One of the leading reasons for forming a LLC is the lawsuit protection it offers the owners, known as members. If the LLC is sued, the members’ financial exposure is limited to their amount of investment. An investment of $10,000 is the maximum that can be lost. This assumes there is no fraud perpetrated by the LLC, and it assumes the LLC is in compliance with applicable laws. When the LLC is sued, the assets of the LLC are at risk, but the liability and financial exposure stops when the LLC assets are gone. This is a significant benefit, and one that most business people are aware of, but LLC’s offer a second form of asset protection that few are aware of, and it’s extremely powerful. This second type of protective shield comes from restrictions placed on a creditor when using the charging order against a debtor member.
Charging Order Explained
To best understand the charging order one must separate the LLC and the owners of the LLC, again referred to as members. The LLC, or business, owes money to creditors in the everyday course of doing business. The money owed is called inside liabilities, and the people or businesses the money is owed to are called inside creditors. Inside simply refers to the business, or LLC. It does not imply anything about payments being made on time or late; but merely refers to the business.
Members of the LLC will owe their personal money to their personal creditors from time to time. These creditors could be for a rent payment, cell phone, heating bill, water bill, or any number of bills we personally face in our day to day lives. These financial transactions have nothing to do with the LLC, but rather from personal activities. These personal bills are called outside liabilities, and the people or businesses we owe the money to are called outside creditors. Outside refers to personal activities.
Charging Order and the C Corporation
If a shareholder of a C Corporation is personally sued and loses, the opposing party (plaintiff) is awarded a judgment and is now legally entitled to payment from the shareholder. If the shareholder fails to pay, the stock investment in the C Corporation can be attached by the plaintiff, which entitles the plaintiff to all rights and privileges that are accorded to that stock. The law allows for a complete award of the stock, with all its rights, because there are a minimum of three active classes of decision makers present in a C Corporation. The most basic, yet probably the most important decisions within a C Corporation flow as follows: the shareholders elect the board of directors, the board of directors appoints the company officers, and the company officers carry out the day to day operations and implement the strategies of the board. The law views losing one shareholder and being replaced with another, who happens to be the plaintiff, as simply not critical to the continuing operation of the C Corporation.
Charging Order and the S Corporation
Keep in mind that the S Corporation is significantly different than the C Corporation for restrictions on shareholders. S Corporation shareholders are restricted in number and the type of shareholder. Only natural citizens can be a shareholder; no LLC’s, no C Corporations, and no businesses. Should an S Corporation shareholder lose their stock to a business, or some type of restricted party, the IRS Subchapter S status could be revoked by the IRS causing possible tax problems to the shareholders. This possibility should serve as an incentive to all shareholders to reach some type of agreement, such as a possible purchase of the stock from the restricted party, to keep the restricted party from becoming a shareholder.
LLC and the Charging Order
We have seen that owners of C Corporations, called shareholders, can have their stock legally attached, and have all rights and privileges accorded to that stock go with it. Owners of LLC’s are treated differently. The law views owners of LLC’s, the members, as partners in the LLC’s. As partners, their role in the LLC is viewed as much more critical than shareholders in a corporation. Partners are viewed to contribute more than just the cash investment; they are considered to be involved in some manner in the important decision making and may make valuable contributions in other areas as well. The forced absence of a partner via legal attachment of the partner’s ownership percentage may hamper, or reduce the future prospects of the LLC’s chances for survival. Additionally, if a creditor attaches the member (partner’s) ownership percentage with all it rights, the creditor effectively becomes a partner in the LLC by assuming all rights of the debtor partner. This is not what the other partners want, and it does jeopardize the future of the LLC. The laws governing LLCs recognize this, so a “limited” attachment is provided for, called a Charging Order.
The rules that govern a corporation are called bylaws; the rules governing the LLC are called the operating agreement. The importance of the operating agreement cannot be overstated. A member in a LLC has the right to receive their share of any financial distributions and any additional benefits provided for in the operating agreement. In return, the operating agreement will state what is expected of the members to continue receiving LLC benefits.
