Last week's post talked about the asset protection properties of LLCs and LPs. For a recap, click here. One of the key points of that post was that charging order protection is beneficial because it prevents a creditor from having direct access to assets.
All over the internet, you will see that another supposed benefit of charging order protected entities is giving a creditor a "KO from a K-1". In this post, I will discuss why I think that notion is somewhat misconstrued.
Assuming that an LLC or LP keeps its default tax classification of partnership, at the end of each year it sends each of its members a Form K-1 showing the member's distributive share of the entity's income. The member then has to claim that share of income on his personal tax return and pay tax on it. According to most of what you read on the internet, if a creditor gets a charging order against a member's interest, he gets the K-1 every year and pays the tax instead of the member. This is hyped as a powerful tool because the creditor in this situation will be required to pay tax on his share of the entity's income without ever receiving a distribution of income from the entity. In other words, the creditor is being taxed on "phantom" income. According to some, this will discourage a creditor from even pursuing a charging order.
The authority for this position comes from Revenue Ruling 77-137. In the Revenue Ruling, a partner in an LP transferred his interest without approval of the other partners. Under the law of LPs (and LLCs), when this happens the transferee gets the economic interest in the entity but doesn't get to vote or participate in management. Such a transferee is called an "assignee". Anyway, in the scenario in the Revenue Ruling, the operating agreement allowed the transferor to keep his voting and management rights even though he had transferred his economic interest. The transferor then made a separate agreement with the transferee to use these voting and management powers to vote at the direction of the transferee.
The IRS ruled that in the above scenario, the transferee had all the "dominion and control" over the LP interest, so he was the proper recipient of the K-1.
As you can see, the situation in the Revenue Ruling is very different from a typical charging order scenario. First, the Revenue Ruling didn't involve a charging order at all. Second, how many times have you seen a debtor agree to exercise his rights in favor of a creditor? The situation in the Revenue Ruling was an unusual one.
Sometimes, however, I do have clients that want to pursue sending a creditor a K-1. For those clients, I do the best I can to give the creditor the "dominion and control" referenced in the Revenue Ruling. Since there is no dispositive IRS guidance on what constitutes "dominion and control" I try to establish "dominion and control" over an LLC interest for a creditor in the LLC's operating agreement as best I can, so at least there is a good faith argument for sending the creditor a K-1. If the client is willing, generally I do this by making the entry of a charging order against a member an "event of default" for that member which reduces his rights to that of an assignee. The member then has little or no "dominion or control" over the LLC interest. Then, to give the creditor comparatively more "dominion and control" than the [former] member, I give the creditor certain voting rights for the duration of the charging order.
No one can be sure that the above procedure makes the creditor the proper recipient of the K-1, especially since the creditor never consented to the "dominion and control" given to him. It does at a minimum give the LLC a reasonable good faith argument for sending the creditor the K-1. The creditor could of course try and fight the K-1 issue out in court.
That said, I wouldn't rely on "KO"ing anyone with a K-1 as a primary asset protection tool in and of itself. I doubt that many creditors will avoid pursuing a charging order solely for fear of a K-1. It's at best an extra throw-in feature for clients who want it in a closely-held LLC. In my opinion, there are many reasons to use a closely held LLC (as outlined here), but the "KO" factor isn't one of the top ones.
If you are interested in using a specially crafted, closely held LLC as part of an estate plan, I can help. Contact me for an appointment.
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