by Richard Keyt, Arizona LLC 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.
Arizona Limited Liability Company
Ease of Formation & Cost
To form a limited liability company under Arizona law, you file Articles of Organization with the Arizona Corporation Commission (the “ACC”), submit a cover sheet to the ACC along with the Articles and publish the a Notice of Publication in a newspaper of general circulation for three consecutive publications. Although Arizona law no longer requires that you submit an Affidavit of Publication from the newspaper to the ACC, I recommend that you do it so you will have prove on file with the ACC that the company complied with the publication requirement.
The ACC fee to file the Articles of Organization is $50. The fee to expedite the filing is another $35. You should always pay the additional $35 to get expedited review of your Articles of Organization. The time difference before ACC approval or rejection between regular filing and expedited filing can be as much as a month.
For a detailed step-by-step explanation about forming an Arizona limited liability company, see my article entitled “How to Form an Arizona Limited Liability Company.”
Number of Owners & Restrictions
The owners of an Arizona limited liability company are called “members.” An Arizona limited liability company may be formed with a single member or an unlimited number of members. There are no limits on the number of members or the types of entities that can be members of an Arizona limited liability company. Caveat: Some membership interests in a limited liability company may be securities for the purposes of federal and state securities laws, in which case securities law may limit the number and types of investor/members.
Control & Management
Control of an Arizona limited liability company is vested in the members. Arizona law provides for two types of management of an Arizona limited liability company. The type of management must be stated in the Articles of Organization filed with the ACC. Arizona limited liability companies are either member managed or manager managed. If the company is member managed, all members have management responsibility.
If the company is manager managed, the manager(s) selected by the members are responsible for managing the business and affairs of the company. A manager managed company may have one manager or more than one manager. Managers do not have to be members. Managers can be a person or an entity and reside inside or outside Arizona.
An Arizona limited liability company may operate without a written agreement among the members. Attorneys recommend that limited liability companies that have more than one member adopt a written agreement called an “Operating Agreement” that states the rights and obligations of the members and the company. For why your company may need a comprehensive written Operating Agreement, see my article entitled “Arizona Limited Liability Company Operating Agreement FAQ.”
Arizona law does not require that a limited liability company have annual meetings, file reports with the Arizona Corporation Commission, Arizona Secretary of State or other state agency or that the limited liability company pay any annual fees.
The Articles of Organization of a manager managed Arizona limited liability company must state the business address of the company in Arizona (post office boxes are not allowed in the Articles) and the name and business, residence or mailing address of: (i) each person who is a manager of the limited liability company, and (ii) each member who owns a twenty per cent or greater interest in the capital or profits of the limited liability company. An Arizona limited liability company that is manager managed must amend its Articles of Organization on file with the ACC within thirty days after a change in: (i) the persons who are managers, or (ii) the members who own twenty per cent or greater interest in the capital or profits interest of the limited liability company.
The Articles of Organization of a member managed Arizona limited liability company must state the name and business, residence or mailing address of each person who is a member of the limited liability company. An Arizona limited liability company that is member managed must amend its Articles of Organization on file with the ACC within thirty days after there is a change in the persons who are members.
An Arizona limited liability company must also maintain a statutory agent within Arizona to accept service of legal documents on behalf of the company. The name and address of the statutory agent is a matter of public record.
Owner’s Protection from Liabilities
Like stockholders of a corporation, the general rule with respect to Arizona limited liability companies is that the members and managers are not liable for the company’s obligations and liabilities. There are exceptions to this general rule such as managers may be liable for authorizing improper or illegal conduct.
There is a legal concept called “piercing the company veil,” which is the term given when a court disregards the company shield that normally protects members from liability and imposes liability on one or more members. When a court pierces the company veil, it is usually because the members and/or managers have not followed the formalities of operating in the company form.
Federal Income Taxation
A limited liability company may be taxed for federal income tax purposes as one of the following four tax methods:
- Sole proprietorship if the LLC is owned by one individual or by a husband and wife who own the company as community property.
- Disregarded entity if the LLC is owned by a single entity.
- Partnership if the LLC is owned by two or more owners.
- C corporation if the LLC files an IRS Form 8832 .
- S corporation if the LLC files an IRS Form 2553 signed by all owners and their spouses; provided, however, the owners must satisfy the requirements applicable to S corporation taxation.
If the limited liability company does not elect its classification, the IRS assigns a default classification of partnership (for multi-member limited liability companies) or sole proprietorship or disregarded entity (for single member limited liability companies).
The limited liability company may elect to be taxed as a partnership or as a corporation for federal tax purposes by filing IRS Form 8832: Entity Classification Election. For more information, see IRS Publication 542 Corporations, and IRS Publication 541 Partnerships.
