Charging Order Misconceptions

In terms of new business entity formations, the Limited Liability Companies (“LLCs”) are the king. The former ruler of the land – the corporation – has been dethroned after a viscous coup. Very few corporations are now being formed for asset protection reasons. In fact, unless one hopes to eventually take a company public or has some other unique requirement (e.g. employee benefit plans), there is very little reason to use the corporate form of ownership.

Charging Order Protected Entity

The Limited Liability Company has become popular because it offers decentralized (read “relaxed”) management and bookkeeping. LLC statutes have dispensed with the need for a Board of Directors, not to mention the need for a Board resolution every time somebody wants to flip a light switch. Limited liability companies also offer relaxed bookkeeping requirements, and they are taxed as partnerships by default (though an LLC can be disregarded if single-member or elect to be treated as a corporation or S-Corporation).

Probably the biggest driver behind the formation of many LLCs, as with Limited Partnerships (“LPs”), is the existence of statutory “charging order protection.” Simply, this means that if a member of an LLC becomes a debtor, the creditors do not get direct assets to LLC’s assets or even ownership of the debtor’s LLC membership interest. Creditors are prohibited by law (in some states) from levying on the interests of an LLC. This is exactly the opposite of what happens in the context of corporations, where creditors can simply seize the ownership interests.

Liens Instead of Seizures

Rather than take control of a debtor’s membership interest in an LLC, creditors are limited to getting a lien against the debtor/member’s LLC interest. These liens lasts until their underlying judgments are satisfied. This means, more specifically, that a creditor gets only a lien against whatever distributions of income that the LLC makes to the debtor/member, if any distributions are made at all.

In my mind, this makes LLCs a lot like country clubs, where membership can be exclusive and unwanted people can be barred from membership.

Charging Order Misconceptions

The charging order is surrounded by misconceptions. The charging order itself is not a lien. Rather, the lien is put in place by the charging order. Think of the charging order as gun. The lien is a bullet. The charging order is the mechanism by which the lien is placed on the debtor’s membership interest. The charging order itself is not the lien.

Under most LLC laws, the charging order is the “exclusive remedy” that a creditor can use to pursue a debtor’s LLC membership interest. The term “remedy” is a term of art in this context. It doesn’t mean an “outcome,” which is the reason that so many planners misunderstand it. The charging order is the “remedy” that a creditor must use in this situation. It means that other “remedies” like levies, garnishments, assignment orders, etc. simply aren’t available.

If a creditor has an alternative avenue to attack an LLC (e.g. alter ego theory), if it is not defined as a “remedy” then it is not blocked by charging order exclusivity. There have been instances where creditors have been able to circumvent the charging order procedure by attacking the LLC itself as opposed to attacking the debtor.

The purpose of a charging order is not to protect debtors. Instead, charging order exclusivity exists so that the other, non-debtor members of the LLC aren’t forced into involuntary business relationships with another member’s creditor(s) or ex-spouse. Again, think about it like a country club with exclusive membership rights. This rationale for the existence of charging order protection is important. Based on that rationale, some courts have effectively held that if all member of an LLC are debtors of the same creditor, then the charging order protection should not exist. This often occurs in the case of single-member LLCs (i.e. where there is only one member who is also a debtor). It also occurs when all of the members of an LLC are co-guarantors of the same line of credit, as an example.

Remember, a charging order gives creditors the right to lien a debtor’s membership interest. That means the creditor can intercept distributions. The creditor is not a “member”and has no right to become a member, and is therefore not liable for the taxes of the LLC that flow through to members. One of the biggest lies told by asset protection marketers is that “the creditors get the tax bill even though they can’t touch the assets.” To the contrary, if distributions are made to the debtor pursuant to his or her economic rights, then the creditor gets to intercept the cash and NOT the tax bill, which still belongs to the debtor! Wowza!

Some asset protection planners (liars) tell their clients something like, “You can always access cash in the LLC through loans, salary, etc.” Sounds great, right? Only in theory and by asset protection attorneys who have never been in court, in front of a judge, and have ZERO experience with actual charging orders. In practice, court issued charging orders are usually loaded with all sorts of prohibitions that specifically prevent the making of loans or payment of salary or fees to the debtor. Anything and everything that can be considered a distribution is subject to being intercepted.

What often happens is an Old West style standoff between creditors and debtors. The creditor can’t access the assets while they’re inside the LLC, and the debtor can’t distribute the assets from the entity. The creditor can almost always win if they are patient, especially if the creditor doesn’t have an urgent need for the cash (e.g. if the creditor is a bank or other institutional investor). Nonetheless, almost all of these types of cases settle, but debtor usually gets the short end of the stick at the negotiating table.

Charging orders are too nuanced to discuss every detail of them here, but suffice it to say that charging orders present complicated issues of law. They are even more complicated when the law is applied to particular fact patterns. The moral of the story is quite simple. LLCs and FLPs aren’t enough to protect your assets completely.