by Christopher M. Riser, J.D., LL.M.
Published in the Asset Protection Journal, Winter 1999

There is a common belief among many, if not most, practitioners in the fields of estate planning, business planning, and asset protection planning that a judgment creditor who obtains a charging order against the membership interest of a debtor limited liability company (LLC) member or against the partnership interest of a partner in a partnership will be taxed on the debtor's distributive share of income to the extent charged, regardless of whether the governing LLC or partnership act provides that an assignee receives the creditor-assignor's share of items of income, gain, loss and deduction.⁽¹⁾ This belief that the creditor will be "K.O.'d by the K-1" is apparently the prevailing view among practitioners, judging from the number of such assertions in the professional literature and the dearth of assertions to the contrary.⁽²⁾ However, a review of the relevant law as well as tax policy rather clearly indicates that it is inappropriate for a creditor who obtains a charging order to be taxed on the debtor member's share of taxable income.

The argument that a judgment creditor who obtains a charging order against a partner's interest is taxable on the distributive share of income attributable to such interest is usually based on Rev. Rul. 77-137⁽³⁾ and Evans v. Commissioner.⁽⁴⁾ In Rev. Rul. 77-137 and in Evans, a partner assigned his interest to a third party assignee, and the assignee was held to be taxable on the distributive share of income attributable to the distributive share of the assignor's partnership interest. However, neither Rev. Rul. 77-137 nor Evans dealt with the situation of a judgment creditor and a debtor partner. Rather, each dealt with the situation of a partner who fully assigned his partnership interest (i.e., his assignable economic rights) to a third party and irrevocably agreed, or was compelled as a fiduciary, to exercise his residual rights as a partner in favor of the assignee.

Rev. Rul. 77-137 and Evans

Rev. Rul. 77-137 stands for the proposition that assignees of partnership interests are required to report distributive shares of partnership income or loss attributable to the assigned interests, even though they do not become substituted limited partners, when they acquire dominion and control over those interests. The assignor partner in Rev. Rul. 77-137 irrevocably agreed to exercise his residual rights in favor of the assignee. The assignee was taxable rather than the assignor, because the assignee was essentially the owner of the assigned interest. However, to the extent that assignors retain substantial rights with respect to those interests that are not required to be exercised solely on behalf of the assignees, assignees do not have the requisite dominion and control and are not required to report distributive shares of partnership income or loss attributable to the assigned interests.⁽⁵⁾

The Evans case involved the assignment of a partner's partnership interest (his right to income and capital) in a partnership in which capital was a material income-producing factor to the assignor's wholly-owned corporation. The court found that, after the assignment, the assignor, in his capacity as an officer and director of the corporate assignee, continued to do the work he had done for the partnership in his capacity as a partner prior to the assignment. The assignor was obligated as a fiduciary to exercise his residual rights as a partner in favor of the corporation.⁽⁶⁾ Thus, Evans stands for the proposition that where a partner has "not simply assigned income but... also his entire equitable interest," the assignor retains only "naked legal title" to his partnership interest, "the income from which is computable in the same manner and on the same basis as any other property, the legal title to which is in a naked trustee."⁽⁷⁾

Thus, the key to whether an assignee's interest is taxable is the extent of the assignee's dominion and control over the assigned interest and the extent of the assignor's retention of rights. If an assignor makes a complete assignment of his beneficial interest in a partnership, and if there is an express or implied agreement to exercise any residual, non-assignable rights in favor of the assignee, the assignee will be taxed on the assignor's distributive share of partnership income. If an assignor retains substantial rights with respect to the assigned interest, and if there is no express or implied agreement to exercise any residual non-assignable rights in favor of the assignee, the assignee will not be taxed on the assignor's distributive share of partnership income.

A Charging Creditor's Dominion and Control is Typically Insufficient to Indicate Taxability

A judgment creditor who obtains a charging order against a partner's interest or an LLC member's interest has the rights of an assignee to the extent that the interest is charged. An assignee does not participate in the management and affairs of the partnership or LLC without the consent of the other partners or members. An assignee is not a proper party to an action affecting the assignor's retained (non-economic) rights as a partner.⁽⁸⁾ An assignee is owed no fiduciary duties by general partners or managers other than the duty to pay the assignee those amounts which the assignor would otherwise be entitled.⁽⁹⁾ An assignee may not become a partner or member without the consent of the non-assigning members or partners.⁽¹⁰⁾

