There is minimal applicability to many companies when talking about different distributions. However, in a consulting company where one member’s worth to the LLC is significantly higher than the others, the members can vote to distribute to that key member more in the way of distributions than his/her member interest would call for on a percentage basis.
Similarities between LLCs and S- or C-Corporations
LLCs are treated the same from a corporate liability standpoint as S- or C-Corps in that professionals providing professional services still have personal liability when giving advice. LLCs also provide the standard corporate protection to shareholders and directors for negligence actions against the LLC itself.
Major Difference between an LLC and an S- or C-Corporation
The Charging Order
What is a Charging Order? A charging order is the ONLY* remedy a court of law can give a creditor who is trying to obtain the assets of a debtor when the assets are in an LLC or limited partnership. A charging order DOES NOT allow creditors to sell assets of the LLC or to force distributions of income. The best way to illustrate what a charging order does is to use an example. (Always check your state statute to make sure there have been no changes in the law since the publishing of this book.)
Example:
Creditor, Mr. Lucky, sues and obtains a $3,000,000 judgment against a professional athlete for an auto accident. The athlete has $1,000,000 worth of auto coverage and has the rest of his major personal assets owned by an LLC of which he owns 100%.
Mr. Lucky asks the court for satisfaction, and asks the court to have the athlete turn over the assets in his LLC to him. The court tells Mr. Lucky that the only remedy the court can give her is a “charging order.”
What does the charging order get Mr. Lucky in the above example? Only the right to pay the taxes on income generated in the LLC. (Explained below)
* Only a handful of states have solid charging order statutes. When using an LLC as an asset protection tool, it is vital to set one up in a state where a charging order is deemed the “sole” remedy of a creditor.
What a creditor cannot get with a charging order
1) A charging order does not transfer the interest in the LLC to the creditor or force the debtor to sell his/her interest and turn over the sales proceeds to the creditor.
2) A creditor cannot force the LLC to sell assets.
3) A creditor cannot force an LLC to distribute income
What does a creditor get with a charging order? The right to pay income taxes on income generated in the LLC but NOT distributed.
There was a revenue ruling issued in 1977 (77-173) which states that a creditor who obtains a charging order can be treated as a partner for federal income tax purposes. Why does 77-173 matter? Following is an example to illustrate the power of 77-173:
Using the example with Mr. Lucky who has a $3,000,000 judgment against the athlete who only had $1,000,000 worth of auto coverage, assume that Mr. Lucky obtained a charging order against the athlete’s LLC, which owns the athlete’s $1,000,000 brokerage account.
Further assume that the athlete earns dividend income of $25,000 a year from the brokerage account. Normally, the athlete takes the $25,000 home as income from the LLC and spends it as he sees fit.
When Mr. Lucky obtains his charging order, the athlete, as the managing member of the LLC, decides not to take any of the $25,000 out as income, but instead leaves the income in the LLC.
Normally, when a corporation does not distribute all the income out of the corporation, there will be corporate taxes levied on that income. If the LLC is treated as an S-Corp or partnership (which is the case 95% of the time), the income is passed through to the shareholder or member, and taxed at his/her individual tax bracket as if he/she took the money out of the LLC.
Now that Mr. Lucky has a charging order against the athlete’s LLC, he, not the athlete, will receive the income from the LLC. However, in our example, the athlete, as the managing member, did not distribute the income from the LLC.
What happens?
Mr. Lucky gets a K-1 for the taxes on what would have been distributed from the LLC to the athlete. If the athlete were a 100% owner of the LLC interest, Mr. Lucky would get a K-1 for all $25,000 that he NEVER received. I call this “phantom income,” which is income you do not receive but have to pay taxes on anyway.
The power of an LLC is derived from the fact that a creditor can only obtain a charging order against the LLC (vs. forced distribution of assets or income or, in the alternative, the sale of a debtor’s interest in the LLC) where, if the LLC creates income and does not distribute it, the creditor will get a K-1 for income they never did and never will receive.
The following is a little schematic that might help you visualize what happens (or does not) with a charging order.
More Differences between an LLC and S- or C-Corporations? If your assets are held in an S- or C-Corp, the judge has a few different viable remedies to implement upon request of a creditor. Those are:
1) The court can order a debtor’s interest in an S- or C-Corp sold to satisfy the judgment. (A client/defendant becomes a debtor after a judgment is entered against him/her and in favor of a plaintiff-who then becomes a creditor.)
This means, if you are a 100% owner of an S- or C-Corp that owns a $1,000,000 brokerage account and $1,000,000 vacation home, a judge can make you sell your stock, which should be worth $2,000,000 in the open market. (If you own less than 100% of the stock, a court can make you sell whatever interest you have.)
2) The court can order that the ownership interest of a debtor in an S- or C-Corp be transferred to the creditor.
Once the stock ownership in an S- or C-Corp is transferred to a creditor, that creditor can:
1) Vote as a stockholder and act as a stockholder of the company. If you had majority interest in an S- or C-Corp and your children had a minority interest, the creditor would then be the majority owner in that corporation with your children. The same goes if you have friends as partners.
As the majority owner, the creditor would have the right and power to vote to sell corporate assets and make distributions of income.
2) Sell the stock to any third party allowed by the corporation’s operating agreement.
In either scenario, the owner of the S- or C-Corp stock would lose that stock.
Real World Example. If the previous material confused you a bit, that is normal, you are not alone. Here is a real world example of how to protect your assets.
Assume Athlete X is 35 years old, married with two children, lives in Michigan, and has the following assets:
| Value | |
| Personal residence | $1,000,000 (with a $400,000 mortgage) |
| Vacation Home | $450,000 (with a $200,000 mortgage) |
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