the Internal Revenue Code of 1986 or an S corporation if it is taxed under Subchapter S of the Internal Revenue Code. C corporations and S corporations are taxed differently for federal income tax purposes [discussed below], but structurally and for most other purposes, they are the same.

1.4.2 Formation and Operation. Forming and operating a corporation under Arizona law is the most complex and costly of the real estate entity alternatives. Articles of Incorporation are filed with the Arizona Corporation Commission [“ACC”] and the shareholders will be subject also to its by-laws, as well as any shareholder agreements and other binding instruments. After forming the corporation, the directors named in the Articles prudently should have an organizational meeting to adopt resolutions approving the corporation’s bylaws, naming the officers of the corporation, and authorizing the the issuance of stock to the stockholders, the form of the stock certificate, and the opening of corporate bank accounts. Filing the Articles of Incorporation with the ACC is relatively nominal, but still more than that for a partnership or limited liability company. Arizona corporations must have a statutory agent, file an annual report with the ACC and pay a $45 fee to the ACC annually. The annual report, available on the ACC’s website, must disclose the names and addresses of all: (i) stockholders that own 20% or more of the stock, (ii) the directors, and (iii) the officers.

If the annual report is not filed timely, the ACC assesses a penalty and will eventually revoke the charter of a corporation that does not timely file its annual report. A single person may form an Arizona corporation and be its sole shareholder, officer and director. There are no limits on the number of stockholders or the types of entities that can own stock of a C corporation.

1.4.3 Control & Management. While the shareholders own a corporation, the Board of Directors is responsible for managing the corporation, with the assistance of the corporation’s officers. The shareholders elect the members of the Board of Directors at the annual meeting of shareholders. A corporation is operated day-to-day by its officers, and they report to and serve under the guidance of the Board of Directors. Arizona law requires that the shareholders hold an annual meeting, but directors should meet as often as necessary to manage the corporation and oversee the officers, [but not less than once a year]. Meetings of shareholders and directors must be called by giving proper notice as set forth in the Bylaws of the corporation. Each meeting requires a quorum to be able to conduct a meeting and to approve any action. All meetings of directors and officers should be documented with written minutes duly signed by the authorized managers.

1.4.4 Limited Liability. The engine for the growth of corporations, and arguably for the growth economically of the United States, is that a corporation will afford ordinarily its shareholders and managers limited liability. That is, shareholders, officers and directors of a corporation are not liable for the corporation’s obligations and liabilities. There are exceptions to this general rule; for example, directors and officers may be liable for improper or illegal conduct. The legal concept “piercing the corporate veil” occurs when a court permits creditors to penetrate this corporate shield of limited liability and imposes general liability. Piercing the corporate veil may result from something as seemingly innocuous as not observing the formalities of operating in the corporate form. The risk of having the corporate veil pierced is why it is very important that corporations hold properly called and documented annual and special meetings of stockholders and directors and that they file their annual reports and pay the filing fee timely.

1.4.5 Different Federal Income Taxation Treatment for C and S Corporations. A corporation is a distinct taxpayer under federal income tax law that files its own federal income tax return [Form 1120]. A C corporation must pay at its corporate tax rate on taxable income, and its losses can only be offset by the corporation’s income. Profits, losses and other tax items of a C corporation are not passed through to its shareholders for them to use on their personal income tax returns.

1.4.5.1 Because a C corporation is subject to double taxation on income—at the corporate level and again at the individual [shareholder] level—Subchapter S corporations are an attractive alternative for corporate ownership of real estate and other purposes. For qualifying S corporations, there is ordinarily no tax at the corporate level, i.e., distributions are ‘passed through’ to the individual level and taxed at the shareholder’s marginal tax rate.

An S corporation must file an in informational tax return on IRS Form 1120S to notify the IRS
of its profits, losses and other tax significant items, despite not being a taxpaying entity for
federal income tax purposes, it. See IRS Publication 542, Corporations.

1.4.5.2 An S corporation may not have more than 100 shareholders [spouses (and their estates) are treated as a single shareholder. Shareholders may only be individuals, estates, exempt organizations described in Internal Revenue Code Sections 401(a) or 501(c)(3) or certain trusts described in Section 1361(c)(2)(A). The corporation must not have more than one class of stock. The corporation must have a tax year end based on the calendar year unless a different year end was approved by the IRS. A shareholder may not be a nonresident alien. All shareholders of an S corporation must have agreed on Form 2553, the form to elect subchapter S tax treatment within 75 days from the date of formation, to adopt S corporation status.

