Limited Liability Companies (LLCs) and Charging Order Protection - dummies

Limited Liability Companies (LLCs) and Charging Order Protection

By Jennifer Reuting

So now you know that an LLC protects your personal assets if the business gets sued or goes bankrupt. Pretty great, eh? Well, it gets even better. Unlike corporations, LLCs have a dual layer of liability protection called charging order protection.

Many moons ago, when a creditor obtained a judgment against a partner of a partnership, the creditor could simply take the partner’s interest in the business (and, proportionally, all related assets) and liquidate them in order to get paid, often leaving a ravaged business in his wake. Clearly, this wasn’t fair to the other, innocent partner(s), who was just going about her business when suddenly everything she’d worked for was destroyed!

To remedy this unfairness, the courts amended the laws so that the creditor of a member (the partner) cannot go after that member’s individual interest, but only the economic right to that interest.

How charging orders work

One day, finally getting a break from the constant demands of the restaurant you started and built, you drive to the supermarket and accidently hit someone with your car. Sure, the woman mindlessly walked in front of you and you only barely bruised her, but that means nothing when she shows up to court in a neck brace.

The jury, sympathetic to the woman’s plight, finds in her favor, and you now owe this woman more than your insurance covers and more than you can afford. After wiping out your family’s savings, your equity in your home, and your kid’s college funds, you still come up short.

But the bad news gets worse if the restaurant you’ve spent the past four years building is structured as a corporation. Your ownership interest (stock) in that corporation is considered a personal asset of yours, and the judgment creditor is therefore allowed to foreclose on it. Before you know it, your corporate account’s been frozen, and you’re holding a fire sale of your kitchen equipment to satisfy the debt. Your company is toast.

Now imagine a different scenario: Instead of forming your restaurant as a corporation, you formed it as a limited liability company. When you are sued, the plaintiff can’t foreclose on your business, but instead can only obtain a charging order against your LLC.

This means that she has no say in the day-to-day operation of the business and can only wait patiently with her hand out, should you decide to issue her profit distributions. And why would you ever do that?

Economic rights versus other rights

To better understand charging order protection, you should know that a member can have two rights in an LLC: economic rights, or the right to receive profit allocations and distributions from the company; and other rights, which include the right to vote on important matters or be involved in the day-to-day management of the business.

Assuming that your operating agreement allows for it, charging order protection grants only economic rights to the assignee under most state laws. In other words, the creditor has no choice but to shut her trap, sit back, and receive whatever distributions you decide to grant her. You could stop profit distributions altogether, and the creditor would have no say in the matter.

This is the worst possible situation for your judgment creditor, because while you are withholding profit distributions from her, she is still required to pay taxes on that allocated share of the profits. This is called phantom income, and it usually isn’t a good thing.

In this case, however, it works in your favor, and you can easily force your creditor to end up with nothing except the pleasure of paying down your tax bill. It’s funny how this arrangement can make even the most bull-headed creditors call up, ready to negotiate an extremely favorable settlement!

Of course, considering that her attorney would know that trying to seize membership interests in an LLC is a losing proposition, it’s unlikely that she would risk suing you at all. But who knows? Maybe that fake neck brace cut off circulation to her brain.

When formed and maintained properly, LLCs always hold up in court. When creditors see that you have shielded your assets with an LLC, they very rarely go through the hassle of taking you to court. And avoiding a lawsuit is always better than winning one, or, as legendary Chinese strategist Sun Tzu wrote, “The best battle is the battle that is won without being fought.”