In general, the difference between being taxed as a corporation and being taxed as a partnership is that partnerships are not taxpaying entities and corporations (other than S corporations) are. The profits, losses and other tax items of an limited liability company taxed as a partnership are passed to the members of the company pro rata according to their ownership and included on the members’ federal income tax returns. By electing to be taxed as a partnership for federal income purposes, a limited liability company can avoid the double tax that can occur with a C corporation when the C corporation has taxable income.
Example: If two people form a limited liability company (taxed as a partnership) in which they are 25% and 75% members and the company has $100 of profit at the end of the year, the profit is allocated $25 to the 25% member and $75 to the 75% member. The company does not pay any income tax on the $100 of profits.
One of the advantages of a limited liability company (taxed as a partnership) has over a corporation is that the members can agree to make special allocations among them of tax items such as profits and losses. In the preceding example, if the members agreed that the 75% member should get 100% of the profits until she receives an amount equal to the amount she initially contributed to the capital of the company ($100) plus a simple return of 8% per annum, all of the $100 of profit would be allocated to the 75% member and the 25% member would get nothing.
Before electing how your Arizona limited liability company will be taxed, you should consult with your accountant because the election could have significant economic consequences. Facts and circumstances applicable to each new Arizona limited liability company will influence the taxation election that is best. An erroneous tax election can be very expensive.\
Arizona limited liability companies formed to hold real estate should be aware of and resolve three important issues that may arise with respect to the company owning real estate. The issues are: (i) insurance coverage, (ii) existing lien “due on sale” clauses, and (iii) title insurance.
If your limited liability company holds title to real estate, improved or unimproved, you must make certain that the company is covered by insurance appropriate for the type of real estate and the activities of the company and that the amount of coverage is adequate. If your company is involved in a business or for-profit activity, it probably must acquire business insurance coverage.
If you are relying on your personal insurance coverage or umbrella coverage to protect you and your limited liability company and you have a claim, your insurer may deny coverage on the basis that the insurance covers personal losses only rather than losses arising from a business or for-profit activity. Read your insurance policy carefully to confirm if you have coverage or not. In general, if you do not have an insurance policy that names your limited liability company as an insured, there is a substantial risk that your insurer might deny coverage if the company suffers a loss. The best way to protect your limited liability company with respect to insurance coverage is to GET EVIDENCE OF COVERAGE IN WRITING FROM THE INSURANCE COMPANY.
Business insurance generally is more costly than personal insurance so you can expect to pay more. Beware of paying less for personal insurance coverage for real property owned by your limited liability company because you may not actually be covered.
Due On Sale Clauses
Most financial institutions and home loan lenders use loan documents (promissory note and/or deed of trust) that contain a “due on sale” clause. This type of clause is usually broadly worded and gives the lender a right to call the loan (accelerate the entire balance owed) if the borrower sells, transfers or encumbers any interest in the real property.
If you own real estate that you want to transfer to your limited liability company, you must sign and record a deed that conveys title to the company. Notwithstanding the fact you may be the sole owner of your limited liability company, a transfer of title from you to your solely owned limited liability company will be a violation of most due on sale clauses and give your lender a right to call your loan.
If you own land that you want to put into your limited liability company and the land is subject to a lien that contains a due on sale clause, the prudent course of action is to obtain the written consent to transfer the land to the company from the lender before you transfer the land. If you transfer the land without obtaining the lender’s consent, you risk having the lender demand immediate payment in full.
Lenders make loans to a specific borrowers under very specific terms. In general, lenders do not like to make a real-estate secured loan to a borrower and find that the borrower is not the actual owner of the property. Some lenders have policies requiring strict enforcement of their due on sale clauses. If you cannot obtain your lender’s written consent authorizing you to transfer your land to your limited liability company, a solution to the problem is to refinance the loan with another lender with your limited liability company as the borrower and you as the guarantor of the company’s debt.
If you enter into a contract to purchase land that you want to be owned ultimately by your limited liability company, you should apply for the loan in the name of the company before closing and have the company sign the promissory note and deed of trust as the borrower and take title to the land at the closing. The lender should not care that you are using a limited liability company to hold title because it has both the company and you (as the guarantor) on the hook to pay the debt. Putting the land in a limited liability company also enhances the lender’s ability to get paid in full because if there is a disaster arising from the ownership of the land, you may be protected from creditors’ claims arising from the land, which would leave your personal assets free of the creditors’ claims and available to the lender to pay the debt.
If you take title to real property in your name, the title insurance policy will insure your title. If you later transfer the land to an entity, that entity is not covered by the title insurance. If there is a title defect, the limited liability company does not have a claim because it is not a named insured under the policy, and you do not, as a general rule, have a claim because you no longer own the property. Therefore, by taking title in your name and then conveying the land to your limited liability company, you may be effectively throwing your title insurance coverage out the window.
If you have a contract to purchase real property and you want your real property to be owned by your limited liability company, it is best to assign your rights to buy to the company and have the company take title at closing and be the named insured under the title insurance policy.