By Jason Watson, CPA
Posted Tuesday, July 6, 2021
If you are financially in trouble, and a creditor wants to take your assets, your multi-member LLC and its assets might be safe. Instead of taking the LLC directly, a court can issue a Charging Order which allows the creditor to receive any distributions from the LLC. The theory is quite simple- if you are in business with another person, and that person has financial trouble, why should it be your problem? Your only problem should be where to send the profit distribution check for that person’s distributive share.
A Charging Order puts the creditor in line for any financial rights that the debtor has, but does not convey any management rights. Therefor the creditor cannot order the LLC to make a distribution. However, many states have allowed the creditor holding the Charging Order to foreclose on the membership interest of the debtor. Yuck. This is done under the auspice that the debtor will not be able to re-pay his obligation. So now the creditor is the permanent owner of the financial rights of the debtor’s portion of the LLC, but the creditor still does not own any member interest in the LLC. This results in the debtor owning a portion of an LLC that he will never receive any money from since his financial rights are now in the hands of the creditor.
It doesn’t stop there. Some states and certain courts can also assign the full interest (ownership and financial, or some would say equity and economic) to the creditor. This create a big mess for the other members of the LLC who suddenly need to scrape up enough money to pay off the creditor so as to not be tethered to them as a co-owner.
What does all this mean? Some attorneys want to automatically add a spouse to the LLC so it suddenly becomes a multi-member LLC with the financial protection of a Charging Order. Sure, why not? There is some protection there with very little effort.
As a side note, here is Delaware’s verbiage about Charging Orders under Title 6, Section 18-703–
(d). The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.
Makes you want to run out and form your LLC in Delaware doesn’t it? Again, if you are marching into court with a boatload of financial woes and hanging your hat on Charging Orders for your financial protection, you might have bigger problems. Creditors are wise to this, and they usually make you personally guarantee the financial obligation as an individual.
Also, if you form an LLC in Delaware and operate in Colorado, you will need to file as a foreign entity in Colorado. If you receive process of service in Colorado for a lawsuit, you are now asking a Colorado court to interpret and enforce Delaware law in your matter. Courts and judges are not fond of this ask. We keep mentioning this concept is several spots just to drive it home (and because small business owners jump into our book at various spots).
Taxpayer’s Comprehensive Guide to LLCs and S Corps 2021-2022 Edition
This KB article is an excerpt from our book which is available in paperback from Amazon, as an eBook for Kindle and as a PDF from ClickBank. We used to publish with iTunes and Nook, but keeping up with two different formats was brutal. You can cruise through these KB articles, click on the fancy buttons below or visit our webpage which provides more information at-