The Charging Order of the creditor can only attach the right to financial distributions of the debtor; any remaining rights provided for in the operating agreement stay with the debtor. The restrictions placed upon the Charging Order prohibits full member status to the creditor, rather only allows access to the revenue stream. The operating agreement is instrumental by stipulating the package of rights accorded to a member. These rights, less the revenue stream, still belong to the debtor. The legal structure of the LLC in combination with a well written operating agreement creates the restrictions within the Charging Order.
Five Steps Creditor’s Use to Maximize Charging Order Value
There are five steps a creditor should take to maximize the value of their Charging Order.
First, the creditor must win in court, and obtain a judgment against the debtor. Charging Orders can only be issued to those creditors who have a judgment. There is a significant amount of time between when the debtor allegedly defaults on an obligation and when the court proceedings start. Experts strongly recommend curing any deficiencies in the LLC and the operating agreement during this time. This puts the debtor in the best possible position before going to court.
Second, the creditor must obtain the Charging Order that provides access to the financial distributions of the LLC. When the Charging Order is granted, the creditor must present an enforceable assignment of distributions to the LLC management showing and proving to them where the debtor’s distributions should be sent, and to whom. This does not make the creditor a member; it only addresses the distributions provided for in the operating agreement. The creditor is entitled to keep the distribution assignment in place until the judgment amount is paid. When will the judgment be paid off? No one knows; the operating agreement typically states the size of the distributions in a percentage of profits, but those distributions can be very small, or even non-existent, depending upon the profit. Perhaps management changes the operating agreement to further reduce the payout. The creditor wants to get as much money as possible, as quickly as possible. The creditor has another strategy available.
Third, the creditor can foreclose on the Charging Order. The Charging Order itself is in place until the debtor pays off the judgment either voluntarily or involuntarily through the Charging Order. At the payoff date, the right to financial distributions reverts back to the debtor. It is a temporary legal attachment. Foreclosure of the Charging Order is a permanent legal status where the right to receive a financial distribution is permanently transferred to the creditor. Since the creditor has permanent ownership of the right to financial distributions, the creditor can sell that right. This strategy is likely to bring money in quicker than waiting for the annual distributions. The key problem with selling the right, is finding a willing buyer to pay a fair price. It is very likely the only buyers are those already affiliated with the LLC. The market for that right is probably one of the individual members, or the LLC itself. Either way, the members know the creditor is not in a position of strength, and will very likely get a fraction of the real value, or may not even get an offer to buy. It is simply an unknown.
Thus far the Charging Order has been described as a beneficial tool of the creditor. One can reread the above material to see how the Charging Order works to secure financial distributions for the creditor, either temporarily or permanently. Now, the negative side of the Charging Order needs to be addressed. If the LLC elected to be taxed as a partnership, which most do, the IRS requires the members to pay the LLC income tax on the members’ personal income tax return. This is known as a flow through entity. A creditor’s Charging Order may put the creditor in the position of having to pay the taxes due on the debtor’s share of profits. The creditor may argue that the debtor is liable for the taxes, because of the temporary nature of the Charging Order. The court will decide that outcome, but there is no question that when the Charging Order foreclosure occurs, the creditor will be responsible for taxes because of the permanent nature.
The fourth step is for the creditor to ask the court to appoint a receiver to monitor the LLC activities and to protect the creditor’s interests. The court is more likely to appoint a receiver if the foreclosure took place, and if the foreclosed interest is a large percentage of the LLC.
The fifth and last step is for the creditor to ask the court to split the assets of the LLC, such that the creditor is in charge of assets approximately of equal value to the size of the judgment. The court is not likely to award this, but if it did, the creditor could sell those assets and keep the proceeds.
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State by State Comparison of Charging Order
Members living in different states than where the LLC was formed may present more work to obtain the Charging Order. This is likely to vary with the different applicable state laws. The following example is for illustrative purposes only. Assume the LLC was created in Iowa, but a member debtor lives in Wyoming. A creditor sues and wins a judgment against the Wyoming debtor. The Wyoming court awards a judgment to the creditor, but the Wyoming courts may not have the authority to issue a Charging Order applicable to an Iowa LLC. The creditor may have to take the Wyoming judgment, ask an Iowa court to honor it, and if Iowa does honor it, further ask the Iowa court to issue a Charging Order against the Wyoming member debtor. This scenario is dependent upon state law and must be researched, but it is possible that the additional work and legal fees required to go to another state may serve as a deterrent to the creditor to sue the member debtor. If the creditor does not then sue the debtor, and walks away, the result is a form of asset protection for the debtor. The debtor was just not worth suing.
