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The
Charging Order
and Limited Liability Companies
If a judgment is awarded against
the LLC itself, it may be levied, and LLC’s property seized
or sold in payment (this would be the same result if it were a
corporation). On the other hand, if it is awarded against a member,
to the extent that the operating agreement so states, distribution
usually cannot be compelled to satisfy a member’s judgment
debt (this is why it is critical to have a well crafted operating
agreement, otherwise you have no protection). Creditors have
to satisfy themselves with a ‘Charging Order’.
This gives them the rights to any distributions made by the LLC
to that particular member, but little else.
Is this going to guarantee
that the assets will be secure? Not always. Why? No matter what
the situation, you are always at the mercy of the judge. Even
if this plan was properly formed and there were no challenges
with creditors, the judge may see things differently. For example,
imagine forming this plan and 5 months later you are hit with
a devastating lawsuit. The judge might claim fraudulent conveyance
and reverse the transfer of the assets to the LLC.
In 1997 Congress enacted Proposed Regulations
on how an LLC would be taxed. The following discusses detail what
these proposed regulations entail. Just recently, Congress has
banned them from being finalized. This means that they never were
officially approved as law, but they are on the books. That means
there are no guidelines to determine how members or managers distributions
should be handled. A recent tax newsletter made these comments, " A ban on proposed IRS rules slapping SECA taxes on limited
partners ended earlier this year. But final rules saying when
limited partners owe SECA haven’t been reissued…aren’t
likely to be in the near future. Instead, look for cases to arise
in tax audits and be settled or be taken to court and decided
under existing rules, which experts say are far from clear.
Our opinion is that even though no regulations
exist, following the expired proposed regulations as a guideline
would be helpful.
**LLCs and other flow through Entities:
They have income subject to self-employment
taxes. There are exceptions to this: (ideally you would like
to receive income not subject to these taxes!):
- Rental income from real estate and personal
property leased with real estate (except for real estate dealers).
Sec 1402(a) 1
- Dividends and interest (except for dealers
in stocks and securities). Sec 1402(a) 2
- Gains on the sale of capital assets. Sec 1402(a)
3
- Distributive share of income to a limited
partner other than guaranteed payments for services
actually rendered (the question is, can a limited partner have
guaranteed payments.
This really means that if is you are involved
in an LLC and receive income from the LLC and it is in the form
of rents, dividends or gain on the sale of capital assets,
it doesn’t matter if you are viewed as a general partner
(managing member) or limited partner (non-managing member) for
SE tax reasons; this income will not create SE taxes!
Since, many LLCs are operating a business;
the key question is will that income be subject to SE taxes?
Again, many LLCs are simply holding and protecting assets, there
is no other income to worry about which would be exceptions mentioned
above. But more and more companies are operating an LLC taxed
as a partnership, and the want to know how that income distributed
to them by the LLC will be treated? We are talking about active
income being earned by the LLC and how that flows though.
Under the 1997 Proposed Regulations, an LLC member,
for tax purposes, will be classified as a limited partner
unless one of four tests is met in
which case the member will be treated as a general partner. The
four tests are: (bottom line, if you fall under one
of these tests, you will be viewed as a general partner and your
distributions, unless under one of the exceptions (1402(a), will
be subject to SE taxes).
- The Liability Test: The member faces
personal liability for claims against the LLC .
- The Authority Test. This requires that
the member has the authority to create binding contracts on
behalf of the LLC (this means if you run your business through
the LLC, you could never sign a contract on behalf of the LLC.
The manager would have to do this).
- The Participation Test: Here the member
must participate more than 500 hours per year in the business
of the LLC (if you operate a business and are there everyday,
there is no way you will be viewed like a limited partner).
- The Personal Services Test: The member
must provide greater than a de minimis amount of services
on behalf of the business of the LLC, and the business must
involve the areas of health, law, engineering, architecture,
accounting, actuarial science, or consulting. (In other words,
if you don’t form a corporation to avoid the Personal Service
Corporation rules, and you form an LLC that doesn’t have
that category, then you still are trapped if you provide one
of these services to the LLC. You will be viewed as a general
partner and be subject to SE taxes).
Planning tip: Make sure only Managers
have the right to bind the company, not members.
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