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Who gets K.O.'d by the K-1? The creditor or the debtor?

The limited liability company (LLC) is becoming the preferred entity to conduct business, largely due to the limited liability protection offered to owners and the ability to elect to be taxed as a partnership, which allows for flexible, pass-through income taxation. While C corporations afford limited liability to shareholders, the double taxation of earnings is often a sufficient deterrent to avoid doing business as a C corporation. And while shareholders of S corporations have limited liability as well, the pass-through taxation system for S corporations is not as flexible as the pass-through taxation system for partnerships. Partnerships do not generally provide limited liability protection; limited partnerships provide some, but usually at least one general partner is subject to unlimited liability. Thus, the LLC combines the best of both worlds--limited liability for all owners and partnership pass-through taxation.

In addition to favorable income taxation, LLCs may offer owners better creditor protection than corporations. Corporate shareholders and LLC members have limited liability with respect to the business's creditors, meaning that if a creditor of a corporation or LLC obtains a judgment against the business, only the business's assets are available to satisfy the judgment, not the owners' personal assets. Furthermore, LLCs may offer some additional protection if a member's personal creditor obtains a judgment. When an LLC member is liable for a personal debt, an LLC interest is personal property that a creditor may be able to use to satisfy a judgment. Most states' LLC statutes, however, protect a member's interest from personal creditors by only allowing a creditor to obtain a charging order against the debtor's LLC membership interest. A creditor with a charging order generally cannot force a LLC to make distributions or liquidate. In contrast, with a C or S corporation, a judgment creditor may be able to seize the debtor's corporate stock and force a sale or liquidation to satisfy the judgment. Note that charging order protection may not be available with single-member LLCs because charging orders are generally meant to protect the members other than the debtor-member.

There may be some confusion as to what a charging order actually gives a creditor of an LLC. A charging order only grants a creditor the right to receive distributions from the LLC to the extent that the LLC makes any distributions and to the extent that the debtor-member would otherwise be entitled to a distribution, somewhat similar to a garnishment of wages. As the Nevada Supreme Court stated, "after the entry of a charging order, the debtor member no longer has the right to future LLC distributions to the extent of the charging order, but retains all other rights that it had before the execution of the charging order, including managerial interests" [Weddell v. H20, Inc., 271 P3d 743 (Nev. 2012)].

Form K-1

To further promote the creditor protection that LLCs can offer, some advisors suggest that a creditor with a charging order will be "K.O.'d by the K-1." The theory is that a judgment creditor who has a charging order will receive a Form K-1 from the LLC, which is taxed as a partnership, and be responsible for the distributive share of LLC profits even if the LLC makes no distributions to the creditor. But this theory seems to miss that a charging order only gives the creditor the right to receive the debtor-member's LLC distributions, if any. The creditor's charging order exists until the underlying judgment is paid off, at which time the charging order is released and the debtor-member starts receiving LLC distributions to the extent entitled.

Promoters of the K.O.'d by the K-1 theory often put forth the following argument: when an LLC does not make any distributions to any of its members, and therefore the creditor-member will be responsible for the taxes on the distributive share of profits but receive no actual payment, the creditor will be more motivated to settle the dispute with the debtor. This possibility should not be overlooked, since there is significant debate over the theory. Whether a judgment creditor would be allocated any of the LLC's profits even when no distributions are being made to it seems to depend upon a charging order being considered an assignment of the debtor-member's LLC interest to the creditor, as opposed to merely acting like a lien. Furthermore, general tax principles weaken the K.O.'d by the K-1 theory, as explained below.

Taxation of Judgments

An individual who obtains a judgment and receives payment for that judgment may or may not be liable for federal income tax on that payment. The underlying cause of action will determine how the payment is taxed to the recipient. For example, compensatory damages for physical injuries suffered by a pedestrian who is struck by a car will not be subject to income tax [Internal Revenue Code (IRC) section 104(a)(2)], Similarly, if a creditor is successful in obtaining a court judgment because the debtor defaulted on a loan, the debtor's satisfaction of the judgment will not result in taxable income to the creditor because it constitutes a return of principal (although payments that would have constituted interest on the original debt would be taxable). On the other hand, if a judgment is for unpaid wages, the plaintiff would be taxed on the payment from the defendant [IRC section 61(a)(1)].

