by Richard Keyt, Arizona LLC, corporate and business lawyer
This article is part of a series of nine related articles I wrote about the seven types of entities used in Arizona to operate a business and to hold business assets and investment real estate. The articles are: (1) the “Best” Arizona Entity, (2) limited liability companies, (3) sole proprietorships, (4) general partnerships, (5) limited partnerships, (6) C corporations, (7) S corporations, (8) business trusts, , and (9) the entity comparison table. The type of entity can have significant income tax and asset protection consequences. The articles discuss the entities in terms of ease and cost of formation, number of owners & restrictions on ownership, privacy, control and management, owners protection from liabilities of the entity, and federal income taxation issues.
Warning: Never, never, never, never own or operate a business using a revocable business trust because the trust creator is 100 percent liable for everything that goes wrong and his or her life savings is at risk.
Ease of Formation & Cost
A trust is relatively easy to form if you have a good trust agreement. The trust does not need to 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. 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. 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 that involves valuable property should be evidenced by a good written trust agreement that instructs the trustee on exactly what to do with the trust property. A written trust agreement should be prepared by an attorney and custom drafted to meet the needs and desires of each trustor. A written trust agreement prepared by an attorney can cost as little as $500 or more than $2,500.
A “land trust” or “Illinois land trust” is a special type of trust used by some owners of real property to hide the identity of the owner. The land trust is usually revocable. The trustee of a land trust is frequently an entity or a person other than the property owner. Apparently, in some states, the identity of the beneficiaries of the land trust can be hidden from the public.
I am not a fan of Arizona land trusts. See my article called “Arizona Land Trusts: Deal or No Deal? Unsubstantiated Sightings of Bigfoot & Arizona Land Trusts.”
Number of Owners & Restrictions
One person can form a trust and be the sole trustor, trustee and beneficiary. Arizona law does not restrict the number or types of entities that may be trustees or beneficiaries of a trust.
Control & Management
Trusts are managed by the trustee or trustees who are controlled by the trust agreement. Trustees owe a special or fiduciary duty to the beneficiaries of the trust. Because of this fiduciary duty, trustees must take care to carefully follow their instructions in the trust agreement. A trustee who breaches a fiduciary duty that causes harm to a beneficiary is liable to the beneficiary for any damages. Because a trustee assumes a high risk of liability for mismanagement of assets, the job of trustee should not be undertaken without careful consideration of the risks versus the rewards of being trustee.
The trustee can manage only assets that are actually transferred to the trustee. For example, if a trustor creates a land trust to hold land, but fails to sign and record a deed that conveys the land to the trustee, the trustee cannot manage the land because the trustee does not have title to it. This is an example of failing to fund a trust, which unfortunately happens much too often.
A trust can be a very private method to own and administer assets. Because the trust agreement is normally not a matter of public record, the names of the trustor, the trustee and the beneficiaries and the assets held by the trustee are not open to public inspection.
Some of this privacy is lost, however, when real property located in Arizona is transferred to or from a trust. Arizona Revised Statutes Section 33-404 requires that every deed of Arizona real property in which the grantor or grantee is a trustee must disclose the names and addresses of the beneficiaries for whom the grantee holds title and shall identify the trust.
Owner’s Protection from Liabilities
In general, the beneficiaries of a trust are not liable for the obligations and liabilities of the trust, but the trustee is liable to the extent of the value of the assets held in trust. Some commentators claim that a land trust can be used to acquire title to real property without assuming any existing liabilities. This may be possible in some acquisitions if the trustee acquires title subject to an existing lien or if the trustee assumes the existing lien without looking beyond the trustee. Before consenting to a transfer of title a knowledgeable lienholder, however, will ask to see the trust agreement to confirm that it is revocable and then require that the trustor guaranty or assume the liability in addition to the trustee.
Caution: If a trust is revocable, the trustor continues to be deemed to be the ultimate owner of the trust assets. For example, if I create a revocable land trust and convey my single family rental home to my land trust and a tenant is injured on the property because of a faulty electrical system, the injured tenant may sue the land trust and me because the revocable trust does not protect me from creditors. This potential trustor liability could be avoided if the land were held by a limited liability company owned by the trust.
Warning: You should never use a revocable trust to own and operate a business because it does not provide any asset protection to the creators of the trust.
Federal Income Taxation
If a trust is revocable, it is a “grantor” trust and its profits, losses and tax items are reported on the federal income tax return of the trustor. If a trust is not a grantor trust, it must file an IRS form 1041. The taxation of non-grantor trusts is complex and may result in federal income taxes payable by the trust and/or one or more beneficiaries. Trustees of non-grantor trusts should have an experienced accountant prepare the trust’s tax return.
This article is a general discussion of the characteristics of trusts. The article is not specific advice. Before choosing your new entity, you should consult with your accountant and business attorney and discuss your options and choose the type of entity that is best for you in light of your particular facts and circumstances.