After my last post involving the legislative change in Florida that confirms the charging order as the exclusive remedy for a judgment creditor against an ownership interest in an limited liability company (“LLC”), I received a number of calls and inquiries wanting to know why and how the charging order remedy actually works. This is my explanation.
When someone obtains a judgment (the “judgment creditor”) against another person (the “judgment debtor”), there are various remedies available to the judgment creditor that provide alternatives for the judgment creditor to collect the judgment amount from the judgment debtor. Typical collection activities include filing the judgment in the public records which gives the judgment creditor a judgment lien against the real and personal property owned by the judgment debtor. Personal property to which the lien attaches includes both tangible personal property (jewelry, automobiles, furniture, art work, etc. – things you can touch and hold) and intangible personal property (stocks, bonds, money, promissory notes, trade accounts receivable, etc.).
Typically the judgment lien against these properties can be foreclosed upon, just as a mortgage on real property can be foreclosed, with a forced sale of the asset and a distribution (after payment of any expenses of the sale) of the net proceeds of the sale to the judgment creditor. The judgment lien is reduced dollar for dollar for the net proceeds of the sale that are paid to the judgment creditor. The stock that can be seized, and sold, with the proceeds to be distributed to the judgment creditor, includes the stock of a for profit corporation that is closely held (as well as stock of publicly held companies). A public auction of the asset is the typical manner in which the stock of the closely held company will be sold – but the court can order that the sale be through a private auction or sale. The judgment creditor usually will bid for the asset being sold upto the amount of the judgment lien – or to an amount that represents the actual value of the stock of the closely held company being sold.
The newly revised Florida Statutes, Section 608.433, specifically provides that a judgment creditor may not foreclose a judgment lien against the ownership interest of a limited liability company. Florida law provides for the same rule with respect to the ownership interest of a general or limited partnership. Both the LLC statute and the partnership statutes specifically provide that the only remedy a judgment creditor has against the judgment debtor’s ownership interest of an LLC (or partnership) is the “charging order.”
Perhaps a little background on the common law of partnership will help in reaching an understanding of why there is a distinction made between the ownership interest of a corporation (stock) and the ownership interest of a partnership or LLC. Because of the nature of a limited liability company, it is treated under the law as having the legal status of a partnership, so partnership law is the basis for the charging order protection for LLCs as well as partnerships.
Partners in a partnership owe a fiduciary duty to each other because of the special relationship that partners have under the common law. General partnership law provides that all of the partners are liable for all of the actions and liabilities of the partnership, regardless of which partner may have been involved in the particular action that gives rise to the liability. A fiduciary duty is the highest level of trust and confidence that the law recognizes. It is the same duty that is owed by an attorney to his client, or a trustee to the trust beneficiaries.
Under the common law, because of the fiduciary duty owed by one partner to another, the law will not impose or force the partnership to admit someone as a partner, unless all of the partners agree to accept that person as a partner. The law simply will not force you into a relationship with the high trust and confidence of a fiduciary duty, unless you willingly accept that relationship.
Hence, when a judgment is rendered against a partner, for non-partnership liability (for instance an unpaid personal debt of the partner, a personal injury caused by the partner outside the operation of the partnership, etc.), the judgment creditor is unable to “seize” the partnership interest or foreclose on the partnership interest, because that would mandate that upon the sale of the partnership interest at the public auction, some “stranger” to the partnership would become a partner and force the other partners to have a partner with whom they might not have the trust and confidence sufficient to fulfill the fiduciary duty that exists among partners.
So, the concept of a charging order developed. The above referenced statutes provide that a judgment creditor may not foreclose a judgment lien against a partnership interest, or an ownership interest in a limited liability company. A judgment creditor, who wishes to do so, can obtain from the court a charging order against the judgment debtor’s interest in the LLC (or partnership interest). A charging order gives the judgment creditor two (2) rights with respect to the LLC ownership interests: (1) the right to receive any distributions made by the LLC to the judgment debtor; and (2) the right to the judgment debtor’s share of the profits of the LLC. These are two very different rights both legally and practically speaking.
The right to receive the judgment debtor’s distributions is a fairly simple concept. It simply means if the LLC distributes any money or property to the judgment debtor who has the ownership interest, that distribution must be made instead to the judgment creditor who has exercised the right to the charging order. Importantly, if there are no distributions from the LLC to the judgment debtor, the judgment creditor gets nothing.
The right to the judgment debtor’s share of the income of the LLC is conceptually a little different and more difficult, because it is impacted by the Internal Revenue Code. Basically, the judgment debtor’s share of the income is going to be dictated by whether the LLC has elected to be taxed as a partnership or corporation; and if a corporation, whether as a C corporation or an S corporation.
If the LLC has elected taxation as a C corporation, then the individual ownership interest of the judgment debtor is entitled to income only if dividends are declared and paid by the LLC’s governing body (the Manager or Managing Members). So there is no difference between the judgment creditor’s distribution and share of the income. The distribution of the dividends will be taxed to the judgment creditor when the dividends are received by the judgment creditor. Very few LLCs elect to be taxed a C corporations.
