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The Charging Order--A Powerful Asset Protection Tool.

By Randall K. Edwards - Email Editor

Date : Nov 09, 2006

Dear Subscriber:

I’m often asked, “What is the best Asset Protection tool available?” I never know quite what to say because the question is a lot like asking a doctor, “What is the best surgery available?” The answer is much the same for both questions: “Whatever you happen to need right now.” Not every tool is going to work every time. Nonetheless, in order to know what’s going to be right for you, you need to know what’s available.

In this newsletter, I’d like to discuss one particular tool that is very helpful in a lot of cases – the Charging Order; a protection that is available for certain types of business entities, such as Limited Liability Companies (LLCs), Limited Partnerships (LPs), Limited Liability Partnerships (LLPs) and the redundantly-named Limited Liability Limited Partnership (LLLPs). Importantly, Charging Orders are not allowed for corporations – although I am aware that there is a move afoot in at least one state to attempt to employ the concept in a corporate context. Now, Charging Order protection isn’t the end-all be-all Asset Protection wonder that will remedy all of your problems, cure male-pattern baldness and hangnails, and make you irresistible to those you’d like to attract. And, you need to be aware, Charging Orders don’t always work – there are instances in which courts have decided that a Charging Order was used to attempt to simply defraud a creditor, in which case the protection has been set aside. But, used properly and judiciously, a Charging Order can keep the barbarians outside the gate – or at least outside your company – where they belong.

Here’s how a Charging Order works. Let’s suppose that you are a 25 percent owner of an LLC, and the business of which is to manufacture widgets. You get sued personally, and you lose. Your adversary gets a judgment against you, and he wants his money. He starts to look around for whatever he can attach to satisfy the judgment.

What can your judgment creditor squeeze out of you? Pretty much anything that you own, as long as it isn’t what’s known as “exempt property” (which I don’t have time and space to get into here, except to say that your state’s laws set aside certain types of property that you get to keep even if you get a judgment rendered against you). Can he grab your LLC interest? Under the laws of most states (you’ll want to check and see if your state is among them), the answer is no. The best that your judgment creditor can get is a “Charging Order.” (Even in those states in which the statutes don’t provide for protection, a well-drafted Operating Agreement will probably provide that shield). What a “Charging Order” means is that the LLC is ordered to pay to the creditor any distributions that would otherwise go to you, until the judgment is paid in full. Your creditor doesn’t acquire any fiduciary rights over the LLC, such as the ability to force the other members of the LLC to make a distribution. Instead, the creditor must wait patiently for the LLC to decide to make a distribution. Of course, there is a strong possibility that so long as your creditor is hanging onto the charging order, the LLC will never make a distribution, and your creditor is going to be waiting a long, long time. This puts you in a very advantageous position. You can approach your creditor and negotiate a quick settlement for much less than he’s got the judgment for. After all, the smart creditor is going to want a small piece of something now as opposed to a huge piece of nothing for who knows how long?

There may be another incentive for your creditor to settle with you quickly, and it has to do with taxes. Because the LLC is a “flow-through”entity for tax purposes, it may well be that the other members of the LLC will issue a K-1 (the tax form used to report an individual member's share of the LLC's income) to your creditor under the idea that he is liable for taxes due on LLC profits, even if he hasn’t yet seen a dime of distributions from the LLC. Will he have to pay those taxes? Strangely enough, there appears to be no definitive answer to this question. The experts aren’t of one mind on whether a judgment creditor holding a Charging Order can be “KO’d by the K-1,” and, if so, exactly when that liability arises. As far as I’ve been able to ascertain, the IRS hasn’t answered that specific question definitively. Be that as it may, is your judgment creditor going to take the chance that he may be on the hook for taxes on money he’s never seen and which he doesn’t have a distribution to help fund? I think it’s pretty unlikely that he’s going to take that chance … at least I wouldn’t if I were him.

Now, there’s a lot of details that I don’t have space or time to discuss here, such as whether Charging Order protection applies to a single member LLC (just for safety’s sake, I always recommend that the LLC have more than one member); which state’s laws apply to an LLC’s creditors and how the creditor goes about satisfying his judgment against an LLC interest in a state other than where the judgment was rendered; whether Charging Order protection applies in bankruptcy (the wise rule of thumb in bankruptcy court is that you’re always playing with fire and that essentially “all bets are off,” especially with the new bankruptcy reforms); exactly how Charging Order protections apply to the other entities I mentioned above (LPs, LLPs and LLLPs); and how to draft an Operating Agreement or Limited Partnership Agreement to take your best advantage of this tool.

You’re well-advised to talk to your lawyer or an otherwise well-qualified Asset Protection planner in order to get the answers as to how Charging Order protection can be applied to your particular situation. The point here is to make you aware that this powerful tool exists, and to help you ask the right questions of your Asset Planning professional to see if it’s right for you.

Randall K. Edwards practices law in Utah, Nevada, California and Arizona, with his main office in Salt Lake City.

Randall K. Edwards

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