Delaware Statutory Trusts and Other Creations of State Law
More than ever before, clients have asked about forming a Delaware Statutory Trust, sometimes known as a Delaware Business Trust. They might be a real estate investor in California, or a small business owner in Arizona. But how will California treat a Delaware Statutory Trust? What about your state? This is an essential question that should be answered before forming such an entity.
When used appropriately, the Delaware Statutory Trust is an effective entity for its flexibility and liability protection. It has many benefits as provided by state statute under the Delaware Statutory Trust Act of 2002, which superseded the Delaware Business Trust Act of 1988. A few of the benefits are:
- Liability Protection. It offers beneficial owners of the trust the same liability protections that Delaware law provides to stockholders of a Delaware corporation.
- Asset Protection. It also limits the creditors of the beneficial owners of the trust in the same way a limited partnership or other charging order protection entity prevents personal creditors from liquidating or obtaining the trust assets.
- Contractual Flexibility. The Delaware Statutory Trust Act, which created the Delaware Statutory Trust, provides maximum freedom of contract. This means that in the trust agreement, the parties are able to agree as between themselves on management rights, economic rights, liability/indemnification, etc.
- Ease of Formation and Maintenance. The process and fees in forming and maintaining the Delaware Statutory Trust are reasonable. A certificate of trust is filed with the Office of the Secretary of State of Delaware. A trust agreement must be drafted but it is not required to be filed with the State of Delaware. There are no annual fees in Delaware for such a trust. It is not subject to Delaware’s franchise tax.
- In Delaware, it offers privacy to the beneficial owners of the trust.
- Trust Series. Delaware law permits the trust agreement to establish separate series of the trust, which may each have its own objective, beneficial interests, trustees, managers, assets, and liabilities.
- Flexible Tax Treatment. A Delaware Statutory Trust can be taxed as a corporation, a partnership, or a trust.
However, it requires a Delaware Trustee. It is also important to note the distinction between a business trust created at common law (by the courts), sometimes referred to as a Massachusetts Business Trust, and a statutorily created trust. The Delaware Statutory Trust falls in the latter category because it is a creature of statute, so even if your state recognizes business trusts at common law, this does not automatically suggest that a court in your state is going to recognize a Delaware Statutory Trust with all of its benefits described above. Although a Delaware Statutory Trust is a powerful business structure and may be appropriate for structured finance transactions and other financial transactions, this might only true in Delaware or another state that has adopted it own statutes which create a statutory trust, e.g., Kentucky. This is similar to other states which, in order to attract businesses, or for other reasons that are specific to their state, have passed laws that create unique types of business entity structures or that create incentives to do business in that state. Here are a few examples:
- Tennessee and Nevada are among about thirteen states that passed laws which allow for the creation of Series LLC’s. But unless you plan to own rental(s) or do business in a state that recognizes the Series LLC, it is not productive to form a Series LLC.
- Illinois, Florida, and a few other states have laws that allow for the creation of land trusts. Although a land trust, where used appropriately, can provide a measure of privacy and ease of transferability, it could be unproductive to form or use a land trust in a state that does not have laws that recognize such a trust.
- Some states do not assess corporate income tax, as is the situation in Florida, Texas, Nevada, and a few other states. But unless you are actually doing business in Nevada, Nevada’s zero corporate income tax will not help you.
Even if a state recognizes another state’s common law or statutory business trusts, the process to register it into that state can be time consuming and costly. For instance, Arizona will recognize another state’s business trust; however, in order to register a business trust in Arizona the trust must be: registered with the Arizona Corporation Commission, recorded in each County where real property is located (if the trust owns real estate), and receive approval from the State Banking Department.
Delaware Statutory Trusts in 1031 Exchanges
Even if your state will recognize a Delaware Statutory Trust, if your intent is to use the trust in connection with a 1031 exchange, as this is a common use for such a trust, be sure it meets the requirements of Rev. Rul. 2004-86 to be considered a trust and not a business entity type. Otherwise, the beneficial interests of the trust are treated as interest in a partnership or corporation and would not constitute valid like-kind Replacement Property under IRC §1031.
Delaware Statutory Trusts in California
Business trusts are generally recognized under common law in California, but this does not mean a California court will accept a Delaware Statutory Trust with all of its statutorily created benefits – it could disregard some of those features that are not common to other business trusts in California.
As it concerns taxes and California’s franchise tax, under California law, Section 23038(b)(2)(A) of the Revenue and Taxation Code, California appears to define “corporation” to include business trusts for tax purposes. Any business trust doing business in California is treated as a corporation under California law, and thus presumably subject to California’s franchise tax, unless, under federal law, it has elected to be taxed as a partnership. If a trust is considered a non-business trust, it is probably not subject to California’s franchise tax. Under California’s definition of a business trust in Section 23038, a non-business trust is a trust arrangement established for the mere purpose of the conservation of assets, to collect and disburse fixed, periodic income, or to secure an obligation. While having your trust characterized as a non-business trust might avoid California’s franchise tax, such a characterization might not be favorable in terms of limiting liability of the trust parties, as explained below.
On the issue of limiting liability in California, if a California court decides to recognize the Delaware Statutory Trust and all of the liability protections established by Delaware statutes, the Delaware Statutory Trust will be a powerful entity to utilize in California because of the benefits outlined above. It is unclear under what circumstances, if any, a California court would do that. Until that happens, a California court would likely construe such a trust as either: (a) a common law business trust, in which some liability protection could be provided, but not to the extent of a Delaware Statutory Trust; or (b) a non-business trust, e.g., a probate trust, in which no liability protection or asset protection will be afforded to any of the parties to the trust, other than through a spendthrift clause. There are many bankruptcy court cases in California in which the judge has to decide, based on the facts, whether a trust is a business trust or a non-business trust. Each situation requires an analysis by a competent attorney of these complex issues.
Therefore, before you rush to form a Delaware Statutory Trust, so as to avoid a state’s fees, for example, California, be sure to understand: (1) whether your state will recognize such a trust/business entity with all of its benefits created under a foreign state’s statutes, and (2) the tax and liability ramifications of such a trust.
Kevin Kennedy is an associate attorney with Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”) in its Phoenix, Arizona office and has extensive experience in helping client register their trademark and protecting their brand identity. He can be reached at firstname.lastname@example.org or by phone at (888) 801-0010.