LLCs vs. Corporations: Which Type of Arizona Entity Should You Form?
by Richard Keyt, Arizona LLC attorney
People frequently ask me what type of entity should they form to engage in business in Arizona or to hold Arizona real estate. They also frequently tell me that their accountant or friend said they should form an “S corporation.” Arizona has “for profit corporations” and “nonprofit corporations,” but technically, there is no such thing in Arizona or any other state as an “S corporation” or a “C corporation.”
Subchapter C and Subchapter S of the Internal Revenue Code
The terms “C corporation” and “S corporation” refer to the specific subchapter of the Internal Revenue Code under which an entity is taxed for federal income tax purposes. If an entity formed under Arizona law is a corporation that elects to be taxed under subchapter S of the Code, the entity is commonly referred to as an “S corporation.” Although partnerships are taxed under subchapter K of the Internal Revenue Code, nobody refers to partnerships as “K partnerships.” People commonly confuse the way an entity is taxed for federal income tax purposes with the type of entity formed under state law.
Like corporations, LLCs can be taxed under subchapter S or subchapter C of the Internal Revenue Code, but if the LLC elects either of those methods of federal income taxation, the LLC does not then transmute itself into a corporation. The LLC remains an LLC even if it is taxed under subchapter S or subchapter C of the Code.
Beware the Ignorant Advisor
If your advisor tells you that you should form an S corporation you should ask your advisor the following question:
“Do you mean I should form an S corporation or an entity that is taxed as a S corporation?”
If your advisor answers that you should form an S corporation, you should run, not walk, to a more knowledgeable advisor. It is a very bad sign of federal income tax knowledge if your advisor does not answer that you should form an entity that is taxed as a S corporation. I would not want that person to give me federal income tax advice because he or she lacks a fundamental knowledge of federal income tax law and how it relates to they type of entity.
Question 1: What Type of Entity?
Therefore, before engaging in business or forming an entity to hold real estate, the first question should be: Which type of entity should you form?
In Arizona, the types of entities used to conduct a for profit business are:
- the limited liability company
- the corporation,
- the limited partnership, and
- the general partnership.
In reality, nobody should ever form a general partnership because all partners are one hundred percent liable for the debts and obligations of the general partnership. See Beware the Stealth General Partnership: A Common Real Estate Investment Scenario Is a “TIED,” a Ticking Improvised Explosive Device Waiting to be Detonated.
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. Since 1992 when LLCs were created in Arizona, the LLC has become the most popular type of Arizona entity.
Over the last three ACC fiscal years, people formed 136,503 Arizona LLCs and 22,742 Arizona for profit corporations. That is 6 times more LLCs than corporations. In the fiscal year of the ACC ending June 30, 2011, the ACC formed 6.3 LLCs for every corporation. See “Arizona Corporation Commission Entity Statistics.”
As you can see from those numbers, the LLC is the most popular type of entity in Arizona today and it is growing in popularity. Most people who form Arizona corporations do so out of ignorance. They are familiar with the corporation, but simply do not know that the Arizona LLC is a better entity than the Arizona corporation in most cases. People who form an Arizona corporation now do not know that the corporation is an obsolete entity that should be used only in a few select circumstances.
Most of the time, the Arizona limited liability company is the preferred entity for operating a business in Arizona. If the entity is to hold title to Arizona real estate, an LLC is almost always the best type of entity. There are limited instances, however, when a corporation makes sense, but rarely for holding real estate.
Question 2: How Should the Entity Be Taxed For Federal Income Tax Purposes?
After forming the entity, the next question is: How should the entity be taxed for federal income tax purposes?
If you form a corporation, it will be taxed one of TWO ways, either under:
- subchapter C of the Code, or
- subchapter S of the Code.
However, if you form an LLC, it can be taxed FOUR possible ways. The four choices of federal income taxation for an LLC are:
- a sole proprietorship (if the LLC has only one member or only two members who are a husband and wife who own their interest as community property – see Revenue Procedure 2002-69),
- under subchapter K of the Code as a partnership (if there are at least two members),
- under subchapter C of the Code as a “C corporation,” or
- under subchapter S of the Code as an “S corporation” (if the LLC satisfies the requirements for subchapter S taxation).
Four Tax Choices vs. Two Tax Choices
One reason the LLC is so popular today in Arizona is because the LLC has maximum flexibility in picking the method of federal income taxation. LLCs can chose the best of four methods of federal income taxation, while corporations only have two of the four choices.
Once you form your LLC, you have 75 days from the date of formation to decide how to tax the entity and to file with the IRS any necessary election forms (IRS Form 8832 – to elect subchapter C taxation, or Form 2553 – to elect subchapter S election).
Important Asset Protection Reason Why an AZ LLC is Better than an AZ Corporation
There is a major asset protection reason why an Arizona LLC is preferable to an Arizona corporation. A creditor that gets a judgment against the stockholder of an Arizona corporation has significantly greater enforced collection power than does a creditor that gets a judgment against the member of an Arizona LLC. The difference in creditor’s rights when an Arizona corporation vs. an Arizona LLC is involved is as different as night is from day.
Consider the following two scenarios:
- Corporation: You are the sole shareholder of an Arizona corporation with a value of $100,000.
- LLC: You are the sole member of an Arizona LLC with a value of $100,000.
If a creditor gets a judgment against you for $50,000, the creditor can use Arizona law to collect the judgment and do the following:
- Corporation: Sell all of your stock of the corporation at an auction. Result: You lose your entire interest in the corporation, including the value of the corporation over and above the amount of the debt.
- LLC: Serve a charging order on the LLC that includes a court order that if any money or property is ever distributed to you, the LLC must instead deliver the money or property to the creditor. Result: You do not lose any part of your interest in the LLC, but simply do not distribute any money or property from the LLC to you.
