Planning Notes

In contrast to corporations, in which a creditor who obtains a judgment in court (judgment creditor) can execute on shares of a shareholder, most states provide that judgment creditors of owners of interests in some types of legal entities are limited to obtaining a charging order. A charging order is a court-ordered remedy that only entitles the holder of the order to temporarily receive distributions from an entity in which a judgment debtor has an interest until the judgment has been satisfied. Holders of charging orders are not entitled to participate in management of the entity or compel distribution.

Entities

The most common types of entities that limit creditors to obtaining charging orders are the limited liability company (LLC) and limited partnership (LP). However, other entities may also limit creditors to obtaining charging orders, including the limited liability partnership (LLP) and limited liability limited partnership (LLLP).

Rationale for Charging Orders

Unlike corporations, in which the shareholders generally possess the right to elect the board of directors, but do not have the right to manage the corporation (unless it is a statutory close corporation), interest holders in some partnerships or partnership-like entities, e.g. member-managed LLCs, possess the right to actually manage the entity. Legislatures have been reticent to force those non-debtor members into an involuntary partnership-like relationship with judgment creditors.

Distribution Provisions

Although a charging order may seem like an effective remedy for creditors, what happens if the entity simply doesn't make distributions? Some partnership agreements and LLC operating agreements provide that distributions will be made entirely in the discretion of the general partner or manager, thereby providing no means through which creditors can compel distributions. This means that a charging order may be significantly less effective and valuable than may appear on its face.

Foreclosure, Taxes, & Phantom Income

Although charging orders are often viewed as a creditor's exclusive remedy against partnership and partnership-like interests, courts in some states have permitted creditors to foreclose on such interests. However, Arizona limits creditor remedies against both LPs (ARS § 29-341) and LLCs (ARS § 29-655) to charging orders as "the exclusive remedy."

Charging orders are one feature of LLCs
Learn More »In those states that do allow foreclosure, either tacitly or affirmatively, it does come with a very significant potential cost: income taxes.It is unclear whether the Internal Revenue Service (IRS) or state taxing authorities will require the holder of a charging order, to whom distributions have not been made, to pay taxes on the holder's share of an entity's taxable income or so-called phantom income, but the possibility cannot be ignored (Revenue Ruling 77-137). However, it is very likely that IRS and state taxing authorities will require a judgment creditor who forecloses upon a partnership or partnership-like interest to pay taxes in such circumstances because the creditor is the owner of the interest.

Because of the above-described limitations of a charging order or successful foreclosure of an interest in a limited partnership, a limited liability company, and similar entities that are taxed as partnerships, creditors may be less inclined to pursue those interests or more willing to settle their claims than if they had access to the assets held in these entities.

This brief overview of some important considerations associated with charging orders and asset protection is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Two bills, Senate Bill 1499 (SB 1499) and House Bill 2424 (HB 2424), have recently been introduced into the Arizona Legislature to reform Arizona's probate, conservatorship, and guardianship laws under the Arizona Probate Code, primarily by modifying the Arizona statutes applicable to Persons Under Disability And Their Property (A.R.S. § 14-5101 to 15-5501). In addition to these modifications, HB 2424 also proposes to create a Probate Advocacy Panel to oversee Arizona's probate courts.

Senate Bill 1499

SB 1499 proposes to:

• Require guardians and conservators to submit estimates of costs to probate courts;
• Require probate courts to oversee and approve expenditures in excess of those estimates;
• Permit probate courts to require a party challenging guardian or conservator actions to reimburse the other party if the court determines that an action was not filed in good faith, was not grounded in fact or based on law, or had another improper purpose.

House Bill 2424

HB 2424 proposes to:

• Establish a Probate Advocacy Panel to oversee Arizona's probate courts;
• Require guardians and conservators to account for expenditures on a monthly basis;
• Require the Arizona Supreme Court to establish a schedule of fees permitted to be charged by fiduciaries acting in furtherance of a conservatorship or guardianship;

Although HB 2424 doesn't expressly apply to conservatorships, the text of the bill appears to be intended to apply to both guardianships and conservatorships.

As of this writing, neither bill has been passed by either chamber of the legislature and only time will tell whether these specific reforms, or some derivative(s) thereof, become law.

This brief overview of some important considerations associated with Arizona Probate, Guardianship, & Conservatorship Law Reform, SB 1499, and HB 2424 is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Minority discounts are a generally accepted practice used in determining the fair market value of non-controlling, minority interests in corporations. Such discounts are also often deemed valid by the Internal Revenue Service (IRS) when calculating the federal estate and/or federal gift taxes that are associated with interfamilial transfers of interests within a corporation.

