Wednesday, October 19, 2011

Dialing back the enthusiasm for charging orders a bit

One of the most desirable asset protection features for any state business entity law is charging order protection. The states that offer it as an exclusive remedy provide that, should a judgment be issued against an individual owner of a business, the creditor's only recourse (aside from piercing the corporate veil) is the acquisition of a charging order, preventing the creditor from foreclosing on the business owner's interest. The charging order requires any distributions to that owner be diverted instead to the creditor. This is good news for both the debtor and non-debtor business owners. The debtor wants to keep his share of the business and the non-debtors do not want their business disrupted by an unknown third party. Further good news is that, to avoid paying the creditors, assuming special allocation measures are available to the owners, the debtor-owner's distributions may be cut off, presumably forcing the creditor to negotiate payment for a smaller sum since there won't be any proceeds be coming in.

Here in Nevada, a charging order as the exclusive remedy is not only available for LLCs and limited partnerships, but to closely-held corporations as well. A boon for local business owners.

A charging order is great, but as discussed in this July Forbes article, some advisers take it a bit too far. The suggestion has been that since the creditor is entitled to distributions, he is also entitled to the accompanying tax liability. Therefore, the owners would issue the creditor the debtor-owner's K-1, forcing the creditor to pay taxes on the business's income despite never receiving distributions. Certainly that would provide even greater leverage to the debtor for a smaller settlement ... if it were true. As the author points out, in reality a charging order holder essentially applies a lien against the debtor's share. As distributions are made, the lien is paid down until it is satisfied. Since the creditor doesn't actually hold the debtor's share, but only a lien against it, the creditor is not responsible for the K-1.

It's a common claim I've heard dozens of times and believed myself at one time. Unfortunately, as terrific as charging order protection is for business owners, the benefits only extend so far.

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