New Legal Advantages to Being an LLC

According to a newly decided, not yet published, Louisiana Appellate Court ruling (CHANNELSIDE SERVICES, LLC v CHRYSOCHOOS GROUP, INC., 2016 WL 2772268 (2016).), it may be even more advantageous to operate your business as an LLC than a partnership or corporation.
 
Imagine you are owed money by someone. You go through the court and get a judgment against that person saying that they now legally owe you this money. Now imagine that this person does not own anything but a membership in an LLC. It is difficult to get paid the money you are owed if the person who owes you the money does not have anything with which to pay you. As a judgment creditor, you have the right to go back to the Court and ask that the Court give you something called a “charging order”. A charging order essentially gives you the right to any financial interests that the person who you have a judgment against has in the LLC. “Great!” you think. Now you have the right to get paid the money you are owed from the LLC. But that is not actually the case.

 
Essentially, what the recent court ruling means for a member of an LLC is that a judgment creditor who obtains a charging order against a member of an LLC only has the rights to financial interests of that LLC member, not management rights in the LLC. So, if the member of the LLC were to be allocated a $100,000 share of the profit for the LLC, the judgment creditor/assignee would be allocated that $100,000 share. Conversely, if the member of the LLC were to be allocated $100,000 share of the losses for the LLC, the judgment creditor/assignee would be allocated that $100,000 loss. But, because the judgment creditor/assignee does not have management rights in the LLC, the judgment creditor/assignee cannot actually make the LLC distribute any money to them.
 
What you actually have the right to is any distribution by the LLC that the member may have received. You, as the judgment creditor/assignee are now allocated the $100,000 share of the profits instead of the member because of the charging order given to you by the Court. But that does not actually mean that the LLC is going to pay you the $100,000. You have only been allocated that share of the profits. Because you only have the right to the financial interest of the member who you have a charging order against, and not the management interest, you do not have the right to force the LLC to actually distribute the money to you. What is worse, you now owe the income taxes on that $100,000 profit allocation. Basically, this means that not only are you not getting the money owed to you, but you now also have to pay taxes on income you never received!
 
This has HUGE tax implications for the judgment creditor/assignee. Income taxes for LLC’s are paid by its members. Any profit allocated to a member of the LLC is taxable as income to that member. Any losses are a deduction for that member. Where things get tricky are that the LLC does not actually have to distribute that profit allocated to the member. So, potentially, a member could be required to pay income taxes on $100,000 that they never actually received. This is potentially a very big problem for any judgment creditor/assignee who only has an interest in the financial rights of the LLC member. Some refer to this problem as a “poison pill”.
 
If the person who had owed you the money was a partner in a partnership, you would have been able to take the entire interest in the partnership owned by that partner. You would have then been able to make the partnership pay you the fair market value of that partner’s interest and to terminate that partner’s/your interest, thereby receiving payment for the money owed to you.
 
If the person who had owed you the money had a shareholder’s interest in a corporation, you would have been able to take the shareholder’s stock. Once you had the stock, you would have been able to vote the stock or to sell it for fair market value and receive payment for the money you were owed.
 
Clearly, from a creditor standpoint, obtaining an assignment to a member’s LLC interest is quite possibly a losing proposition all the way around – a type of “poison pill”. However, from a business standpoint, the protections are extremely beneficial for an LLC and its members. This makes creating an LLC a much more advantageous way to protect your assets than creating a partnership or even a corporation! If you have an existing partnership or corporation, you may want to consider converting it to an LLC.