Generally, a lien is simply security for a debt. Black's Law Dictionary defines a lien as "a qualified right of property which a creditor has in or over specific property of his debtor, as security for the debt or charge or for performance of some act." When a plaintiff obtains a court judgment against a defendant and then further obtains a lien on the defendant's property as security for that judgment, the lien itself should not create a taxable event. A hen is not an assignment, as the debtor is not transferring the entire interest in the property to the creditor. A creditor obtains the right to "use" the liened property only if the debtor defaults or does not otherwise satisfy the judgment.

Taxation of Assignments

A complete assignment generally occurs when an assignor transfers his whole right and interest in property to an assignee. The complete assignment of any property, including an LLC membership interest, is generally classified as a sale or gift, with the respective tax consequences to the assignor. Once the assignment is complete, the assignee is the owner of the property, and with ownership of the "tree" comes the "fruit from the tree" and its tax consequences, including from the sale of or receipt of income from the property.

Supporters of the K.O.'d by the K-1 theory cite Revenue Ruling 77-137 (1997-1 C.B. 178), in arguing that a charging order constitutes an assignment and thus shifts the income tax liability to the creditor instead of the debtor, even though the debtor remains a member of the LLC. In Revenue Ruling 77-137, a limited partner assigned his partnership interest to a third party, and the partnership agreement provided that the assignee did not become a substituted limited partner without the written consent of the general partners. The partnership agreement did, however, allow a limited partner to assign his right to share in partnership profits and distributions, with a provision requiring him to exercise any residual powers remaining in him solely in favor of the assignee. The IRS held that the assignee was a substituted limited partner who acquired all "dominion and control" over the limited partnership interest and therefore had to report and pay tax on his distributive share of partnership income. A charging order does not grant a judgment creditor dominion and control of the LLC membership interest, and thus Revenue Ruling 77-137 is not applicable.

Some commentators also point to Evans v. Comm'r [447 F.2d 547 (7th Cir. 1971)], to support this theory. In Evans, a general partner assigned his half interest in a partnership, including his half interest in all of the partnership's profits and losses, to his solely owned corporation. The court determined that because the corporation had the right to income and a distributive share under state law, the same was true for federal income tax purposes, and the corporation was responsible for the income tax on its distributive share of partnership profits. Contrary to the corporation in Evans, a judgment creditor with a charging order only has the right to distributions that would have been paid to the judgment debtor. Therefore, the creditor does not inherit the income tax liability on the distributive share of the LLC's profits.

State LLC Statutes on a Charging Order as a Lien

The model LLC act that many states have adopted, at least in part, refers to a charging order as a lien. The Revised Uniform Limited Liability Company Act (RULLCA) states that "a charging order constitutes a lien on a judgment debtor's transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor" [section 503 (a)]. Many states have adopted similar language, and a review of several states' LLC statutes indicates that a charging order acts like a lien and nothing more.

For example, California, Delaware, and Florida use the word "lien" in their respective LLC statutes with respect to charging orders. California's statute provides that "a charging order constitutes a lien on a judgment debtor's transferable interest and requires the limited liability company to pay over to the person to which the charging order was issued any distribution that would otherwise be paid to the judgment debtor" [Cal. Corp. Code section 17705.03(a)]. Delaware's statute provides that a "charging order constitutes a lien on the judgment debtor's limited liability company interest" [Del. Code Ann. Title 6, section 18-703(b)]. Florida's statute provides that a "charging order constitutes a lien upon a judgment debtor's transferable interest and requires the limited liability company to pay over to the judgment creditor a distribution that would otherwise be paid to the judgment debtor [Fla. Stat. section 605.0503(1)]. For these and other states that use the word "lien" in their respective LLC statutes, it seems clear that the legislatures intended for a charging order to be nothing more than a lien.

