When creditors pursue a judgment against a debtor who is the owner of a business, the courts issue what is referred to as a charging order. These orders authorize a lien against distributions from a Limited Liability Company (LLC).
It’s important to understand how these orders work and what they mean for your LLC, and the members, partners, and owners of the LLC before creditors are pursuing such a judgment. LLCs provide liability and asset protection that other entities do not, including protection from some aspects of charging orders for multi-member LLCs. The same consents in this article also apply to corporations, limited partnerships, and other entity types.
What Charging Orders Do
Charging orders allow creditors to claim a debt from an individual who receives payments out of an LLC they are a partner or owner of. The creditor seizes the money owed to them through a lien placed on the distributions from the LLC. The lien goes only against distributions paid out directly to the individual named in the charging order and not other members or owners of the LLC.
Some states, including California, allow creditors to foreclose on a debtor’s membership interest in an LLC with the use of court judgements. This creates a significant risk for single-member LLCs that have no other partners to prevent the complete liquidation of the company, and for multi-member LLCs who want to distribute assets out to the owners (this creates a conflict in what the owners wishes are).
Some states other than California indicate that the only remedy that a creditor has is a charging order. These states include Wyoming, Nevada, and Delaware. However, choosing the correct state to form your LLC in is much more complicated than this, and requires careful planning.
How LLCs Protect Against Charging Orders
A single-member LLC may be exposed to complete liquidation in the foreclosure of the debtor’s interests. A multi-member LLC protects other members from the debt of the lone member who has the lien applied against them. Ensuring your LLC has a buy-out clause for members adds an additional layer of protection should a member’s debts disrupt company operations.
The lone protection single-member LLCs get from charging orders is that this does not expose company or personal assets to any form of liability. Distributions are the sole element of an LLC that are able to be targeted by a charging order. If the debt does not represent a large portion of the interest in the LLC then your company can survive.
Even if the distributions are being paid directly to the creditor instead of the LLC member, the creditor does not obtain any operating interest in the LLC. Prior to the Uniform Partnership Act of 1914, companies would have to sell the member’s interest in the LLC to the creditor. This often resulted in the complete dissolution or sale of even multi-member LLCs.
Tax Consequences for LLCs Facing Charging Orders
Because the creditor only assumes the resulting distribution and not an actual controlling interest in the LLC, the debtor retains sole responsibility for the tax payment of the distributions. This means the distribution goes to the creditor but the tax bill stays with the member.
The only time the creditor would be held responsible for the taxation of the interest in the LLC is if the creditor moves to foreclose on or liquidate the LLC or the debtor’s interest in the LLC.
Facing a Charging Order? Hire an Attorney
Charging orders put the entire business at risk if the necessary asset protection strategy is not in place. The team at the Law Offices of Tyler Q. Dahl helps single and multi-member LLCs optimize their asset protection strategies to avoid these circumstances or at least prepare for them.Contact our offices if you are facing a charging order or need to adjust your strategy to protect your work from them in the future.
Dahl Law Group
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