Thursday, June 23, 2011

Charging Order Protection for Members of Limited Liability Companies

Many state laws make a charging order the “sole” remedy for a creditor of a limited liability company (LLC) member.  Some states have provided that the charging order is the “exclusive” remedy.  The judgment creditor could collect the debtor’s share of any income distributed by the LLC.

A charging order entitles a creditor to distributions (not management fees, loans, or sale proceeds) made to the debtor Member.  For this purpose the creditor is given a status that is the equivalent of an assignee of the debtor member’s interest.  The IRS (Rev. Ruling 77-137) is read by many commentators to suggest that the assignee should receive a K-1 statement showing the assignee’s share of LLC income, even if no distributions of cash are made from the LLC.  Since the LLC is a pass-through entity for income tax purposes, the debtor’s share of undistributed income may be taxed to the judgment creditor even though the debtor did not receive the LLC income.  This type of income is sometimes referred to as “phantom income.”

The possibility of “phantom income” can provide a strong disincentive for someone who sues a person owning interests in an LLC or a strong incentive to settle early.  If the creditor’s share of phantom income is a significant amount, it may throw the creditor into a higher tax bracket, and could even force the creditor to pay more in income tax in a year than he actually received in income.

For example, Nevada's legislature recently passed revisions to its charging order statutes. 

The revisions which are effective October 1, 2011 enhance Nevada's creditor protection laws for its LLCs, LPs and corporations. The revisions expand Nevada's protections to not only make the charging order the exclusive remedy, but to also remove all potential equitable remedies that might apply.

The new legislation also specifies that creditors of a member of a single member LLC and creditors of a shareholder of a single shareholder corporation are limited to the charging order remedy, thereby distancing Nevada from the laws of other states.

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Garrett Griffin