September 14, 2005
Author: , Jr.
Limited partnerships, limited liability companies, and limited liability partnerships are becoming very popular forms of business organization. One of the main benefits of such forms of organization is that a judgment against a partner, member, or other owner of an interest in the organization in most states results only in a charging order, at least where there is more than one such owner. The result is generally that the judgment creditor cannot satisfy its judgment against the company’s underlying assets until distributed to the owner. However, the tax effects of a charging order are only beginning to be seen.
Charging orders generally, with respect to multi member companies, provide the creditor with the rights of an assignee to the distributions that the debtor member would otherwise be entitled to receive, but do not provide the creditor with access to the underlying assets of the company or any voting or control rights over the company itself. The story can be rather different if the company only has one member. As to single member LLC, a bankruptcy court in the case In re Ashley Albright, 291 BR 538 (Bankr. D. Colo. 2003) allowed access to the company’s underlying assets; also some state statutes allow the purchaser of an interest at foreclosure of a charging order lien to exercise voting rights (which can be used to force a dissolution) where the charging order is as to a single member company.
In some states as to some forms of such organizations the charging order gives rise to a lien which can be foreclosed. In Utah, for example, such a foreclosable lien is created by a charging order on LLCs but not on LPs. Does foreclosability make a tax difference? Who is required to report the partner or member’s distributable share of income or loss where there exists a charging order?
After foreclosure (where allowed) of a company member’s interest pursuant to a charging order lien, if voting rights pass to the purchaser at the foreclosure sale, the purchaser will be treated as a member for tax purposes and be required to report the appropriate distributable share of any income, whether or not the income is actually distributed. Rev. Rul. 77-137, 1977-1 C.B. 178 (assignee acquired substantially all dominion and control over the interest based on a contract as well as state law); GCM 36960 (12/20/76). This should also be the effect in the Ashley Albright situation where the creditor has access to the company’s underlying assets with respect to a single member company. With respect to a multimember company, being taxed on the income could put a forclosure purchaser of such an interest in the difficult position of paying the tax with other funds on income it has not actually received, if the operating agreement does not provide for required distributions. However, with respect to a single-member company, if voting rights come with the purchase of an interest in foreclosure, they can be used by the creditor to dissolve the company or force distributions.
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If the foreclosure does not involve voting rights, the effect of the ruling is less clear and will turn on the sorts of assignee rights the foreclosure purchaser obtains and whether or not such rights can be said to transfer substantially all dominion and control over the interest. It remains to be seen if some stronger form of “dominion and control” is necessary as well as sufficient to result in taxation for the creditor or whether the creditor-assignee’s economic rights alone will be sufficient.
For a charging order on an interest without a foreclosure, either because the foreclosure is not available or has not yet occurred, the issue is also unclear. The authority of Rev. Rul. 77-137 needs to be viewed in the light of assignment of income principles. See Lucas v. Earl, 281, US 111 (1929). Whose income should it be? The debtor’s, with the income treated as if it were garnished by the creditor? Or the creditor’s on the basis that it now controls all the transferable rights which could be passed to an assignee? Absent the sort of contract right which existed in Rev. Rul. 77-137 and which required the partner to exercise the partner’s residual rights in favor of the assignee, perhaps the better view would be that the income should be taxed to the partner or member where the partner or member has any significant residual rights left.
Another issue that can arise relating to charging orders is when does the judgment giving rise to the charging order obtain priority over a tax lien. There is little authority on the matter. A judgment creditor will not, however, have priority over a federal tax lien where the tax lien was filed before the court actually issued its charging order. See Watson Clinic, LLP v. US, 86 AFTR2d 2000-5532 (2000 DC Fl) (applying Florida law).