When Charging Order foreclosure occurs, the creditor would be responsible for his percentage of the LLC tax liability. Assume his percentage of profits was $65,000, but the financial distribution was only $5,000. The creditor’s tax on $65,000 at 20% is $13,000, but the distribution was only $5,000, leaving the creditor to take money out of his own pocket to pay the additional $8,000 in taxes (13,000 less 5,000). This becomes a strong deterrent to foreclosing on a Charging Order. In fact, it puts the debtor in a much stronger bargaining position to perhaps negotiate a much less pay off for whatever is owed. Just like in the previous paragraph, the debtor may not be worth suing. The creditor must decide if it’s worth the risk.
The value of a well written operating agreement was previously stated. What follows are additional examples of why the operating agreement can be tremendous protection for the members if drafted properly.
After foreclosure, the creditor should ask the LLC to receive some of the rights a member normally enjoys. These may include inspecting the financial statements or any other activity accorded members. A well written operating agreement can prevent and protect inspection of sensitive documents, and stop further requests normally reserved for members.
The creditor may ask for a receiver to be appointed, and the court may grant it, but a protective operating agreement can limit the scope of what the receiver can do. Conversely, a poor or non-existent operating agreement provides few restrictions about what the receiver can do within the LLC.
A creditor may also ask the court to have assets placed in his charge, to be done with as the creditor sees fit. This is very unlikely if the operating agreement protects against that.
LLC Operating Agreement
The operating agreement provides the rules under which the LLC operates. A well written operating agreement contemplates day to day activity, and provides a body of rules, protections, and restrictions to negative events that may occur.
Creditors and member debtors have been discussed at length, but the bankruptcy of a member has not been addressed yet. When a member debtor files for bankruptcy, the courts take the position that there are two types of members: active members that make consistent contributions to the operation of the LLC, and passive members, who do not contribute to the ongoing operation of the LLC. An Arizona court has held that when the member is passive, the bankruptcy trustee may seize assets of the LLC, and sell them to satisfy the judgment. The opposite is thought to be true for the active member. When an active member files for bankruptcy, the trustee’s powers are limited by the operating agreement, so once again, a protective well written operating agreement should be able to save the assets of the LLC. The lesson learned here is to draft the operating agreement in such a manner that, if possible, all the members will be classified as active.
Remember that the Charging Order was restricted to the financial distributions. This was done to prevent the creditor from imposing himself as an unwanted member with full member rights, among the remaining members. In the case where a single member owner of an LLC files bankruptcy, the court has held that the trustee can seize the assets and sell them to satisfy creditors. The argument can be made that the single member is active, which should limit the trustee’s actions to those allowed in the operating agreement. The court instead placed a higher priority on the fact that the trustee would not be imposing his full member rights on any other member because there are no other members; therefore, the Charging Order limitation to financial distributions only, did not prevail, and the entire LLC was disposed of by the trustee. The single member LLC still provides powerful protection to the owner personally when the LLC is sued, but the bankrupt single member currently does not enjoy Charging Order protection given to multimember LLC’s. So, if the single member of an LLC feels a creditor will be suing him, what kind of defensive measures can he take? It would seem now is the time to sell a very small percentage of his LLC to a second member, making the LLC a multimember LLC, which entitles it to Charging Order protection. Additionally, ensure the new member will be classified as active, which should limit the trustee’s powers, if the single member files bankruptcy, to what’s allowed in the operating agreement. Finally, make sure the operating agreement is well written and protective of your interests. It is likely that the creditor will try to have these protective measures reversed, or disallowed, but the creditor’s plea may be denied resulting in some degree of protection for the LLC and the debtor member.