How A Charging Order Can Force Your Creditor's Hand,
Keeping Your LLC's Assets Where They Belong -- With YOU!
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.
In such instances, creditors may find themselves
with more problems than profits. Since an assignment of the rights of
income under a charging order may also mean an assignment of the liability
for taxes, the creditor may be given a K-1 form reflecting the taxable
income allocated to the charging order. He or she may have to pay
the taxes whether any distribution is made or not! This will strongly
dampen the enthusiasm of a creditor and also his/her attorney to pursue
an LLC member’s interest in the first place. In the real world
this may cause the creditor to want to either drop the lawsuit or settle
for pennies on the dollar.
… But The Waters Are Still Murky
Protect Yourself And Your Business From Disastrous Personal Lawsuits
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!
If Your Business Has ANY VALUE,
An S Corporation Is Probably The WRONG Approach!
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.
Ready to Incorporate,
Build Business Credit &
Keep the IRS Off Your Back?
Call NCP Today at
1-800-351-5111
Avoid Costly Mistakes!
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