Charging order protections are some of the most important but least understood business organization law features of LLCs under all U.S. LLC statutes. The fact that LLCs provide charging order protections and corporations do not is of significant importance in business entity formation practice. The law governing charging order protections is arguably one of the single most comlex area of LLC business organization law. Charging orders are also comlex and often misunderstood froma federal income tax viewpoint.
What types of business and business owners can benefit from charging order protections?
Any business that has valuable business assets, including cash, intelectual property, or hard assets such as real property, vehicles and equipement, can derive major benefits from LLC charging order protections.
A few issues concerning charging orders:
When creditors of members of multi-member LLCs ("member-debtors-in-default") obtain unsatisfied judgments for conduct member-debtor-in-default unrelated to the business of their LLCs, these creditors may obtain "charging orders" agianst the LLC. These orders will require these LLCs to pay these creditors any amounts otherwise payable as distributions by these LLCs to these member-debtor-in-default. With respect to the member-debtor-in-default, the other members, and the LLC these chargind orders are the creditors' only remedy. In particular, the creditors cannot obtain any of the members' other rights, including voting rights. Which means that the creditor cannot become a substituted member to the LLC and therefore cannot forc the sale of LLC assets in satisfaction of their judgments.
Under the LLC acts of most states, the relevant case law and the policies underlying charging order provisions hold or strongly suggest that charging order protections are available only to the members of multi-member LLCs. Wyoming, however, has amended the charging order provisions in its LLC act to provide the members of single member LLCs with charging order protections (see § 17-29-503 of the Wyoming LLC Act). However there is serious doubt as to whether other states would enforce these provisions of the Wyoming LLC Act.
LLC charging order protections originated in the 1880s in Enlgish general partnership law. There are three somewhat diverse policies underlying charging order protections:
Charging order protections can provide several different kinds of powerful business asset protections to multi-member LLCs and their members. Therefore if LLC formation clients need or can benefit from charging order protections, you should form their LLCs as a multi-member LLC and have at least two members. However, remember that the LLC must have a business purpose.
Due to the collection of unsatisfied judgments under charging orders being a slow process, the availability of charging order protections to member-debtors-in-default may effectively force creditors to negotiate settlements of their judgments on less then favorable terms. Nontheless, because members whose interests are subject to LLC charging orders must pay taxes on their shares of LLC income even though they cannot receive LLC distributions until the relevant credit judgments are paid in full, their liability for these taxes may cause some member-debtors-in-default to settle with judgment holders on terms that are unfavorable to these members.
Due to the charging order protections that are provided by LLCs and not corporations means that many corporations should convert to LLCs to obtain charging order protections. Under the laws of many states there is a process called "statutory conversion" that makes these conversions relatively easy. If properly structured these statutory conversions are "F reorganizations" under the Internal Revenue Code (IRC § 361(a)(1)(f) and are tax-free.
The DLLC act is the preeminent United States LLC act, has strongy impacted many other state's LLC acts, and many charging order provisions in non-Delaware LLC acts generally resemble DLLC Act §18-703.
Overview as provided by § 18-703 of the DLLC Act:
Creditors' only Remedy: A judgment creditor that holds an unsatisfied judgment against a member of a Delaware LLC who is a member-debtor-in-default may obtain from a court of competent jurisdiction a "charging order" against a the LLC. This is the exclusive remedy of the judgment creditor as it is the only way that the judgment creditor may satisfy the judgment based on the member's LLC interest
The Effect: The order requires that the LLC distribute to the creditor, to the extent of the judgment, any assets (including cash), which it would otherwise distribute to the member
The creditor has no remedy with respect to the LLC's property which is arguably because creditors can obtain an LLC's property only if they are able to vote to distribute this property to themselves in an LLC liquidation or otherwise.
a) Compensation: By an LLC to its members means payments by the LLC to its members specifcally regarding compensation for their services.
b) Distributions: Transfers by the LLC to its members of cash and other assets in the members' capacity as members not as compensation for members' services to or for the LLC.
