The mystery of why attorneys and accountants continue to recommend Limited Liability Companies (“LLCs”) with their inherent risks instead of “S” corporations has finally been solved. Corporations have 400 years or more of case history supporting limited liability, LLCs have virtually none. So we ask “Why do these advisors continue to put their clients at risk by recommending LLCs when it is not necessary?”
We now know it is something called a “charging order.” A charging order basically is a lien against the member/debtor's economic right to distributions from a partnership or LLC. The reason why LLCs are grouped with partnerships is that they are both considered an aggregate of its owners and not a separate legal, artificial entity as is a corporation. Under this aggregate theory, an LLC is not an entity separate from its members, the LLC is merely an outward extension of the cooperative form of doing business
A corporation is a legal, “artificial” person that exists entirely separate and apart from its owners/stockholders. Because a corporation exists apart from its stockholders, the corporation alone is liable for its debts. Even though they own and manage the corporation, the shareholders are not personally liable for its debts.
LLCs can and do offer limited liability to various degrees on a state by state basis. The LLC form of organization is relatively new, so some states do not always treat LLCs in the same manner as corporations for liability purposes.
Jay D. Adkisson noted attorney and author of “The Asset Protection Book” (the assetprotectionbook.com) says:
“Business entities are created by state legislatures primarily to allow individuals to group together to invest capital in new ventures. The primary statutory goal of most entities is to shield the investors from the liabilities of the business so that their risk is limited by the amount of the capital investment. Thus, if the business itself has a creditor, the creditor’s relief is limited to the assets of the business, and, except in extreme cases, the creditor cannot pursue any assets other than those of the business itself.
The liabilities of the business are known as “inside liabilities,” and the claims of creditors against the business are known as “inside creditors.” As long as the entity is distinct from its owners, is adequately capitalized, and is not used to perpetuate a fraud, then, the entity should protect its investor-owners from inside liabilities and inside creditors. The exception is the general partnership. In a general partnership, general partners are liable for the debts and liabilities of the partnership. Similarly, general partners of Limited Partnerships and related entities are also liable for the liabilities of the partnership.
The flipside is where an investor-owner attempts to protect partnership from personal creditors of the investor-owner. The creditors of an investor-owner are known as “outside creditors,” and the claims giving rise to those creditors are likewise called “outside liabilities.”
From a statutory perspective, the creditors of an investor-owner are treated much differently than the creditors of the business itself. The hard truth is that most state legislatures have no desire to protect a debtor’s interest in a business entity from creditors. To the contrary, if an investor-owner has debts, then he or she should pay those debts from whatever non-exempt property is available, including shares of stock and interests in partnerships and like entities.
Legislatures are not concerned with the interference of corporate business when a creditor has attached an interest in stock because shareholders are two full steps removed from business operations. Shareholders elect the directors, directors elect the officers, and officers run the business. Allowing a
creditor to attach the shares of a corporation only indirectly affects the corporation in the election of directors.” (1)
(1) AUTHOR’S NOTE: Only licensed professionals can own the stock of a professional corporation so a judgment creditor would not be able to attach the stock of a professional corporation owned by a licensed professional judgment debtor unless the judgment creditor too was a similarly licensed professional (highly unlikely).
Jay Adkisson continues:
“Partnerships and pseudo-partnership entities, such as the Limited Liability Company (LLC), are different from corporations. In a partnership or LLC, the investor is a partner and may directly affect the entity’s business operations. A change in ownership may disrupt the operations of the partnership and force non-debtor partners into an involuntary partnership with the creditor. Thus, state legislatures have not allowed creditors to attach partnership interests and become the partners themselves. Instead, legislatures have only allowed creditors a limited form of relief against the debtor’s partnership interest through a “Charging Order.”
“A creditor must usually follow this path to relief when seeking to obtain assets from a Charging Order: 1. Obtain a judgment. 2. Charge the interest. 3. Foreclose the charging order. 4. Appoint a receiver. 5. Partition the entity.
