Laying a trap to make a judgment creditor cry ‘UNCLE!’
Although most cases are settled out of court, we must still plan for the possibility of losing a case and becoming a judgment debtor. A judgment lien may hang over a debtor’s head for twenty years (or more) unless steps are taken to encourage a post-judgment settlement. The best type of settlement, of course, is for pennies-on-the-dollar. Therefore it behooves us to discuss strategies that will facilitate such a settlement.
Leveraging the Charging Order to Stalemate a Creditor
The best asset protection plans often use Charging Order Protected Entities (COPEs) such as LLCs and Limited Partnerships to hold at least some assets. When a member or partner of such an entity is sued, the creditor’s available debt remedy is restricted to a charging order. This means that he is entitled to receive only a distribution of profit or loss from the COPE that the debtor-member/partner would have otherwise received. However, a properly structured COPE will be able to withhold distributions within the entity (usually they are converted into operating capital) and therefore the creditor ends up with nothing. The problem then arises: how can a debtor pay for his living expenses if he is no longer receiving distributions from his entities? Fortunately, the solution is easy: he can simply render services to the COPE as an independent contractor (not an employee, since wages may be garnished) and then be compensated by the entity. Although it is not impossible for a judgment creditor to seize such payments, a properly drafted service contract will make it very difficult.
The underlying strategy to this approach is to wear out the creditor, who will tire of waiting for distributions that he may never receive and who’ll therefore move for a quick pennies-on-the-dollar settlement. Leveraging a Charging Order in such a manner is not without its pitfalls. For example, if a COPE has multiple members, then withholding distributions from the debtor-member while making distributions to the other members would be a bad idea.
Such an obvious attempt to evade a creditor would likely irritate the court and trigger unpleasant consequences. This pitfall is sidestepped by using another COPE to hold the debtor-member’s company interest. Then, distributions would be made from the original entity to the debtor-member’s entity, from which profits are then withheld.
Notwithstanding the effectiveness of the above strategy, a sophisticated asset protection planner would want a creditor to truly cry “uncle” instead of merely stalemating him via a fruitless waiting game. Enter IRS Revenue Ruling 77-137. In Rev. Rul. 77-137, the IRS held that an assignee of a limited partnership interest (wherein the assignee had not become a limited partner) was liable to pay taxes on his share of gain, loss, deduction, and credit attributable to his assigned interest, if he had received dominion and control over the interest. This revenue ruling creates some interesting planning opportunities for us, along with a bit of uncertainty. First let’s examine the possibilities, and then we’ll examine the uncertainty. An extrapolation of Figure 1 will make the planning opportunity of Rev. Rul. 77-137 apparent. In Figure 1, the membership interest of LLC #2 belonged to a debtor member.
Let’s assume a charging order assigned the economic interest in this LLC to a judgment creditor. On April 15th of the following year, who would the tax liability for LLC #2’s profits belong to? In partnership tax law, a partner is liable to pay tax on partnership gains regardless of whether those gains were distributed. In light of both Figure 1 and Rev. Rul. 77-137, then, it is feasible that LLC #2 could withhold distributions from the assignee and send him a tax bill (in the form of a 1065 K-1 partnership return) for the distributions he never received. In other words, if LLC #1 distributed $50,000 to LLC #2, for example, and then LLC #2 did not make any distribution, then the judgment creditor could conceivably wind up with a tax liability of $14,000 or more for money he never received! The probable outcome of such a predicament would be a quick, pennies-on-the-dollar settlement and no more problems from that creditor.
This knockout scenario is however somewhat clouded by a closer analysis of Rev. Rul. 77-137. This is because the revenue ruling states that tax liability transfers to an assignee of a limited partnership/LLC interest if the assignee has acquired all of the interest’s “dominion and control”. The question is: does a debtor’s assignment of an LLC or LP interest mean the creditor has dominion and control over the interest? The legal community is widely divided on this issue, and since the courts have not yet provided clarification, no clear answer currently exists. Even so, an LLC or LP that has received a charging order has, at the very least, arguable grounds for issuing a K-1 return to an assignee. If the creditor-assignee doesn’t like it, then he’ll have to litigate in tax court. This alone may be enough to push the creditor into a debtor-favorable settlement. Notwithstanding the uncertainty as to whether Rev. Rul. 77-137 applies to a creditor-assignee, there are two things that can happen which will ensure sure he will be liable for undistributed company profits:
- Some states allow for a foreclosure of LLC membership interests. When a creditor forecloses on his charging order, he receives the right to LLC distributions in perpetuity. Although in some ways this seems like bad news (because it means the creditor has the right to receive LLC distributions forever), a foreclosure of LLC membership interest leaves little doubt that the creditor would have complete control and dominion of the interest. Once he receives his K-1 tax bill, he will probably want to sell the foreclosed interest back to the LLC in a hurry.
- • Language in an operating agreement may give an assignee sufficient dominion and control over the membership interest so as to ensure he will be the one liable for the debtor-member’s taxes arising from company gain. An example of this language would be as follows:
- “In the event of an assignment of a limited member’s interest, the Company’s managers, in their sole discretion, may by unanimous agreement transfer the member’s voting rights to the assignee. The transfer of a member’s voting rights must be proportionate to the percentage Company membership interest assigned. A transfer of voting rights shall be effective upon delivering written notice of such transfer, signed by each manager, to the assignee and each Company member. A transfer of voting rights shall only be effective during the term of the assignment, and such rights shall revert to the assignor upon the assignment’s expiration. A transfer of voting rights does not entitle the assignee to become a substitute member of the Company.”
- Be careful! The transfer of voting rights must not allow a creditor-assignee to replace the company’s management.
- Drafting an operating agreement for a multi-member LLC wherein the members may replace the manager(s) only by unanimous consent is recommended in order to avoid displacement of friendly management.
- As part of a settlement offer, the debtor could give his (non-managing) LLC or LP interest to the creditor. This would definitely constitute an assignment of dominion and control over the interest, and the K-1 in tandem with withholding of distributions would almost certainly make the creditor cry uncle. This particular tactic is very useful in divorce proceedings, where the soon-to-be ex-spouse would probably want a piece of the LLC interest anyway (not suspecting that this interest is actually a trap!)
When laying any of the above traps for a judgment creditor, we must remember the importance of structuring LLC management so that the debtor-member has no control over the entity. If the debtor-member does have control over the entity, then a results oriented judge might force him to make LLC distributions to the creditor-assignee. A multi-member LLC with a carefully drafted operating agreement and an unrelated 3rd party manager will eliminate this possibility. The most creditor-proof arrangement would involve an offshore manager that managed an offshore LLC management company.1 1 For information on how an offshore management company might be structured, see the article Using Offshore LLCs for Advanced Structuring of Management Companies.