If the LLC is taxed as a partnership, or has elected to be taxed as a S corporation, then the judgment debtor’s share of the income is essentially determined by the LLC’s operating agreement provisions, and is reflected by the Form K-1 that is issued to the judgment debtor by the LLC at the end of the tax reporting period in conjunction with the filing of the LLC’s tax return with the IRS. Typically, the share of income, just as is the case with a standard S corporation, does not reflect a cash transaction or cash distribution, it is simply the number that appears on the tax return as that judgment debtor owner’s allocable share of the income. The Internal Revenue Code provides that a judgment creditor who has exercised their right to a charging order is an “assignee” and has the “rights of an assignee.” Therefore, the judgment creditor is issued and receives the judgment debtor’s K-! from the income tax return, and is personally responsible for and must pay the income tax liability associated with the judgment debtor’s share of the income of the LLC.
The net result is that the judgment creditor who has hired lawyers to obtain a charging order receives any actual distributions made by the LLC that otherwise would be made to the judgment debtor, and the judgment creditor has the legal obligation to pay the income taxes associated with the judgment debtor’s share of the LLC income.
If the LLC’s operating agreement is drafted with asset protection as one of is primary features, the operating agreement will provide that there are no mandatory distributions required to any of the LLC owners. It will further provide that if a judgment creditor exercises the right to a charging order against the ownership interest of any of the owners, that the ownership interest subject to the charging order has no right to vote on LLC actions for so long as the charging order is in effect. Accordingly, the LLC makes no distributions to the judgment debtor, and the judgment creditor with the charging order derives no financial benefit from the charging order.
At the same time, if the LLC is engaged in a profitable enterprise, the judgment creditor who has obtained the charging order will receive the judgment debtor’s K-1 for the time period in which the charging order is in effect, and will have to reach into his own pocket to pay the income taxes on the judgment debtor’s share of the income – at the judgment creditor’s income tax rates.
The bottom line is that for a multi-member LLC – with a properly drafted operating agreement, no creditor will ever want to exercise the right to the charging order because there is no financial benefit and the judgment creditor will pay a potentially significant out of pocket cost associated with the judgment debtor’s share of the income, solely as a result of the existence of the charging order.
Based on case law in several jurisdictions, the charging order as the exclusive remedy for a judgment creditor also applies to trustees in bankruptcy. So if one of the LLC owners of a multi-member LLC is forced into bankruptcy because of non-LLC related debts, the bankruptcy trustee cannot seize the actual ownership interest of the LLC, and can get only a charging order. In those jurisdictions where the charging order as the exclusive remedy has been challenged by the bankruptcy trustee, the trustee generally has lost, with a couple of exceptions related to poorly drafted operating agreements. Even bankruptcy trustees do not want ownership of something that does not provide any distributions, and results in an income tax liability that must be paid with the judgment creditor’s own funds.
So, if I’m as small business owner, I want to structure my business to have multiple members, with a properly structured operating agreement, and I don’t ever want to operate as a corporation.
Now, what about single member LLCs. As reflected in the newly revised statute, and the Olmstead case, and a number of bankruptcy cases around the country, the charging order as the sole remedy rule does not apply to single member LLCs. Various rationales have been used by the different courts to come to the same conclusion, but the underlying reason that the charging order remedy’s protection doesn’t apply to single member LLCs is that there are no partners in a single member LLC. With no partners there is no fiduciary duty that must be protected from forced strangers as partners. If I own all of the interest in an LLC, I don’t have anyone that has placed the trust and confidence in me giving rise to the level of a fiduciary duty. So, there is no legal basis for the charging order protection. A single member LLC essentially is treated just like a corporation that is owned by a sole shareholder.
If someone operates one or more single member LLCs, and has other assets that might need protecting, then all of the LLC interests can be transferred into a limited partnership that will have multiple partners, and a properly drafted limited partnership agreement. Then the same protection is provided for the limited partnership interest, and the limited partnership owns all of the LLCs. Not only is the limited partnership statute similar, there is case law in Florida construing the charging order protection for partnerhips consistent with the discussion above.
The potential problem with transfering the ownership interest of LLCs or corporations into a limited partnership to obtain the charging order protection is that a partnership cannot be a shareholder of an S corporation. For that reason, I encourage my clients to carefully analyze whether they want their business operations to be taxed as an S corporation or as a partnership. There are some significant advantages of partnership treatment for income tax purposes that should be explored before automatically opting for the S corporation election. Often clients and accountants suggest that the reason for choosing S corporation status for taxation purposes is to avoid self-employment taxes on some portion of the income of the business entity. However, with proper structuring, the LLC taxed as a partnership can also avoid the self-employment tax on those profits, so that alone should not be the reason for choosing S corporation status for an operating entity.
If for whatever reason the S corporation taxation is the more benficial option, and there remains a need for asset protection for a sole shareolder corporation or a single member LLC that is taxed as an S corporation, then we can evaluate the use of certain S corporation qualified trusts. Such trusts can own S corporations and buld a protective shield around the ownership of the corporation to minimize or eliminate the potential for a future judgment creditor to have access to the ownership interest of that corporation or single member LLC. There are numerous options available in such trust planning including various forms of grantor trust or beneficiary controlled trusts that can have very beneficial income tax results or generation skipping tax benefits, or both.
There are other significant benefits to using the LLC structure, including the ability to transfer fractional ownership interests to other family members or business associaties without giving up control over the business operations and with valuation discounts that leverage the annual exclusion and life time exemption for gift taxes, valuation discounts as death for estate tax purposes, among others.
With more and more businesses and individuals utilizing the courts, and more and more judgments being entered against individuals, it is becoming increasingly important to protect what you have accumulated. Often the most important asset to protect is the ownership of your business or real estate interests. A multi-member LLC can be one of the most effective, tax efficient, ways of achieving the protection of your business interest, while providing you with maximum control over the business operations.
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