Moral of the Corporation vs. LLC asset protection story:
- Corporation: If you own stock of an Arizona corporation, your creditor who gets a judgment against you from an Arizona court may sell the stock at an auction and divest you of your entire interest in the stock.
- LLC: If you own a membership interest in an Arizona LLC, your creditor who gets a judgment against you from an Arizona court cannot force you to sell your interest in the company and you may retain it indefinitely. The charging order will require that any distributions of money or property from the LLC to you must be paid to the creditor. If you have control over the LLC, you can cause the LLC to refrain from distributing money or property to you. This scenario may give the debtor some leverage to settle with the creditor for less than the total amount owed.
LLCs Have Six Fewer Formalities
Another reason to form an Arizona LLC is to avoid six formalities that apply to Arizona corporations. Arizona for profit corporations must satisfy the following six corporate requirements:
- hold annual meetings of shareholders,
- hold annual meetings of the board of directors,
- document the meetings of shareholders with minutes or resolutions,
- document the meetings of the board of directors with minutes or resolutions,
- file an annual report with the Arizona Corporation Commission, and
- pay a $45 annual fee to the Arizona Corporation Commission.
None of those six corporate formalities apply to an Arizona LLC.
The ACC Annual Report Nightmare
Recently a man called me from out of state because he had just discovered that the corporation he formed years earlier to hold title to an industrial property in Arizona had been terminated by the Arizona Corporation Commission. I checked the ACC’s website and he was correct, but the ACC revoked the corporation’s charter NINE YEARS earlier.
The ACC revoked the corporation’s charter because the corporation moved and did not notify the ACC of its new address so the US Post Office did not forward the annual report form to the new address. The ACC instructs the Post Office to return annual report forms instead of forwarding the form to the new address. When the corporation failed to file its annual report, the ACC terminated the corporation’s existence. If somebody had been injured on the land, the former shareholders of the terminated corporation would not have been shielded from liability by the corporation because the corporation ceased to exist.
This scenario happens all too frequently to Arizona corporations. Most Arizona corporations that move do not remember to notify the ACC of their new address. Telling the ACC about a move is not high on the priority list of most corporations. This slight oversight, however, can have dire consequences for the shareholders.
When the ACC revokes the charter of an Arizona corporation and the three year period of time to reinstate the corporation lapses, the shareholders of the corporation suffer the following extremely adverse consequences:
- The dissolution of the corporation causes the shareholders to receive a taxable distribution of their proportionate share of the corporation’s assets. For example, if an Arizona corporation has two shareholders who each own one half of the stock of the corporation and the corporation has $100,000 of assets and is administratively dissolved by the ACC for failing to file its annual report, the IRS will claim that each shareholder receives a taxable distribution from the corporation of $50,000.
- The shareholders cease to have the “corporate shield” to protect them from the corporation’s debts and liabilities and become common law general partners who are each one hundred percent liable for the debts and obligations of the unincorporated business activity. See Beware the Stealth General Partnership: A Common Real Estate Investment Scenario Is a “TIED,” a Ticking Improvised Explosive Device Waiting to be Detonated.
The Annual Meeting and Minutes Problem
In my experience practicing business law in Arizona since 1980, most Arizona corporations do not hold annual meetings of shareholders and directors and therefore do not document the meetings. These are four corporate formalities that are almost always neglected.
When creditors try to pierce the corporate veil and hold the shareholders of a corporation liable for the debts and obligations of the corporation, one of the weapons they use is to claim that the court should disregard the corporate shield and the shareholders should be liable for the corporation’s debts because the shareholders did not operate the corporation in compliance with Arizona corporate law. Arizona law requires annual meetings. The way to document meetings is with minutes or signed corporate resolutions.
No annual meetings of shareholders and no minutes means that a corporation has FOUR STRIKES against it right out of the box. Four strikes does not mean the corporation is “out” and the corporate veil will be pierced because Arizona courts have not said how many strikes a corporation gets before it will find the shareholders liable for the debts of the corporation. An Arizona court will pierce or not pierce the corporate veil depending on all the facts and circumstances of a case, but it is not a good thing to start your defense with four strikes against you.
Arizona LLCs Have Fewer Required Legal Formalities
One of the main reasons informed people prefer to form Arizona LLCs over Arizona corporations is because the Arizona LLC does not have any of the six corporate formalities listed above. An Arizona LLC will never have its existence terminated by the Arizona Corporation Commission for failing to file an annual report because Arizona LLCs do not file annual reports. An Arizona LLC is not required by Arizona statutes to have meetings of members and managers or to document meetings with minutes or signed resolutions. If a creditor tries to pierce the company veil and hold the members liable for the debts of an Arizona LLC, LLC will NOT have FOUR STRIKES against it right out of the box.
Although annual or regular meetings of members and managers are not required by Arizona statutory law, I recommend that all Arizona limited liability companies hold regular meetings and annual meetings of members and managers because it is a good business practice. An Arizona LLC that has a documented history of holding regular and annual meetings of members and managers will be in a strong position to convince an Arizona court that the members of the LLC are operating the LLC like any prudent business and should be entitled to the protection of the LLC shield.
People are forming six times as many LLCs as corporations in Arizona because the LLC is cheaper to form, cheaper to operate, has four choices of federal income taxation, and has fewer formalities than Arizona corporations. Let us form your Arizona limited liability company for our low fixed price of $597, which includes the $85 ACC expedited filing fee and the cost to publish the Notice of Publication in an Arizona newspaper approved by the Arizona Corporation Commission.
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For a complete description or KEYTLaw’s low price fixed legal fee LLC formation service and the tasks we will perform if you hire us to prepare your new Arizona limited liability company, see the KEYTLaw LLC Formation Service.
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