Asset Protection Planning: Transmutation by Utilization of Charging Order Business Entities
A charging order is a court order available to a judgment creditor directed to the partnership or LLC of which the judgment debtor is a partner or member which grants the judgment creditor the right to whatever distributions would otherwise be due to the debtor partner or member whose interest is being charged. The charging order has its origins as part of the English Partnership Act of 1890. The relevant provisions of that act are very close to similar provisions later adopted in the United States in the Uniform Partnership Act in 1914 and Uniform Limited Partnership Act in 1916. The purpose of the charging order was to prevent the judgment creditor of an individual partner from access to the partnership assets while at the same time, giving the creditor some relief relative to distributions from the entity to the partner. The charging order then became the exclusive remedy of the judgment creditor of a partner denying him direct access to the partnership assets and limiting the creditor exclusively to collection of the income or distributions which the partnership assets might engender for the benefit of the judgment debtor.
B. Foreclosure of the Charging Order
Many states now allow a judgment creditor to foreclose on the charged interest. However, it appears that the purchaser at the foreclosure sale becomes at most an assignee of an economic right to the judgment debtor’s income distributions. As such, the judgment creditor is still not a substantive partner and not entitled to participate in partnership or LLC management. A judgment creditor who forecloses may also face adverse tax consequences as he may be considered a partner for federal tax purposes. The income tax consequences to a judgment creditor who has foreclosed are to be differentiated from a judgment creditor who is a mere holder of a charging order. Most likely, the mere holder would not be considered a partner for tax purposes.
C. California Law
Section 15522 of the California Corporations Code deals with charging orders for California limited partnerships subject to the California Uniform Limited Partnership Act. Section 15673 applies for California limited partnerships governed by the California Revised Limited Partnerships Act (“CRLPA"). Limited partnerships formed after July 1, 1984 are governed by the CRLPA. Section 15673 makes it clear that a judgment creditor with a charging order only has the rights of an assignee. The relevant LLC charging order statute is found in Section 17302 of the California Corporations Code. In addition to giving a judgment creditor the right to a charging order, the legislation provides that the charging order constitutes a lien on the judgment debtor’s assignable member interest and the court can order a foreclosure on the member interest subject to the charging order. However, it is pointed out that the purchaser of the foreclosure sale has only the rights of an assignee. This Section is the exclusive remedy by which a judgment creditor can satisfy a judgment against a judgment debtor’s membership interest in the LLC.
The charging order seems to be the exclusive remedy for a California creditor when it comes to both a limited partner’s interest or an LLC’s member interest. However, the LLC charging order can constitute a lien and can be foreclosed upon. It would appear that a foreclosure only transfers the economic rights of the judgment debtor, but does not give the judgment creditor any right to participate in the management or to control the partnership or LLC entity. The greater fear from an asset protection standpoint is the implications of the Albright case decided on April 4, 2003 by the United States Bankruptcy Court for the District of Colorado which allowed a bankruptcy trustee to take any and all necessary actions to liquidate property owned by a single member LLC. The holding in the Albright case was based on the fact that the charging order limitation serves no purpose in a single member LLC because there are no other party’s interests affected. In a footnote, the Court indicates that in a multi member LLC, the charging order provision of Colorado state law would govern, although bankruptcy avoidance provisions and fraudulent transfer laws would come into play with respect to the setup of a multi member LLC intended to delay or defraud creditors.
E. The Charging Order Entity
The asset protecting planning concept of conveying assets to a limited partnership or limited liability company is simply that assets that would otherwise be attractive to a creditor are shielded from creditor attachments by transferring them to the entity in exchange for general limited partnership interest and LLC member interest. After the transfer, the assets are owned by the entity and not the transferor. Accordingly, the creditor’s claim must be satisfied as against the entity interest of the transferor. If the charging order is the exclusive remedy for the creditor, the creditor is precluded from actually having access directly to the assets. Instead the creditor in effect steps into the shoes of the partner or LLC member with respect to the right of distribution. As an assignee, the creditor is only entitled to receive the distribution to which the assignor would be entitled. What this means is that a creditor who has obtained charging order only has the right to receive distributions from the entity when and if such distributions are ever made even though the entity itself may have substantial income.
- Charging Order Erosion:
Over the last several years, several state courts including California had a lot of judicial foreclosure sale of limited partnership interests. The trend in California begin with Cocker National Bank v. Perroton, 255 Cal. Rptr. 794 (Cal. Ct. App. 1989) wherein the California Court of Appeals allowed a judgment creditor to attaché and sell and partnership interest where the debtor demonstrated that the charging order it had obtained was insufficient to satisfy its judgment. Subsequently, in Hellman v. Anderson 284 Cal. Rptr. 830 (Cal. Ct. App. 1991) the California Appellate Court, adhering to the precedent set in the Perroton case, allowed a judgment creditor to foreclose on a partnership interest when foreclosure of the interest would not unduly interfere with the business of the partnership. In Prestly, 193 Br. 253 (Bankr. D.N.M. 1988), the Federal Bankruptcy Court in New Mexico determined that the bankrupt’s interest as a general partner and limited partner in several limited partnerships were assets of the bankruptcy estate and the bankruptcy trustee had the power to sell them.
It should be pointed out that there are several reasons why a court may refuse to order foreclosure with respect to a limited partnership or LLC set up. Moreover, even if foreclosure is ordered, it still does not mean that the creditor actually will get control of the assets within the entity. See Section V. B., above.
F. Asset Protection Structuring
With respect to the asset protection strategy and planning, relative to limited partnerships, it is important to understand that both the limited partner interest, as well as the controlling general partner interest, needs to be protected. In a limited partnership the general partner is personally liable and does not have the charging order protection. Therefore, the general partner should have the smallest possible interest. But this interest also needs to be protected because if the creditor obtains control of the general partner interest, it can possibly order distribution of the assets to the creditor by dissolving the partnership. Accordingly, to protect both the general partner and the limited partner interest, it may be appropriate to form a corporation to act as the general partner and have an offshore asset protection trust hold the limited partner interest. Since the general partner makes all partnership decisions including the right to make or not make distributions and the right to dissolve the partnership, it is important that the creditor of a limited partner not have the ability to gain control of the general partner. Therefore, normally, the transferor client should not be the general partner. It would seem that the best method of protecting the general partner interest is to form a new corporation, LLC or even another Limited Partnership and have it act as the general partner. Preferably, the client should not own the stock of the corporation general partner or the member interest of the LLC general partner. The general partner corporation can be domiciled in an offshore debtor friendly jurisdiction. An election can be made with the IRS to have the offshore corporation treated as a domestic entity in order to avoid negative foreign corporation tax consequences. It may be even possible to have a partnership of offshore corporations be the general partner so that a creditor would have to penetrate more than one offshore jurisdiction at the same time.