Revenue Ruling 93-12

In a significant departure from its previous position, the IRS issued Revenue Ruling 93-12 in 1993 holding that a minority discount is permissible for the gift of a minority interest in an enterprise entirely controlled by the donor or the deceased donor's family. Previously the IRS aggregated the interests of family members in determining whether a minority control discount was valid.

At issue was the validity of minority control valuation discounts taken when a donee who owned 100% of the outstanding shares of a corporation, having one class of stock, simultaneously gave all of his interest, in equal amounts, to his five (5) children. In specific the IRS stated, "[i]f a donor transfers shares in a corporation to each of the donor's children, the factor of corporate control in the family is not considered in valuing each transferred interest."

Private Letter Ruling 9449001

The IRS further acknowledged the position above in a private letter ruling stating that the fair market value standard is used in determining the valuation of gifts, i.e. price at which a willing buyer and willing seller, neither being under any compulsion and both having knowledge of the relevant facts, would exchange property.

Economic Substance

In certain circumstances, and in spite of the aforementioned rulings, the IRS has argued that minority control discounts in closely-held corporations are invalid if a corporation or partnership was created principally to produce such discounts. In particular, the IRS has claimed that these transactions lack "economic substance," i.e. there were no substantial changes in the relationships and rights of the parties involved, rather, changes in form.

For example, three years prior to Revenue Ruling 93-12, the tax court disregarded a minority control discount in Estate of Murphy (60 TCM 645). In Murphy, a woman with terminal cancer transferred 2% of her interest in a corporation to her children thereby decreasing her interest just below 50% and she subsequently died 18 days later. The tax court reasoned that no substantial change in the parties positions had occurred despite such a significant change in form.

Conclusion

Although the IRS has effectively prohibited the use of minority control discounts in certain limited situations, such discounts are, more often than not, an approved strategy to reduce federal gift taxes directly and federal estate taxes indirectly.

This brief overview of some important considerations associated with minority control discounts and gift taxation is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Although S-corporations and LLCs that elect partnership tax treatment are often thought to be very similar in terms of taxation, i.e. they allow pass-through taxation in which the entity itself is not taxed, there are a number of important taxation-related differences between them because they are not taxed under the same provisions of the Internal Revenue Code (LLCs may be taxed as partnerships under Subchapter K of the Internal Revenue Code while S-corporations are taxed under Subchapter S, hence the name "S-corporation").

Entity-Level Recognition of Gain & Loss

One important difference between S-corporations and LLCs is whether gain or loss must be recognized at the entity level when property is distributed to shareholders/members.

S-Corporations

When property is distributed to S-corporation shareholders, the corporation must recognize any gain or loss associated with the property. Any gain is then passed through to the shareholders. 26 U.S.C. §1368(b).

LLCs

In contrast, most distributions of property by an LLC that is taxed as a partnership, do not require the LLC to recognize gain or loss on the distribution. 26 U.S.C. §731(a)(1).

Shareholder / Member-Level Recognition of Gain & Loss

Another important difference between S-corporations and LLCs is whether the shareholders/members themselves must recognize gain and loss on distributions.

S-Corporations

Because S-corporations must recognize gain or loss on the distribution of property to a shareholder, all the individual shareholders, even those shareholders who do not receive the property distribution, must recognize gain or loss on the distribution of the property and will be taxed accordingly.

LLCs

Because an LLC, generally, does not recognize gain or loss on distributions of property, the individual LLC members who do not receive the distributed property usually need not recognize the gain or loss associated with the distribution. However, the member who receives the distribution of property may or may not recognize gain or loss on the receipt of property depending upon the type of property distributed and the recipient member's cost basis in his or her LLC interest.

This brief overview of some important considerations associated with the taxation of Subchapter-S corporations and limited liability companies (LLCs) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

The transfer of property to an asset protection plan after liability has attached is fraudulent and will not be respected by the courts.

Asset protection is the process of arranging one’s assets to preserve maximum value for the owner and family, etc. in the event of creditor problems. It is not a single device that can be simply employed or elected. Instead, it involves the coordinated use of multiple legal disciplines, planning techniques and tools tailored to the assets and circumstances of the individual.

That being said, one of the key techniques of an asset protection strategy is to title assets in separate legal entities, but first a little background about liability and separate entities.

Inside Liability

In this post we refer to the liabilities associated with specific assets, e.g. real estate holdings, as inside liabilities, i.e. the liability originates from the asset. For example, if a tenant or visitor is injured on the premises of an apartment building, the tenant or visitor may sue the owner of the apartment building for damages associated with his/her injuries. 

An asset protection plan can help to insulate the owner from inside liabilities by having the asset owned by a separate legal entity to create a barrier between creditors and the owner's other assets. Single-member LLCs are widely used for this purpose.

