By Garrett Sutton
The charging order is a key to LLC asset protection. If you are sued in a car wreck and the victim wants to get at your assets, the charging order (n many states, including Wyoming and Nevada) is the victim’s only relief. It provides for a lien on distributions, meaning the victim can only get what is distributed to you from the LLC.
But in some states (including California and Utah), if not enough money is forthcoming to pay off the claim, the victim can foreclose on your LLC interest. To do so, they go back to court and argue that the charging order is not enough. They aren’t satisfied with distributions. They want the LLC interest itself.
IS IT A GOOD IDEA TO FORECLOSE ON AN LLC INTEREST?
If a judgment creditor (the car wreck victim) successfully forecloses upon the LLC membership interest of a judgment debtor, then the judgment creditor acquires a permanent (as opposed to a temporary) right to receive all distributions made by the LLC to the judgment debtor, including any liquidating distributions when the LLC is dissolved. In other words, prior to foreclosure, the judgment creditor has only a temporary right to receive distributions until the judgment is satisfied. After a foreclosure, however, the judgment creditor has a permanent right to receive all distributions irrespective of whether the judgment is satisfied.
With a single member (one owner) LLC, this may be a suitable outcome. You get it all. But in a multiple owner LLC, you should definitely think twice about foreclosing. Consider that:
- There are cogent tax reasons why a judgment creditor should not foreclose upon the membership interest of an LLC member. If a judgment creditor only has a charging order against the membership interest of an LLC member, then for tax purposes, the judgment creditor is merely the holder of a lien, and does not receive a K-1Form from the LLC. See, Revenue Ruling 77-137 and IRS General Counsel Memorandum 36960 (1977). On the other hand, if the judgment creditor elects to foreclose upon the membership interest of an LLC member, the judgment creditor becomes a transferee of a transferrable interest, and, as such, is potentially liable for the distributive share of the LLC member. Thus, as a transferee of a transferrable interest, the judgment creditor who forecloses upon the membership interest of an LLC member runs the risk that income from the LLC may be passed through to the judgment creditor on a Form K-1 from the LLC (on which taxes must be paid), irrespective of whether the LLC distributes any cash to the judgment creditor to pay the taxes.
- A judgment creditor generally stands to gain very little by foreclosing. The judgment creditor already has a charging order against the interest of the LLC member. If the LLC is making distributions to the judgment creditor, then the judgment creditor will have little incentive to foreclose. On the other hand, if the LLC is not making distributions to the judgment creditor, then an auction of the interest of the LLC member will not draw much interest, and will incur attorney’s fees and costs.
- If the underlying purpose of obtaining the charging order was to prevent the LLC member from obtaining distributions, then there is little need to foreclose upon the interest of the LLC member, because the charging order will already serve much the same purpose.
Even in the minority of states where a judgment creditor can ask the court to foreclose upon the LLC membership interest of a judgment debtor member of the LLC, the judgment creditor should think twice before doing so, at least with multiple member LLCs, because there is very little to gain, and much to lose, by doing so.
Garrett Sutton is an attorney, speaker and best selling author. As part of Robert Kiyosaki’s Rich Dad’s Advisor group he has written six books which have been translated into 11 languages. Garrett focuses on corporate and asset protection law and speaks to audiences on the importance of asset protection. His advice is pertinent, timely and valuable.
Garrett received his Juris Doctor Law Degree in 1978 from Hastings College of the Law, the University of California’s law school in San Francisco. He received a B.S. in Business Administration from the University of California, Berkeley, in 1975. He is licensed to practice in Nevada and California.