1.4.5.3 Except in limited instances [e.g., taxable recapture if the corporation used the LIFO inventory method the year before converting to S status, taxable recapture for any investment credit, tax net recognized built-in gain, taxable excess net passive income], the profits and losses of the S corporation are passed through pro rata to its shareholders based on each shareholder’s percentage ownership of stock for them to report tax on their personal returns.

1.5 Limited Liability Company [LLC]. LLCs in Arizona are governed pursuant to Chapter 4 of Title 29, ARS § 29-601 et seq. under the Arizona Limited Liability Company Act.

1.5.1 General Benefits of the LLC Entity. The LLC form of entity enjoys advantages over the other types of entities. Overall, it has few legal formalities [no requirement for annual meetings and minutes]; it is cheap to form; it is cheap to operate [unlike Arizona corporations, no annual report accompanied by an annual fee is due the State of Arizona]; it is good asset protection vehicle [see below]; and it offers multiple ways to be taxed at the federal level. ; )

1.5.2 LLCs Are Simpler to Form and Operate. An Arizona LLC ordinarily is the preferred choice of entity to hold real estate because there are fewer legal formalities. In contrast, Arizona for-profit corporations, the most preferable alternative to an LLC for holding real estate in Arizona, must satisfy the following corporate requirements:

1.5.2.1 hold meetings of shareholders and of the board of directors at least annually;

1.5.2.2 document the meetings of shareholders and the board of directors with minutes or resolutions; and 1.5.2.3 file annually a report with the Arizona Corporation Commission [‘ACC’], together with a $45 annual fee to the ACC.

The significance of this distinction of formalities between an LLC and a corporation should not be lost; a corporation may be dissolved involuntarily by the ACC or a creditor may ‘pierce the corporate veil’ and attach personal assets of the corporate shareholder[s] to satisfy the corporation’s liabilities and obligations. The ACC will revoke the charter of the corporation if the annual meetings are not held and documented, or even if the corporation changes its place of business without notice to the ACC. Revocation of a corporation’s charter in Arizona, without reinstatement within the 6-year time period per ARS § 10-1422, results in punitive consequences for the corporation’s shareholders: [1] The shareholders receive a taxable distribution of their proportionate share of the corporation’s assets; and [2] the shareholders lose the “corporate shield” to protect them from the corporation’s debts and liabilities. They effectively become common law general partners, with each liable for all the debts and obligations of the unincorporated business activity. If an Arizona LLC is found delinquent and dissolved by the ACC, filing for reinstatement must also be made within six years from the dissolution date, which is roughly five months after the ACC discovers any delinquency. This may be accomplished by filing with the ACC the delinquent documents, all filing fees that are due, and the proper reinstatement fee.

1.5.3 LLCs Provide Asset Protection. An Arizona LLC is preferable, ceteris paribus, to an Arizona corporation. A judgment against the stockholder of an Arizona corporation gives the creditor greater collection power to enforce than a judgment against the member of an Arizona LLC. A judgment creditor may compel the debtor to dispose of his entire shareholder interest in a corporation, even if the value of the shares exceeds the amount of the debt. In contrast, a judgment creditor is limited to serving a charging order on the LLC–a court order that when and if any property including cash is distributed to the judgment debtor, the LLC instead must distribute the property to the judgment creditor. ARS §29-655 [A] provides: On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the member’s interest in the limited liability company with payment of the unsatisfied amount of the judgment plus interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the member’s interest.” The judgment debtor’s membership interest in the LLC otherwise is undisturbed. Further, ARS § 29-655 [C] provides: “This section provides the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the judgment debtor’s interest in the limited liability company. Absent a court order compelling the distribution of property from the LLC, the judgment debtor in a sole member LLC may refrain from distributing property indefinitely.

1.5.4 LLCs Permitted Four Alternatives for Federal Income Taxation. An LLC may be taxed at the federal level as [1] a sole proprietorship [single-member LLC or two-members who are a husband and wife who own their interest as community property]; [2] a partnership [if there are at least two members] under subchapter K of the IRC; as a C corporation under subchapter C of the IRC; or as an S corporation [if in compliance with subchapter S of the IRC]. As with a corporation, an LLCs can be taxed under subchapter S or subchapter C of the Internal Revenue Code, but the selection of the method of taxation does not transmute the LLC into a corporation. The LLC remains an LLC.

Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 89-100 (2018)

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