Outside Liability

We'll call liabilities not associated with a specific asset outside liabilities. An asset protection plan can also protect against outside liability. For example, if a malpractice judgment is entered against a physician, the judgment creditor will be able to attach all of the assets to which the physician personally holds title to satisfy the judgment.

A properly created asset protection plan can potentially shield assets from such outside liability attachment by having assets owned by a separate legal entity controlled by someone other than the judgment debtor. This effectively precludes the use of a single-member LLC for outside liability protection.

Charging Orders & Forced Surrender

The applicable LLC statutes of many states, Arizona included, provide that the exclusive remedy against an LLC member's interest in an LLC is a charging order. This means that creditors cannot attach the assets owned by the LLC; rather, they only have an interest in the distributions made by the LLC. If nothing is distributed, the creditor receives nothing. However, if the judgment debtor controls distributions, the court can order the debtor to make distributions or sell LLC assets. For this reason single-member LLCs are generally not effective for protecting assets from outside liability. Furthermore, courts in several of states, e.g. Florida & Colorado, have held that creditors can effectively disregard a single-member LLC and force surrender of all right, title, and interest in the LLC.

Under any asset protection plan, the transfer of assets must occur well before the liability arises. 

This brief overview of some important considerations associated with asset protection and limited liability companies (LLCs) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

This post is part of our continuing series addressing basic areas of the law.

Probate is the process through which a will is validated by the Arizona Superior Court and the personal representative is appointed, gathers the assets of the decedent, pays the liabilities, and distributes the remaining assets in accordance with the provisions in the will.

This probate process is often thought of as expensive and time consuming, however, in many situations it can occur relatively quickly and with relatively little cost.

Probate Assets 

Arizona law provides that a decedent's probate estate contains all of that decedent's separate property and half of the community property in which the decedent had an interest except property that automatically passes to another by operation of law or contract, e.g. real property held in joint tenancy or life insurance proceeds.

Probate Procedures

In Arizona, an estate will be probated via one of three processes: 1) informal probate, 2) formal probate, and supervised probate. In general, informal probate requires the least amount of court involvement and cost, while both formal and supervised probate may require significantly greater court involvement and cost.

Costs

As previously mentioned, a disadvantage of probate can be the cost and amount of time it may entail depending upon the type of probate proceeding Arizona law requires.

In contrast to a living trust, probate may require more out-of-pocket cost than the cost of administration of a living trust. However, there is a less-obvious consideration as to costs: when costs are are paid. The costs associated with living trusts are generally paid while the grantor is alive while the bulk of the costs associated with wills and probate are paid after the testator's death. 

Bar to Unsecured Creditors

Arizona law imposes a limited time period, 4 months from the date of first publication, during which unsecured creditors of a decedent's estate must present their claims against the estate. After this period of time has elapsed, unsecured creditors are barred from making claims against a decedent's estate and any assets transferred out of the estate during probate.  

Taxes

Another common misconception is that estates which are transferred through living trust will be less impacted by estate taxes. Even though assets held in living trust are not titled in the name(s) of the person(s) who created a trust, they will be treated the same as assets that are probated, i.e. included in decedents' gross estate.

This brief overview of some important considerations associated with Arizona probate law is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Although it's fairly well-known that the federal estate tax was repealed for 2010 but returned in 2011, what is the status of Arizona's estate tax? As of January 2011, Arizona does not collect an estate tax, known to many as an inheritance tax.

Prior to 2005, Arizona imposed an estate tax equal to the amount of the federal estate tax credit. However, The Economic Growth and Tax Relief Reconciliation Act of 2001, which phased out the federal estate tax until 2011, also eliminated the federal credit which had the effect of eliminating the state-level estate tax.

Although the estate tax returned in 2011, the Tax Relief Act of 2010 did not reinstate the state-level estate tax credit. Further, in 2006, Arizona officially & permanently repealed Arizona's estate tax. This means that, unlike the federal estate tax which was temporarily repealed until 2011, Arizona's estate tax will not return unless the Arizona Legislature reinstates the estate tax via legislation.

This brief overview of some important considerations associated with Arizona's estate tax is by no means comprehensive. Always seek the advice of a competent tax professional when making important estate tax decisions.

Over the last several decades it has become routine practice to provide in a married couple’s estate plan for the division of the estate of the first spouse to die into two portions which are then to be held in two separate trusts. One portion is the amount that is exempt from federal estate tax (the “exclusion amount”) and the other is the excess, if any, for which the marital deduction is claimed. The result is no estate tax on the death of the first spouse, regardless of the size of the estate. Furthermore, because the exclusion amount is kept separate from the survivor’s estate it is not taxed when the survivor dies.

