What Options does a Creditor Have When Suing a Member?
A creditor has three potential outcomes from a successful claim. The creditor could hope to receive LLC units, could wait until the LLC is liquidated to collect the liquidation value available, or could obtain a charging order.
Can the Creditor Obtain a Member’s LLC units?
LLC units are personal non-exempt property and as such would appear to be collectible. Can the creditor really get the LLC units? Since status as a member depends on the terms of the agreement, a debtor-member would first have to get permission from the other members before making the transfer to a creditor, an unlikely result. A creditor might be an assignee, but that is merely a right to receive distributions, not a right to exercise LLC rights such as voting.
Can the Creditor Obtain LLC Assets from a Member?
Since a member has no right to take assets from the LLC, the creditor does not have the right to take assets from the LLC either. The creditor could sue the member, get a judgment, and wait until the LLC is liquidated to collect it as that member collects his or her share of the liquidated assets. If the LLC is set up to last for 50 years with a 50-year option, the creditor might not collect for almost 100 years. That is a long time to wait. Will the creditor be willing to wait years, even decades, to be able to collect? For most people, waiting until liquidation to collect is not a viable option.
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Can the Creditor Obtain a Charging Order?
Most state laws make a charging order the “sole” remedy for a creditor of a limited member. Some states have provided that the charging order is the “exclusive” remedy. The judgment creditor could collect the debtor’s share of any income distributed by the LLC.
A charging order entitles the creditor to distributions (not management fees, loans, or sale proceeds) made to the debtor Member. For this purpose the creditor is given a status that is the equivalent of an assignee of the debtor member’s interest. The IRS (Rev. Ruling 77-137) is read by many commentators to suggest that the assignee should receive a K-1 statement showing the assignee’s share of LLC income, even if no distributions of cash are made from the LLC. Since the LLC is a pass-through entity for income tax purposes, the debtor’s share of undistributed income may be taxed to the judgment creditor even though the debtor did not receive the LLC income. This type of income is sometimes referred to as “phantom income.”
The possibility of “phantom income” can provide a strong disincentive for someone who sues a person owning interests in an LLC or a strong incentive to settle early. If the creditor’s share of phantom income is a significant amount, it may throw the creditor into a higher tax bracket, and could even force the creditor to pay more in income tax in a year than he actually received in income.
Some creditors will not be deterred by a charging order. Some creditors have significant loss carry-forwards that they will never be able to use. These potential creditors are rare. A creditor with a tort judgment is the more common creditor of a limited member. When we consider who the most likely creditors might be and their commitment to forcing settlement or receiving an award, the typical creditor will usually be deterred by the tax consequences of a charging order.
Since the charging order might not be a deterrent for that particular potential future creditor, consider an asset protection trust to hold LLC units. The trust is not the same legal person as the member being sued and would not even be a proper party to the lawsuit or claim. Remember that an asset protection trust needs to be created and funded before the potential liability occurs or becomes reasonably known for the best protection.
So What Do Creditors Do?
Many creditors prefer to settle the lawsuit rather than dealing with a charging order and facing the risk of phantom income. The LLC helps to level the litigation playing field by forcing a creditor to spend at least the same amount of money pursuing the claim, as the debtor will spend defending it. With the addition of asset protection trust planning, the situation shifts even more in favor of settlement on favorable terms for the client.
Maintaining Proper Insurance Coverage
Adequate liability insurance coverage for the LLC is critical. First, insurance coverage means that defense counsel will be provided. Second, insurance is the carrot that will make some creditors settle their claims in short order. Insurance proceeds provide an easy alternative to costly litigation with uncertain results.
Additional Protection Using LLCs
Creation of subordinate limited liability companies (LLCs) to own risky property can be an effective tool to contain the damages resulting from a lawsuit involving the property that created the liability. Using LLCs to insulate risky assets from safe assets will make a lot of sense for individuals who have personal risk, or who serve as General Partners of limited partnerships. Risky assets held in a separate or subordinate LLC do not contaminate the safe assets held in the LLC itself, or in other LLCs, so long as the entities are operated properly.
Similarly, use of an appropriate entity Manager is an added level of protection for persons serving in that capacity. The use of an asset protection entity makes certain that no individual is exposed to personal liability. Protecting a Manager and protecting the assets of the LLC from any potential joint liability goes hand in hand.