First, the creditor must obtain a judgment, since the charging order is only available to “judgment creditors.” Thus, on the defense side, there is often time for additional structuring or drafting to make sure that the structure is rock solid. Sadly, many planners do not take the opportunity to fix slight flaws in the entity structure or drafting before the creditor obtains the charging order.
After obtaining a judgment, the creditor must obtain a charging order. The charging order is against the debtor’s economic rights to distribution from the entity. A limited partner or member in an LLC does not own shares of stock as in a corporation. Partners own a bundle of rights as defined by the entity’s operating agreement, including certain economic rights to distribution. However, partners do not own a direct interest in the assets of the entity.
The creditor may also garnish or obtain a forcible assignment of the debtor’s right to distribution from the partnership. That is, the partnership must pay the creditor instead of the debtor until the judgment is satisfied. However, the right to payment does not make the creditor a partner or member and does not give the creditor any voting rights.” (2)
(2) AUTHOR’S NOTE: The judgment creditor would be entitled to collect any provider compensation due to the judgment debtor from the accounts receivable or from work done by the judgment debtor after the charging order took effect, plus any other money that might be due to the judgment debtor such as loans to the LLC, etc.
Jay Adkisson continues:
“In response to misperceptions about what the role of charging orders, some states have attempted to limit creditors’ remedies to a charging order by forbidding the foreclosure of the interest. Although such laws are attractive on the surface, under some circumstances, these limitations are less attractive from an asset protection standpoint.
A creditor who holds a mere charging order is probably not liable for the taxes of the entity. Even though this belief is preached at asset protection seminars, there is not any substantial basis for believing that a charging creditor is liable for the taxes of the charged entity. To the contrary, many tax planners have concluded that a creditor holding a charging order is not responsible for taxes of the entity.
Single Member LLCs
In a limited partnership or LLC, the change of ownership from the debtor to a creditor could directly impact the operations of the entity and affect the remaining non-debtor members. The primary purpose of the charging order is thus to protect the non-debtor members from being involuntarily forced into a partnership with the debtor member’s creditor.
However, there is only one member in a SMLLC*, so there are no non-debtor members to protect. It also defies common sense that a creditor would not be able to get at the assets of an entity where the debtor is the only owner.
After years of speculation and the lack of any solid case law, the issue of whether SMLLCs are afforded the protections of the charging order was finally addressed by a U.S. bankruptcy court, In re Albright, No. 01-11367 (Colo. Bkrpt. April 4, 2003). The judge in Albright held that charging order protection does not exist for a SMLLC because there are no non-debtor members to protect. The court granted full economic and non-economic rights to the trustee, allowing the bankruptcy trustee to manage the debtor’s LLC. The trustee subsequently sold the LLC’s property and distributed the net proceeds to the bankruptcy estate for the satisfaction of creditors’ claims. Thus, until Albright is overturned or rejected by other courts, the safe presumption will be that SMLLCs probably do not provide charging order protection.”
* SMLLC = Single Member LLC
In some states, LLCs (especially single member LLCs) can be treated as a disregarded entity. Meaning an individual operating a business as an LLC may be treated as a sole proprietorship, or a group operating as an LLC may be treated as a partnership (which defeats the limited liability purpose of establishing an LLC). A sole proprietor has unlimited personal liability for the business. In the case of a partnership, the partners have joint, and several liabilities, meaning any and all of the partners can be held liable for the business' debts no matter how large or small their percentage of ownership and should be a concern for anyone considering this form of organization.
Charging orders are applicable for “external judgments” only and have nothing to do with protecting your personal liability resulting from the operation of your practice. Take a moment and think about how many of your colleagues have ever had an external judgment enforced against their practice. Then think about how many times you’ve heard of dentists who have been sued for internal practice related issues. The need to maximize your protection against internal issues far surpasses that of any external issues. The liability risks involved with using a new and untried business entity such as an LLC are high, and a single member LLC is even riskier! A corporation has a long, tried and true case history supporting limited liability and perpetuity, neither of which is offered by LLCs. It’s your choice to make, so think it through carefully and decide for yourself.
The information given in this article does not constitute legal or accounting advice or opinion, and should not be relied upon for any planning purposes. It is provided solely and exclusively for general, non-specific educational purposes.