What Is a Charging Order Against LLC? (All You Need To Know)
A charging order is the only legal way by which a creditor can pursue interests from a member of an LLC.
As a Mergers and Acquisitions specialist, I have gained insights into the concept of a charging order. I further consulted legal professionals to provide an in-depth guide on how it impacts an LLC.
This article explains charging orders and how an LLC can protect your assets better than other entities.
- A charging order grants a creditor the right to receive a member's distributions from an LLC to satisfy debts or obligations.
- A charging order protection exempts the business assets of an LLC, as well as that of its members, from any personal liability of an individual in the company.
- According to the Asset Protection Society, around 65% of small business owners use LLCs to protect personal assets from creditors.
- I advise owners of single-member LLCs in other states to obtain general liability insurance to protect their businesses against any legal action.
What Is a Charging Order Against an LLC?
A charging order against an LLC is a legal mechanism used to satisfy the debts of a limited liability company (LLC) or partnership members.
It grants a creditor the right to receive the member's distributions from the LLC instead of directly seizing the member's ownership interest.
Charging orders are commonly associated with LLCs and limited partnerships. They provide a remedy for any judgment creditor seeking to collect debts owed by LLC members without interfering with the LLC's ongoing operations.
What is Asset Protection?
Asset protection is a strategy to protect your assets and wealth from creditors or other claimants who attempt to seize your personal property to satisfy the debt.
Planning on how to protect your assets minimizes the time, money, and energy spent defending asset claims.
Asset protection will help keep your property safe from creditors and other legal action. It helps you avoid losing the most valuable and important property that you own. That's why my clients initiate the process long before they actually need it, preferably when setting up the company.
As mentioned, asset protection can be precious because it allows you to plan for the future and minimize the risk of loss before a problem occurs.
"One of the great responsibilities I have is to manage my assets wisely, so that they create value."
- Alice Walton, American Heiress of Walmart
Charging Order Protection
A charging order protection exempts the business and the other members from any liability arising from the obligations of an individual member.
While limited liability protects the personal assets of members from company debts, I inform clients that a charging order protection insulates the company's assets from any personal obligations of its members.
A creditor generally cannot gain access to your personal assets unless he obtains a statutorily protected charging lien. Instead, a lender may only ask for a distribution from your LLC, through a charging order.
Charging order protection is only available in limited liability companies and not in corporations or general partnerships.
Charging order protection can be stronger than other asset-protection strategies, such as umbrella insurance, because most creditors cannot seize your assets if an LLC member files for bankruptcy.
If an individual member goes bankrupt, then only the assets held in that individual's name are affected.
Charging Order Protection Vs. Single-Member LLCs
A Single-Member LLC is often used for asset protection through limited liability, but it may not protect the business proprietor from a charging order since most states make no distinction between the owner and the company.
A creditor could seize the debtor's interest in a single-member limited liability company, since the owner and the business are one and the same.
Charging Order Protection In Partnerships Vs. Multi-Member LLC
In a limited partnership, business creditors can take charging orders against each partner's membership interest in the business entity.
This business entity allows them to collect from each person's share of the profits until the creditor has been paid off.
Since only one partner is responsible for paying off the creditor, it cannot jeopardize all of the remaining partners' financial interests in the business entity.
This risk is not present with a multi-member LLC because multiple owners have an ownership interest.
State Rules on Creditor's Remedies
Most states recognize the charging order as the creditor's exclusive remedy.
So, asset protection is built into limited liability companies.
However, a few states do not recognize charging orders and allow other remedies, such as:
- Personal asset seizure (e.g., Texas)
- Seizure of an assignment of the debtor's membership interest in the LLC (e.g., California)
- Seizure or transfer of debtor's assets (e.g., Colorado).
Review the statutes on charging orders and creditor's remedies for asset protection entities such as limited liability companies, partnerships, and S corporations to determine what remedies your state allows.
If there are many claims for charged-order creditors, the LLC will have to dissolve or foreclose.
If a member's financial rights are seized, the ownership of the person’s financial rights is permanently transferred to the personal creditor. That's why I advise business owners to draft an operating agreement that includes a transfer of ownership clause.