Creditors who hold charging orders under DLLC Act § 18-703 have the rights of assignees with respect to distributions to the defaulting members but the are not the assignees. Under DLLC Act § 18-703, creditors that are holders of charging orders have, to the extent provided by the charging order, the rights of assignees of the LLC interest of the defaulting member to distributions tot he defaulting members. However creditors do not own these interests; they are not assigness of the LLC interest. Therefore for federal income tax purposes, they do not have the members' federal tax obligations, including, in particular, any obligation to pay federal income taxes on income allocated to the members.
For federal income tax purposes, chargine order payments should not be thought of as "distributions" to creditors holding unsatisfied judgments against defaulting members, but rather, as transfer of LLC cash to these creditors in satisfaction of a judgment. In other words, creditors that obtain charging orders should not thereby be deemed to incur "phantom income," and payments to them from LLCs under charging orders should be deemed for federal income tax purposes to be distributions of cash by the LLCs to the relevant defaulting members followed by payments of cash by these defaulting members to their creditors in satisfaction of their judgment.
Notwithstanding any existing charging order, these defaulting members remain subject to federal income tax on allocations to them of LLC profits. Creditors who recieve payments under charging orders must treat these payments as repayment of debts. These creditors are taxable on these payments only to the extent the payments consist of interest on these debts.
The state tax consequences of charging order protections may vary widely from state to state. That being said, never overlook the impact of state tax issues.
Charging order protections: Charging order protections apply only when an LLC member incurs an unsatisfied judgment to a creditor in a claim unrelated to the business of the LLC. Charging orders do not protect the the general assets of the member-debtor-in-default but only that member's membership rights, excluding the members' rights to distributions. Charging order protections do not directly protect the assets of the LLC or the membership rights of the other members. They do however protect these rights and assets indirectly.
Limited liability protections apply to protect the personal assets of LLC members, including their LLC membership rights, from claims against the LLC. These claims can result from negligence by the LLC's employees. It is important to be aware that the LLC liability shield will not protect an LLC member from the consequences of the members personal misconduct relating to the business of the LLC- No liability shield affords this protection.
Section 365(c)(1)(A) of the Bankruptcy Act as possible defense against trustee in bankruptcy. There are many unanswered questions concerning the impact of federal bankruptcy law and state insolvency law on the protections afforded by LLC statutory charging order provisions. However the existing case law under § 365 (c)(1)(A) of the Federal Bankruptcy Act suggests that with regard to debtors in default that are members of multi-member LLCs, partners of general partnerships, limited partners of limited partnerships, and beneficiaries of statutory business trusts (referred to here collectively as "debtors"):
Is there a need to include provisions in operating agreements regarding charging orders?
Charging orders do not affect LLC operations, they only have an economic effect on the defaulting member. Therefore there should be no need to address charging order issues in LLC operating agreements.
It is however possible to insert provisions to address charging order matters in the operating agreement of an LLC by minimizing the right to distributions and maximizing guaranteed payments, etc. Though because of charging order considerations the members of some LLCs may want to maximize the amount of LLC profits paid to working members on the basis of salary. guaranteed payments, or bonuses, and mazimize payments in the form of distributions.
Converting distributions to guaranteed payments, etc.,
LLC members may want to provide for the possibility of charging orders against their members if the LLC becomes subject to a charging order because of a judgment against a defaulting member, the LLC will convert amounts that might otherwise be paid to the member as distributions to salary of bonus. In this case the allocations to the member will be reallocated pro rata among the other members.
Dissociation of members:
In the case of a member whose misconduct results in charging orders agianst the LLC the othe members may want to provide in their operating agreements that if a member engages in conduct that results in a charging order against the LLC, the other members may dissociate the member. This provision may be useful because, among other considerations, members who are no longer able to receive distributions from their LLCs by reasons of charging orders may lose some or all of their motivation to provide competent services to or for their LLC. However, if the LLC of the other members have a right or duty to buy out the dissociated member, this buy-out may involve significant financial burdens for the LLC or the other members.