So, what is the interest of a judgment creditor who has obtained a charging order against a the interest of a partner or LLC member? A judgment creditor who obtains a charging order is something less than an assignee.⁽¹¹⁾ Without further agreement between the debtor and judgment creditor, or without an additional equitable order by the court, the judgment creditor who has obtained a charging order will have no right except the right to future partnership distributions, to the extent of the judgment plus interest, and the debtor partner will retain all of the rights as a partner that he had before the issuance charging order except the right to future partnership distributions to the extent of the charging order.⁽¹²⁾

In fact, a charging creditor's right to distributions in respect of a debtor partner's interest is so weak as to be subordinate to subsequent liens by partnership creditors.⁽¹³⁾ Surely such a limited interest in a partner's partnership interest does not vest a charging creditor with sufficient dominion and control to require him to be taxed on the debtor partner's distributive share. Neither does a charging order leave a debtor partner with such an insubstantial residual interest that he should not be taxed on his distributive share.

Tax Asymmetry

Where an interest charged is not foreclosed, a charging order is similar to a garnishment.⁽¹⁴⁾ When a debtor's wages are garnished, the debtor is taxed, not the creditor.⁽¹⁵⁾ The debtor is treated as having received the wages, then as having used the wages received to pay the creditor. The same rule should apply to the typical charging order situation. A debtor partner or member should be treated as being entitled to her distributive share of income, which, if distributed, is used to pay the creditor.

Note the potential for tax asymmetry when a charging creditor is taxed. The tax treatment of the receipt of proceeds of a judgment depends on the nature of the claim which gave rise to the judgment. Generally, contract damages are taxable, to the extent they represent the payment of items which would have been included in the creditor's taxable income.⁽¹⁶⁾ Compensatory damages resulting from personal injury tort claims are generally not taxable.⁽¹⁷⁾

If a judgment creditor with a charging order were treated as a partner for tax purposes, then there would be no way to account for the satisfaction of judgment debts for tax purposes. While tax would be payable on the distributive share of partnership income (as it would if there were no charging order), a contract creditor, for example, would never report taxable contract proceeds as income and the debtor partner would never deduct the payment of the debt.

If a judgment creditor were somehow taxable on charging order proceeds, then perhaps to the extent that a judgment creditor actually received distributions (thereby relieving the debtor of the obligation to pay the creditor to the extent of the actual distributions), the debtor would have discharge of indebtedness income. This tax scenario would be the reverse of what it should be -- the creditor would be taxed on the partnership income and the debtor partner would be taxed on the creditor's contract proceeds. This would be confusing and unnecessary. It is simply more reasonable for the debtor to be taxed as having received the distribution and then having paid the creditor.

Consider also the example of a charging order obtained to enforce a judgment for arrearages related to an earlier order for child support. Should the parent who is entitled to the child support payments be taxed on the paying parent's distributive share of income when it is entirely possible that little or nothing will be realized from the charging order, and when amounts paid under the child support order would not otherwise be taxable? Of course not.

Conclusion

It seems inappropriate and illogical to tax a charging creditor on a debtor partner's share of partnership income. The holdings in Rev. Rul. 77-137 and the Evans case should be understood to be limited to their narrow facts. Where extent of the assignee's dominion and control over the assigned interest is like that of a partner, and the extent of the assignor's retention of rights is limited or nonexistent, a charging creditor is taxable on the debtor partner's share of partnership income to the extent of the judgment plus interest. Otherwise, a charging creditor is not taxable on the debtor partner's share of partnership income.

ENDNOTES

1. The partnership and LLC acts of nearly every U.S. jurisdiction provide in some manner that, on application to a court of competent jurisdiction by a judgment creditor, the court may charge a debtor partner or member with payment of the unsatisfied amount of the judgment with interest, and that to the extent so charged, the judgment creditor has only the rights of an assignee of the debtor's partnership or LLC interest. See, e.g., Uniform Partnership Act § 28; Revised Uniform Partnership Act § 504; Revised Uniform Limited Partnership Act § 703; Uniform Limited Liability Company Act § 504.

2. See, e.g., Arthur A. DiPadova & Kevin A. Kilroy, "How Family Limited Partnerships Help Protect Assets," 137 N.J. L.J. 11, 44 (1994); Lewis D. Solomon and Lewis J. Saret, Asset Protection Strategies: Tax and Legal Aspects, § 3.23, at 62 (1999).