Two changes to the estate tax law contained in the recently enacted Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Relief Act) may appear to make that planning unnecessary.

The first change is the increase of the exclusion amount to $5,000,000 per person. Estates of couples which are expected to never reach the combined total of $5,000,000 during their lives theoretically no longer require establishing a trust for the exclusion amount for estate tax purposes. The second change can lead to the same conclusion for estates expected to remain under $10,000,000. One of the reasons for the division was the desire to “preserve” the exclusion amount of the first to die by keeping that part of the estate separate from the part that would be included in the estate of the survivor. Under Section 303 of the Tax Relief Act of 2010, the unused portion of the exclusion amount of the first to die can be claimed by the estate of the surviving spouse in addition to that spouse’s own exclusion amount. Therefore, even if the combined estate is included in the gross estate of the survivor there would be no estate tax if at that time the value is $10,000,000 or less.

Based on these changes it would be easy to conclude that there is no longer a need to keep any part of the estate of the first to die separate from that of the survivor. However, there are at least three reasons for reconsidering that tentative conclusion. First, Congress has proven to be very unpredictable when it comes to estate taxes (among other things). The changes that were made last year could be changed again (in a negative way). Remember that the estate tax was completely repealed at the turn of the century and has now returned.

Second, if the estate of the first to die foreseeably could grow to more than the exclusion amount before the survivor dies, use of the exclusion amount of the first to die at the time of death could save estate taxes compared with waiting to use it when the survivor dies. This is because the value of the assets could grow, but the exclusion amount of the first to die doesn’t! If appreciating assets equal to the exclusion amount are held in a separate trust as is currently common practice, the entire trust value, including growth, is excluded from the estate of the survivor!

Third, there is an important non-tax reason for maintaining separation of the estate of the first to die, rather than leaving it to the total control of the surviving spouse. If the estate of the first to die is left outright to the survivor, that survivor can do with it as he or she chooses, including deciding who should get it on his or her death. When the unlimited marital deduction became law many years ago there was reluctance to use it because at that time the surviving spouse had to be given full power over disposition. Recognizing this, Congress later eliminated the requirement of control over disposition, and the unlimited marital deduction became a standard feature of most estate plans.

Therefore, even though estate tax planning may no longer be an absolute reason for separation/segregation of the estate of the first to die, a couple should carefully consider both the tax and the non-tax implications before modifying an estate plan to simply leave everything to the survivor.

This brief overview of some important considerations associated with estate planning and taxation is by no means comprehensive. Always seek the advice of a competent attorney when making important estate planning decisions.

This post is part of our continuing series addressing basics areas of the law.

Community property law presumes that all property acquired during marriage, except by gift or inheritance, is owned equally by each spouse.

Arizona is one of 9 states that has this community property presumption, the others are California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, & Wisconsin.

Although community property is often associated with divorce proceedings, it has substantial effects on estate planning, asset protection, income tax planning, medicaid planning, probate, etc.

Presumptions

In addition to the general presumption about assets acquired during marriage, the community property regime also presumes that all assets acquired on credit are acquired on community credit.

An important facet of the community property presumption is the inception of title rule which holds that if an asset was community property or separate property when it was acquired, this will not change, except by affirmative action of the owners. However, if the marital community contributes to an increase in a separate property asset's value, it may be entitled to reimbursement or an equitable share of the asset's enhanced value.

Any party contending that an asset is not community property must prove such by clear and convincing evidence.

Complexities

Although determining which assets are community property might seem straightforward, the peculiarities of a particular circumstance can make this very complex. The following three circumstances are of particular interest because they are so common.

1) Community Expenditures on Separate Property Improvements or Discharge of Debt

When community funds are used to improve separate property, the community has a claim to the enhanced value of the separate property because of the improvement(s) but does not have a claim for the separate property funds used to make the improvements.

When community funds are used to discharge separate property obligations, the community has a claim for both the funds expended and a share of the asset's enhanced value because of the expenditure. The amount of the community's share of the asset's enhanced value is equal to the ratio of community expenditure to purchase price multiplied by the enhanced value.

2) Separate Property Expenditures on Community Property

If separate property funds are used to for the benefit of community property, e.g. discharging debt or making improvements, such expenditures are presumed to be gifts to the community. Any party contending that such an expenditure requires reimbursement from the community must prove such via clear and convincing evidence.

3) Quasi Community Property

Property acquired in another state, that would have been community property if it were acquired in Arizona, will be treated as community property in divorce proceedings, i.e. it will be subject to equitable division. However, quasi-community property principles do not apply at death or in any other legal proceedings.

This brief overview of some important considerations associated with Arizona community property is by no means comprehensive. Always seek the advice of a competent attorney when making important estate planning decisions.