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Sunday, January 24, 2010

Rationale behind choosing an Arizona LLP for holding real estate

Several have asked for more detail on our reasoning behind our choice of an Arizona LLP as the holding entity for the real estate property. Why an LLP? Why not an LLC? Why an Arizona entity? Why not an Alberta entity? Why not just hold the property in our own names?

The only benefit we are seeking with a holding entity is liability protection. Specifically, if any lawsuit exceeds the protection offered by insurance on the house or condo, remaining liability will be limited to that property and not any other assets.

A reasonable debate could be had with respect to the size of the risk without such protection. Many people hold property in their own names and insurance would offer some protection. I really do not know the probability of the LLC/LLP protection being required but I do believe the probability is higher if you rent the property, and also that it is higher for a US property than it is for a Canadian property. Even in Calgary there was a recent incident where the landlord is facing a huge liability exposure.

Regarding taxes: there seems to be consensus that holding the property in your own name or in an entity that is taxed as a person results in the lowest taxes in the US. I understand that both rental income and capital gains are taxed at higher rates if the property is held by a corporation.

For US residents that is the beauty of LLCs. LLCs offer the liability protection of a corporation, but from a tax point of view the income flows directly through the LLC to the 'members' of the LLC and tax is paid personally.

Unfortunately it seems that the CRA in Canada treats LLCs as corporations. The outcome may be paying tax personally in the US and not being able to claim it back against corporate taxes in Canada because they are of different classes. Double taxation. Note that there is something called the Fifth Protocol which is a very recent update to the US-Canada Tax Treaty that makes a change to treatment of LLCs. However, it is one of the most obtusely written pieces of text that I have ever read. It appears to have more to do with US LLC's doing business in Canada, and does not look like it fixes this problem, but future interpretations from the CRA may change that.

Anyway, there is another answer: an Arizona LLP. Limited Liability Partnership. Not a Limited Partnership (LP): an LLP with two Ls. An Arizona LLP appears to have the same liability characteristics as an LLC but should be seen by the CRA as a partnership rather than as a corporation. So, personal income on both sides of the border. In most cases the IRS treats LLCs and LLPs in exactly the same way, and in fact LLCs file the same 1065 return that Partnerships do.

So why set up the LLP in Arizona rather than Alberta? My understanding is that Alberta restricts LLPs to a short list of professional partnerships, such as a Medical Practice so it is not an option for holding real estate.

I have recently heard that "oh yes but Alberta has the LP (one L) which can offer the same protection". My belief is that an Alberta LP is similar to an Arizona LP, and it only offers the liability protection if there is also another entity involved, set up as the general Partner: so it is really the other entity (e.g. Corporation) offering the liability protection. Too complicated and too expensive and difficult to maintain in my opinion.

Also, I firmly believe it will be less confusing if the complexity is contained as much as possible to one tax authority. Using an LLP for this purpose is a pattern well understood by the IRS as is foreign ownership of a parnership. And I believe the CRA will also be clear on dealing with Canadian ownership of a US partnership. Some sort of hybrid may confuse one or both tax authorities resulting in painful discussions and/or a surprise outcome.

For me the Arizona LLP route offers the best balance of liability protection and only minor complexity. And it seems to be the lowest cost approach as well. I was able to set up an LLP in Arizona for under $100. Although there may be enough benefit to utilizing the services of an Arizona notary/filer to make it worthwhile if you need assistance.
Realcore referred me to Adam Nierenberg (AccurateSignings@aol.com or 602-779-1873) for another similar purpose and that was a positive experience.

If you are inclined to do it yourself, please refer to the Arizona Secretary of State (AZSOS) site for instructions. If desired we offer our samples to anyone who donates.

The only loose end in the deliberations is whether any of the more complex structures offer better protection against Estate taxes. The fear that I have heard is that if your world-wide assets are large enough and the US propery is worth enough, the IRS may want to calculate estate taxes on your worldwide estate. I have not fully researched that aspect but there are exemption levels that most people probably fall below. If you have any clear insight into that aspect please let me know.

Just to be clear I am not a legal or tax professional. These are just my understandings from reading and from hearing seminars. Please seek your own professional advice as you see fit.

10 comments:

  1. Hi there, this is quite interesting, have you explored an option of the Arizona LLC being owned by and Alberta Corporation? We have bought a personal vacation home, but we are thinking about buying a multi family rental and I am researching the LLC vs LLP option. The only difference is that we do own a AB Corporation that owns our Alberta rentals. Any comments would be appreciated. Agata Nicols (Calgary, AB) 403-804-8304

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  2. I always understood that insurance was protection against something that might or might not happen (e.g. fire, theft), and assurance was protection against something that was bound to happen sooner or later (e.g. death).
    landlord contents insurance

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  3. Just looking though old posts, and not sure we talked or emailed directly. Anyway, for the record...I would be worried about an Arizona LLC being owned by an Alberta corporation from a taxation perspective. The LLC is taxed as an individual in the US. If you end up paying tax in the US it will be "personal tax" and I do not believe you could then get a "Foreign Tax Credit" to credit that back against corporate tax in Canada. I'm no tax expert though.

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  4. Who did you use to set your LLP.?I would love to do it for $100! We also recently purchasedaproperty in Phoenix. So I had all the same concerns as you and I agree about the LLP. The one thing I would add is that I am getting added home insurance on top of that up to $5,000,000 to be extra careful as my husband is a physician and we live in Vancouver ( so I am a little more worried about our personal assets being at risk) just my thoughts!
    Thank you for your article

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    1. I set up my own LLPs. It is not difficult, and the instructions are available on the AZ Secretary of State web site.

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    2. When setting up an LLP, are you required to first form an LP. The AZ SoS website seems to only have forms for conversion of an existing partnership to an LLP.

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    3. One of the forms on the AZSOS site is for converting a general partnership to an LLP, and another form creates a general partnership and converts it all in one step.

      http://www.azsos.gov/business_services/Forms/Partnerships/LP-LLP_combine_certificate_29-308c.pdf

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    4. Thanks for the link. When navigating the AZSoS website, I was not able to find the page that you sent me. I don't think I would have found it on my own.

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  5. From a tax perspective in Canada, do you show rental income on your personal returns only? How does the U.S.-based LLP show up on your Canadian tax return?

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    1. This is a bit of a story so I will create a new post on it. A number of readers have asked. Thanks for the question.

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