3. Rev. Rul. 77-137, 1977-1 C.B. 178. GCM 36960 (Dec. 20, 1976) provides a detailed analysis of the law on which the ruling is based.

4. Evans v. Commissioner, 447 F.2d 547 (7^th Cir. 1971).

5. Rev. Rul. 77-137, supra.

6. See Robert R. Keatinge, "Partnerships Revisited: New Rules, New Entities, Old Issues, New Solutions." Q249 ALI-ABA 195, at 197.

7. Evans, supra, at 52.

8. Dixon v. American Industrial Leasing Corporation, 157 W. Va. 735, 205 S.E.2d 4 (1974).

9. Kellis v. Ring, 92 Cal. App. 3d 854, 155 Cal. Rptr. 297 (1979).

10. An interesting question is how this rule will be applied in the context of charging orders obtained against the membership interest of the sole member of a single-member LLCs.

11. Perhaps the court in Bank of Bethesda v. Koch put it most entertainingly:

[A charging order] is nothing more than a legislative means of providing a creditor some means of getting at a debtor's ill-defined interest in a statutory bastard, surnamed partnership, but corporately protecting participants by limiting their liability as are corporate shareholders... Since the statutory offspring is unique, the rights of creditors against partnerships were necessarily peculiar as well; hence the charging order is neither fish nor fowl. It is neither an assignment nor an attachment. But unlike many such questionable offspring, it resembles both progenitors in some of the characteristics.  44 Md. App. 350, at 354, 408 A.2d 767, at 769 (1979).

12. It is unlikely that there would be such an agreement between the debtor and the judgment creditor nor a court order requiring the debtor to exercise his retained rights in favor of the judgment creditor, because both such situations would require the affirmative action of the judgment creditor to bring about. Such action is unlikely if it would cause the judgment creditor to be taxable on the debtor's distributive share of partnership income.

13. Shirk v. Caterbone, 201 Pa. Super. 544, 193 A.2d 664 (1963).

14. See Keatinge, note 7, supra.

15. I.R.C. §§ 61(a)(1), 83(a)

16. I.R.C. § 61, e.g., contract damages representing the payment of principal on a loan would not be taxable while that portion of the damages representing the payment of interest on the loan would be taxable.

17. I.R.C. § 104 (a)(2)

© Copyright 2001, The Riser Law Firm PLLC. All Rights Reserved. 
 

by John M. Cunningham

Introduction; the concept of LLC business asset protection. On April 4, 2003, the United States Bankruptcy Court for the District of Colorado rendered its decision in In re: Ashley Albright, Debtor, Case No. 01-11367 - ABC, Chapter No. 7 (2003 Bankr. D. Co. LEXIS 291). Albright is a case of first impression on a significant issue of federal bankruptcy law – namely, whether the members of single-member LLCs who incur debts in their personal capacity may invoke the charging order provisions of the governing LLC act to protect these assets from transfer to bankruptcy trustees under Chapter 7 of the bankruptcy code. However, the case has major implications not only under federal bankruptcy law but also under the law of creditors’ rights.

This article briefly describes the facts and holdings of Albright and suggests several major impacts that, in my view, the case is likely to have on LLC practice. However, before discussing these matters, it will be useful to say a word about the general concept of LLC statutory business asset protection.

Since as early as 1890, limited partnership statutes have contained provisions known as charging order provisions. Under these provisions, a judgment creditor of a partner of a limited partnership who is a debtor in default may obtain an order from a competent court requiring that if the partner’s limited partnership determines to make interim or liquidating distributions of its cash or other assets to the partner, it must pay these distributions instead to the creditor to the extent of the unsatisfied judgment. Many decisions have held, and a number of limited partnership statutes, including that of Delaware, expressly provide, that charging order provisions are the exclusive remedy of these creditors and that a creditor of a partner of a limited partnership who is a debtor in default may not force the sale of limited partnership assets in satisfaction of the creditor’s claim even if the partner controls the limited partnership.
LLC statutes did not begin to appear until many decades after the emergence of limited partnerships. However, all LLC statutes are based to a substantial degree on limited partnership law, and, with the exception of the LLC acts of Nebraska and Pennsylvania, all of them contain charging order provisions. Furthermore, the courts have uniformly followed the above limited partnership precedents in holding with respect to multi-member LLCs that LLC charging order provisions, like the corresponding limited partnership provisions, are exclusive. By contrast, no U.S. corporate statute contains a charging order provision or any similar provision. For many start-up businesses, the statutory business asset protection that charging order provisions provide to LLC members is a major factor in making the LLC form preferable to the corporate form.