This includes the financial transaction rights from the LLC . However, The creditor cannot force the LLC to pay money to it or anyone else.
According to a legal analysis by the American Bar Association, less than 5% of creditors pursuing claims against single-member LLCs successfully force cash distributions through legal actions.
The limited liability company and its members would most likely negotiate the debt with the creditor before foreclosure was issued.
A creditor's ability to foreclose on an LLC membership interest puts personal creditors of LLC owners in a stronger bargaining position than they have under the state LLC laws that don't allow for foreclosures.
Personal creditors of LLC owners in a few jurisdictions are permitted to get a court order dissolving the company.
In this case, the LLC would have to shut down and sell its assets. Personal creditors of single-member LLC owners have the most severe option available.
4 Strategies to Enhance Charging Order Protection
A key aim of asset protection is to make it as hard as possible for a creditor to access your assets, and the LLC is an important tool in this regard . According to the Asset Protection Society, approximately 65% of small business owners utilize LLCs to shield their personal assets from creditors.
We can't always influence the charging order laws of a state, nor can we always anticipate which state's rules will apply in any specific lawsuit. Still, we may structure and rule our limited liability companies to improve charging order protection.
If the goal of your LLC is to safeguard an asset from your liabilities outside of it, you might wish to explore some of the following solutions to protect your LLC's charging order better.
1. Use Multiple Layers With A Holding Company Structure
Since LLC asset protection strategies make it hard for a creditor to get what they want, consider creating several LLC layers. A holding company or umbrella LLC will serve as the highest layer, and its only asset should be owned in each lower-level LLC form.
As you go further down, each LLC should own assets like real estate and investment accounts and should be asset-protected in its own state.
2. Turn Your LLC Into A Multiple-Member LLC
The laws in some states only provide asset protection if the debtor and creditor are members of the LLC. These states usually give more protection to multiple-member LLCs than to single-member LLCs.
If the LLC is not located in Alaska, South Dakota, Nevada, Delaware, and Wyoming, I advise clients to either form a partnership or obtain a general liability insurance.
3. Place Restrictions on Distributions and Transfers
Placing restrictions on asset transfers and distributions can help prevent a creditor from seizing an asset if your LLC was dissolved.
Reducing the available cash flow in a multiple-member LLC may make it more difficult for a creditor to gain control of the asset without the consent of other LLC members.
Some operating agreements will have limitations on transferring LLC interests and often provide for automatic payouts at tax time, which is reasonable from an asset protection standpoint.
Provisions requiring the limited liability company to distribute profits just guarantee that the creditor will receive a payout.
Generally, a creditor has the right to obtain anything the debtor is entitled to receive, and it's best if the debtor does not expect distributions.
Limiting or restricting the authorization of disbursements (such as requiring the approval of other members or the manager) makes it less likely a creditor will receive anything, thus negating any impact if one is granted.
4. Insert A Buy-Out Clause
If the other LLC members agree, include a buy-out provision that activates when specific collection action is taken against the debtor.
The provision would allow the members to purchase out the interest of the debtor in the LLC at a pre-agreed price.
Although there are various advantages to thorough planning, there may also be drawbacks; therefore, you should always discuss these things with a professional to determine what's best for you.
How Long Does a Charging Order Last?
A charging order typically lasts several years, depending on the jurisdiction and individual circumstances. It enforces debt repayment, securing the debtor's assets until the debt is settled. The duration can vary but generally takes an extended period, providing creditors with a means to recover owed amounts.
Is a Charging Order the Only Method for a Creditor to Claim LLC's Assets?
A charging order is not the only method for a Creditor to claim an LLC's assets. While personal creditors commonly use it, a judgment creditor might also levy or garnish the LLC's business assets, depending on the state's laws where the LLC is located.
LLC Asset Protection And Charging Orders
A charging order protection for an LLC is a legal safeguard that shields the LLC's assets from the personal debts and liabilities of its individual members.
This protection helps maintain the separation between the business entity and its owners, mitigating the risk of personal creditors seizing the LLC's assets to settle personal debts.
In the event of a member's debt, a charging order allows personal creditors to collect only from the member's distributions without gaining control over the LLC.
You can seek assistance from reputable online legal services for professional advice regarding charging orders and other legal matters.