Charging Order & Asset Protection
April 15, 2011
In contrast to corporations, in which a creditor who obtains a judgment in court (judgment creditor) can execute on shares of a shareholder, most states provide that judgment creditors of owners of interests in some types of legal entities are limited to obtaining a charging order. A charging order is a court-ordered remedy that only entitles the holder of the order to temporarily receive distributions from an entity in which a judgment debtor has an interest until the judgment has been satisfied. Holders of charging orders are not entitled to participate in management of the entity or compel distribution.
The most common types of entities that limit creditors to obtaining charging orders are the limited liability company (LLC) and limited partnership (LP). However, other entities may also limit creditors to obtaining charging orders, including the limited liability partnership (LLP) and limited liability limited partnership (LLLP).
Rationale for Charging Orders
Unlike corporations, in which the shareholders generally possess the right to elect the board of directors, but do not have the right to manage the corporation (unless it is a statutory close corporation), interest holders in some partnerships or partnership-like entities, e.g. member-managed LLCs, possess the right to actually manage the entity. Legislatures have been reticent to force those non-debtor members into an involuntary partnership-like relationship with judgment creditors.
Although a charging order may seem like an effective remedy for creditors, what happens if the entity simply doesn't make distributions? Some partnership agreements and LLC operating agreements provide that distributions will be made entirely in the discretion of the general partner or manager, thereby providing no means through which creditors can compel distributions. This means that a charging order may be significantly less effective and valuable than may appear on its face.
Foreclosure, Taxes, & Phantom Income
Although charging orders are often viewed as a creditor's exclusive remedy against partnership and partnership-like interests, courts in some states have permitted creditors to foreclose on such interests. However, Arizona limits creditor remedies against both LPs (ARS § 29-341) and LLCs (ARS § 29-655) to charging orders as "the exclusive remedy."
Charging orders are one feature of LLCs
Learn More »In those states that do allow foreclosure, either tacitly or affirmatively, it does come with a very significant potential cost: income taxes.It is unclear whether the Internal Revenue Service (IRS) or state taxing authorities will require the holder of a charging order, to whom distributions have not been made, to pay taxes on the holder's share of an entity's taxable income or so-called phantom income, but the possibility cannot be ignored (Revenue Ruling 77-137). However, it is very likely that IRS and state taxing authorities will require a judgment creditor who forecloses upon a partnership or partnership-like interest to pay taxes in such circumstances because the creditor is the owner of the interest.
Because of the above-described limitations of a charging order or successful foreclosure of an interest in a limited partnership, a limited liability company, and similar entities that are taxed as partnerships, creditors may be less inclined to pursue those interests or more willing to settle their claims than if they had access to the assets held in these entities.
This brief overview of some important considerations associated with charging orders and asset protection is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.