Facts and holding of the Albright case. Ms. Ashley Albright, the debtor in the Albright case, filed for bankruptcy under Chapter 13 of the U.S. Bankruptcy Code on February 9, 2001, and converted to Chapter 7 on July 19 of the same year. At the time of her filing, she was the sole member of an LLC named Western Blue Sky LLC (the “LLC”). The LLC, in turn, owned certain Colorado real estate (the “Real Estate”). In a Chapter 7 bankruptcy proceeding, the trustee is the representative of the bankruptcy estate. 11 U.S.C. § 323. With the exception of certain interests exempted from transfer under Section 541(b) and other bankruptcy code provisions, the bankruptcy estate is comprised of all legal and equitable interests of the debtor in property as of the commencement of the case. 11 U.S.C. § 541(a). A principal duty of the bankruptcy trustee in a Chapter 7 is to collect and reduce to money the property of the estate. 11 U.S.C. § 704(1).

Upon the conversion of Ms. Albright’s case to Chapter 7, the trustee asked the Albright court to rule that he, as trustee, was entitled under 11 U.S.C. § 541 and other applicable bankruptcy code provisions to require the LLC to sell the Real Estate and to distribute the proceeds of the sale to the bankruptcy estate. The court granted this request. The court’s principal grounds for doing so were as follows:

Pursuant to the Colorado limited liability company statute, the debtor’s membership interest constitutes the personal property of the member. Upon the debtor’s bankruptcy filing, she effectively transferred her membership interest to the estate. See 11 U.S.C. § 541. Because there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the trustee became a “substituted member.” Id. at 291.

One could argue that on its face, the above ground was erroneous, since:
 

The trustee may order the LLC to sell the Real Estate only if he has the right to manage the LLC – i.e., to make decisions for it and to sign contracts on its behalf.
 

However, under Section 7-80-102(1) of the Colorado LLC Act (the “LLC Act”), a member’s “membership interest” consists only of the member’s economic rights and not the member’s management rights.
 

Thus, the mere fact that Ms. Albright’s membership interest passed to the trustee under 11. U.S.C. Section 541(a) said nothing about whether her LLC management rights passed to the trustee as well.

However, the court went on to hold that although Section 7-80-702 of the LLC Act permits the transfer of a member’s management rights only with the consent of “other members,” this restriction on transfers of management rights makes no sense in the case of single-member LLCs and thus can reasonably be disregarded in such a case. Id. at 292. When read together with the court’s reference to Section 7-80-702, the above holding under Section 7-80-102(1) probably constitutes a sustainable ground for the court’s decision.

Furthermore, in responding to the debtor’s contention that since the trustee was ultimately acting on behalf of her creditors, he was entitled only to a charging order and not to any LLC management rights, the court noted (i) that the rationale for the exclusivity of the charging order remedy is to protect innocent non-debtor co-owners of partnerships and LLCs; and (ii) that this rationale makes no sense in the case of single-member LLCs. In light of limited partnership business organization law theory and case law, this dictum of the court was unquestionably correct.

Ms. Albright has filed an appeal of the Albright decision. At this writing, it is unclear whether the appeal will go forward. In my view, however, if it does go forward, it is highly unlikely to succeed.

The practical implications of Albright. The Albright decision has several important practical implications for LLC practitioners.