Some states use the word "assignee" in their LLC statutes; however, it seems that this use is not intended to reflect a complete assignment in the traditional sense--that is, a transfer of the whole right and interest in the LLC membership interest. For example, Nevada's statute provides that "the judgment creditor has only the rights of an assignee of the member's interest" [Nev. Rev. Stat. section 86.401(1)]. Nevada's law further states, however, that unless the operating agreement provides otherwise, an assignee "of a member's interest has no right to participate in the management of the business and affairs of the company or to become a member unless a majority in interest of the other members approve the transfer." If an assignee is approved to be a member, the assignee "becomes a substituted member" and is "only entitled to receive the share of profits or other compensation by way of income, and the return of contributions, to which the [assignor] would otherwise be entitled" [section 86.351(1)]. Furthermore, the Nevada Supreme Court has held that the entry of a charging order does not take away the debtor's rights as an LLC member (Weddell).

New York also uses the word "assignee" in its charging order statute [N.Y. Ltd. Liab. Co. Law section 607(a)]. Similar to Nevada's statute, however, New York's does not "entitle the assignee to participate in the management and affairs of the limited liability company or to become or to exercise any rights or powers of a member" unless otherwise provided in the operating agreement [section 603(a)(2)]. The law further provides that "unless otherwise provided in the operating agreement, the pledge of, or the granting of a security interest, lien or other encumbrance in or against, any or all of the membership interest of a member shall not cause the member to cease to be a member or to cease to have the power to exercise any rights or powers of a member" [section 603(a)(4)], Except as otherwise provided in the operating agreement, an assignee does not become a member unless a majority of the members other than the assigning member consent [section 604(a)]. Therefore, it seems that New York's legislature, much like Nevada's, intended for a LLC charging order to act like a lien, even though it used the word assignee.

At least one state does not use the words "lien" or "assignee" in its LLC statute. Wyoming's statute provides that "a charging order requires the limited liability company to pay over to the person which the charging order was issued any distribution that would otherwise be paid to the judgment debtor" [Wyo. Stat. Ann. section 17-29-503(a)]. Wyoming's statute does not, however, grant a judgment creditor any other rights and does not appear to imply that a charging order is an assignment. A reading of several other states' LLC statutes does not imply that any of the legislatures intended for a charging order to constitute an assignment, nor intended the result contemplated in the K.O.'d by the K-1 theory.

Does a Judgment Creditor Have Basis in the Charging Order?

The K.O.'d by the K-l theory does not seem to address what happens if a creditor obtains basis in the charging order. While the tax basis issue is ancillary to the main point of the theory, the question should still be addressed. It is arguable that if a creditor is responsible for her pro rata share of the LLC's profits and the corresponding income tax liability, she should increase her basis in the charging order interest, so that the payment would not be taxed again if the creditor actually receives a distribution [IRC section 705(a)].

The theory appears to support the notion that the debtor, who is still a LLC member, does not increase his basis in the LLC membership interest for his distributable share. Instead, it is the creditor who recognizes the taxable income for a pro rata share of the LLC's profits and not the debtor. If the debtor does not increase his basis in the LLC interest, he would be exposed to income taxation later. For example, if an LLC is not distributing profits to any of its members because of an outstanding charging order, the LLC is accumulating profits and cash, the debtor-member is not being sent a K-l for his distributive share of profits, and he is not increasing his basis in the LLC interest, then at the time the charging order is finally removed and the debtor-member receives distributions, the distributions will be taxable income because distributions in excess of basis result in taxable income [IRC section 731(a)(1)]. Such an outcome, which appears to be supported by the theory, would result in both the creditor and debtor being taxed on the same distributive share of the LLC's profits, which hardly seems tenable.

Not Even a Technical Knockout

The author is not aware of any federal or state cases or IRS guidance that verifies whether the creditor with a charging order or the debtor should be taxed for a distributive share of LLC profits. Since, however, a charging order appears to be nothing more than a lien, the K.O.'d by the K-l theory is not supported under the current tax laws. While the tax code is not always logical, this theory stretches logic too far. Therefore, it would be prudent for debtor-members to assume that they will be allocated their distributive share of LLC profits, as well as the resulting income tax liability, if a creditor obtains a charging order.

Michael Geeraerts, JD, CPA, CGMA, CLU, is an advanced planning consultant at Guardian Life Insurance Company of America.
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Title Annotation:TAXATION: partnership taxation
Author:Geeraerts, Michael
Publication:The CPA Journal
Geographic Code:1USA
Date:Jan 1, 2017
Words:2674
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