1) The likely persuasiveness of Albright in non-Colorado jurisdictions. Obviously, Albright is precedent only in Colorado and indeed, only before the judge who decided the Albright case, since other bankruptcy judges, even in Colorado, are free to disregard its holding. However, Albright will undoubtedly be cited not only in the courts of Colorado but also in every other U.S. jurisdiction where the question is raised whether single-member LLCs provide business asset protection to their members, and, in my view, it is likely to be highly persuasive in all U.S. jurisdictions.
2) The application of Albright in non-bankruptcy cases. It is true that the Albright decision by its terms addresses only the rights of trustees in bankruptcy under Chapter 7 of the bankruptcy code and not any issue of creditors’ rights. However, the reasons for its decision apply fully as much to creditors as to bankruptcy trustees, and it will undoubtedly be cited – and cited persuasively – in creditor cases. Furthermore, Albright may provide a new incentive to creditors of members of single-member LLCs to force these members into bankruptcy as a means of enforcing creditors’ rights.
3) The impact of Albright on single-member LLC formation practice. In light of Albright, if a practitioner represents clients that are either entities or individuals forming single-member LLCs, and if LLC statutory business asset protection is important to these clients, the practitioner should recommend to them that they not use single-member LLCs, but rather, that they make every effort to find an accommodation second member and to form their businesses as two-member LLCs.
4) Albright and LLC conversion practice. Furthermore, in light of Albright, individuals and entities that are already conducting their businesses as single-member LLCs and that need business asset protection should consider admitting a second member. For individuals who own single-member LLCs, the best co-member is normally their spouse or another close relative with whom they constitute what amounts to a single economic unit. For entities that own single-member LLCs, the issue can be more complicated. However, if the entity already has another subsidiary or has reasonable grounds for forming one, that other subsidiary may make an excellent second member.
5) “Peppercorn” second members. At the conclusion of its opinion, the Albright court noted that if Ms. Albright had had even a “peppercorn” co-member – i.e., a co-member with even an “infinitesimal” interest in her LLC – the court would have ruled in her favor. This comment by the court should be taken with a large grain of salt, since, especially if the facts are at all unfavorable for the debtor in question, any court would be inclined to disregard the “peppercorn” co-member, especially if it were obvious to the court that the only real purpose of the majority member in having a minority co-member was to provide the majority member with business asset protection. My own advice to LLC clients that need business asset protection is that the second member should have at least a five-percent interest in the LLC and preferably a 10-percent interest.
6) Using separate lessor entities to protect business assets. Business owners who own valuable business assets can protect those assets from claims arising from business operations not only by holding these assets in entities, such as limited partnerships and multi-member LLCs, that provide statutory business asset protection, but also by holding them in separate lessor entities and leasing them to their operating entities. In light of Albright:
 

New single-member LLC businesses. Business founders who wish to create LLCs as their operating entities but do not want co-members should consider (i) forming separate leasing entities to hold their existing operating assets and to acquire new ones; and (ii) leasing these assets from the latter entities to the former.
 

Existing single-member LLCs businesses. Owners of existing businesses who conduct their businesses through single-member LLCs with valuable business assets but who do not want to convert them to multi-member LLCs should consider transforming their single-member operating LLCs into leasing entities, creating new operating entities (which may also be single-member LLCs) and leasing these assets from the former entities to the latter.
 

7) Albright and LLC legislation. In light of Albright, should private or government lawyers who work with their state legislatures in updating their state’s LLC acts seek to amend these acts to make clear either (i) that single-member LLCs do afford business asset protection or (ii) that they do not? Personally, my sense is that in view of the merits of the Albright issue, as discussed above, no state legislature is likely to amend the state LLC act to support the availability of LLC business asset protection to members of single-member LLCs. My sense is also that, in light of Albright, no amendment is necessary to clarify that this protection is unavailable. Thus, in my view, no such legislative project would make sense.
Conclusion. The outcome of the Albright case is unlikely to surprise any knowledgeable LLC practitioner. Rather, the case merely confirms what most or all of us have long believed – namely, that no court in any factual or legal setting is likely to rule that single-member LLCs provide statutory business asset protection. However, the publication of the Albright case makes it all the more important that practitioners steer business founders who need business asset protection away from single-member LLCs and toward multi-member LLCs or, alternatively, toward the using of leasing entities separate from their operating entities. The case also mandates that practitioners urge clients that need business asset protection but that are currently operating through single-member LLCs to consider adding a second member or turning their operating single-member LLCs into lessor entities and creating new operating entities.

At the same time, practitioners should make it clear to their clients that Albright has no impact whatsoever on the strength of single-member LLC liability shields; that shield is a strong as ever. Because of the liability shield that single-member LLCs provide to their owners and for many other reasons, including important tax reasons, the value of single-member LLCs remains great – but not as great as before the publication of the Ashley Albright case.
 

© Copyright 2003, John M. Cunningham All Rights Reserved. 
 

 

 

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ARTICLE 5 of Uniform Limited Liability Company Act (1996)

[The Uniform Limited Liability Company Act has been adopted by Alabama, Hawaii, Illinois, Montana, South Carolina, South Dakota, Vermont, West Virginia, and the U.S. Virgin Islands, and it can be anticipate that most states will eventually adopt ULLCA or some variation or it.]

SECTION 501. MEMBER'S DISTRIBUTIONAL INTEREST.

(a) A member is not a co-owner of, and has no transferable interest in, property of a limited liability company.

(b) A distributional interest in a limited liability company is personal property and, subject to Sections 502 and 503, may be transferred in whole or in part.

(c) An operating agreement may provide that a distributional interest may be evidenced by a certificate of the interest issued by the limited liability company and, subject to Section 503, may also provide for the transfer of any interest represented by the certificate.

Drafters’ Comment to Section 501

Members have no property interest in property owned by a limited liability company. A distributional interest is personal property and is defined under Section 101(6) as a member's interest in distributions only and does not include the member's broader rights to participate in management under Section 404 and to inspect company records under Section 408.

Under Section 405(a), distributions are allocated in equal shares unless otherwise provided in an operating agreement. Whenever it is desirable to allocate distributions in proportion to contributions rather than per capita, certification may be useful to reduce valuation issues. New and important Internal Revenue Service announcements clarify that certification of a limited liability company will not cause it to be taxed like a corporation.
 

SECTION 502. TRANSFER OF DISTRIBUTIONAL INTEREST.

A transfer of a distributional interest does not entitle the transferee to become or to exercise any rights of a member. A transfer entitles the transferee to receive, to the extent transferred, only the distributions to which the transferor would be entitled.

Drafters’ Comment to Section 502

Under Sections 501(b) and 502, the only interest a member may freely transfer is that member's distributional interest. A member's transfer of all of a distributional interest constitutes an event of dissociation. See Section 601(3). A transfer of less than all of a member's distributional interest is not an event of dissociation. A member ceases to be a member upon the transfer of all that member's distributional interest and that transfer is also an event of dissociation under Section 601(3). Relating the event of dissociation to the member's transfer of all of the member's distributional interest avoids the need for the company to track potential future dissociation events associated with a member no longer financially interested in the company. Also, all the remaining members may expel a member upon the transfer of "substantially all" the member's distributional interest. The expulsion is an event of dissociation under Section 601(5)(ii).

SECTION 503. RIGHTS OF TRANSFEREE.

(a) A transferee of a distributional interest may become a member of a limited liability company if and to the extent that the transferor gives the transferee the right in accordance with authority described in the operating agreement or all other members consent.

(b) A transferee who has become a member, to the extent transferred, has the rights and powers, and is subject to the restrictions and liabilities, of a member under the operating agreement of a limited liability company and this [Act]. A transferee who becomes a member also is liable for the transferor member's obligations to make contributions under Section 402 and for obligations under Section 407 to return unlawful distributions, but the transferee is not obligated for the transferor member's liabilities unknown to the transferee at the time the transferee becomes a member.

(c) Whether or not a transferee of a distributional interest becomes a member under subsection (a), the transferor is not released from liability to the limited liability company under the operating agreement or this [Act].

(d) A transferee who does not become a member is not entitled to participate in the management or conduct of the limited liability company's business, require access to information concerning the company's transactions, or inspect or copy any of the company's records.

(e) A transferee who does not become a member is entitled to:

(1) receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled;

(2) receive, upon dissolution and winding up of the limited liability company's business:

(i) in accordance with the transfer, the net amount otherwise distributable to the transferor;

(ii) a statement of account only from the date of the latest statement of account agreed to by all the members;

(3) seek under Section 801(5) a judicial determination that it is equitable to dissolve and wind up the company's business.

(f) A limited liability company need not give effect to a transfer until it has notice of the transfer.

Drafters’ Comment to Section 503

The only interest a member may freely transfer is the member's distributional interest. A transferee may acquire the remaining rights of a member only by being admitted as a member of the company by all of the remaining members. New and important Internal Revenue Service announcements clarify that the transferability of membership interests of a limited liability company in excess of these default rules will not cause it to be taxed like a corporation. In many cases a limited liability company will be organized and operated with only a few members. These default rules were chosen in the interest of preserving the right of existing members in such companies to determine whether a transferee will become a member.

A transferee not admitted as a member is not entitled to participate in management, require access to information, or inspect or copy company records. The only rights of a transferee are to receive the distributions the transferor would otherwise be entitled, receive a limited statement of account, and seek a judicial dissolution under Section 801(a)(5).

Subsection (e) sets forth the rights of a transferee of an existing member. Although the rights of a dissociated member to participate in the future management of the company parallel the rights of a transferee, a dissociated member retains additional rights that accrued from that person's membership such as the right to enforce Article 7 purchase rights. See and compare Sections 603(b)(1) and 801(a)(4) and Drafters’ Comments.

SECTION 504. RIGHTS OF CREDITOR.

(a) On application by a judgment creditor of a member of a limited liability company or of a member's transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.

(b) A charging order constitutes a lien on the judgment debtor's distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.

(c) At any time before foreclosure, a distributional interest in a limited liability company which is charged may be redeemed:

(1) by the judgment debtor;

(2) with property other than the company's property, by one or more of the other members; or

(3) with the company's property, but only if permitted by the operating agreement.

(d) This [Act] does not affect a member's right under exemption laws with respect to the member's distributional interest in a limited liability company.

(e) This section provides the exclusive remedy by which a judgment creditor of a member or a transferee may satisfy a judgment out of the judgment debtor's distributional interest in a limited liability company.

Drafters’ Comment to Section 504

A charging order is the only remedy by which a judgment creditor of a member or a member's transferee may reach the distributional interest of a member or member's transferee. Under Section 503(e), the distributional interest of a member or transferee is limited to the member's right to receive distributions from the company and to seek judicial liquidation of the company.

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Treatment of Limited Liability Companies http://www.assetprotectionbook.com/charging_orders_intro.htm http://www.assetprotectiontheory.com/limited_liability_companies_charging_orders.htm Overview The Uniform Limited Liability Company Act treats the interests of members of the LLC as having no property interest in the LLC. Instead a member has only a “Distributional Interest”, and if the member has a judgment creditor the court can enter an order charging that Distributional Interest., which order basically constitutes a lien on the Distributional Interest that can be foreclosed upon by further court order. The charging order is the exclusive remedy available to the creditor, although (as with limited partnerships) the court can grant various relief and even appoint a receiver to ensure that the creditor’s rights to distribution are protected (this has the potential for the to substantially interfere with the operations of the LLC, depending on how it is structured). Notably, the ULLCA provides for redemption by the LLC of the charged member’s interest, which further makes great meticulousness and forethought in the drafting of the operating agreement a necessity if the fullest creditor protective value of the LLC is to be achieved. See Litchfield Asset Management vs. Howell -- Entity veil of LLC pierced. Special Case of the Single-Member LLC Most states’ LLC Acts now provide for the Single Member LLC (SMLLC), primarily because many planners like to utilize them as an entity which is “disregarded” by the IRS for tax purposes. Outside Liabilities – The text of the statutes that allow SMLLCs do not differentiate the charging order remedy between SMLLCs and those having multiple members. Thus, a dispute quickly arose between two camps of planners: (1) Those who believed that the plain language of the state statute’s allowing SMLLCs that the SMLLC are protected by charging orders means precisely that; and (2) Those who believed that because the historical purpose of the charging order was to protect one partner from being forced into partnership with another partner’s creditors, and this is nonsensical in the context of a single-member entity, that charging order protection would not apply to SMLLCs. It was the latter viewpoint that prevailed in In re Ashley Albright wherein the U.S. Bankruptcy Court for the District of Colorado held: “The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions made on account of her LLC member interest. However, the charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties' interests affected.” [footnote 9] However, the Albright court indicated in footnore 9 that even a minimal membership interest held by another might be sufficient for charging order protection to be respected: “Footnote 9. The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to Colo. Rev. Stat. § 7-80-702, if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, 7-80-702 does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with "peppercorn" co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. § § 544(b)(1) and 548(a).” Inside Liabilities – As of the date of this writing, there have been no cases testing the protection afforded to the single member from the liabilities of the SMLLC. Many planners contend that SMLLCs should provide no worse protection than sole-shareholder corporations. We don’t want to be the test case. Until the law is settled, we advise avoiding SMLLCs until their effectiveness against inside liabilities is validated by case law. Summary – If an LLC is meant to provide creditor protection, it should not be a SMLLC – especially since it is relatively easy to add another member. Offshore Limited Liability Companies Several traditional offshore jurisdictions have adopted Limited Liability Company Acts, which when utilized correctly can cause unique problems for creditors. See http://www.assetprotectiontheory.com/ollc.htm State-by-State Coverage View each state’s Limited Liability Company Act and browse each state’s charging order cases: (picture below of a USA map may not be working, just click anywhere on it and a new webpage and new map should appear) or Select State ... 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