Dear Valued Readers,
When we originally sent this article on October 1st, 2009, we failed to include the change to the Arizona law which made its Charging Order provisions the “exclusive remedy” when enforcing judgments against members of a validly formed Arizona Limited Liability Company. We have updated the article to include this development. We apologize for not including this in the body of our original article; however, in the interests of accuracy, we wanted to make sure that you were aware of this important change to Arizona law.
Best Regards,
Jeffrey M. Verdon
IS YOUR LLC A TIME BOMB? – UPDATED
This article will demonstrate how to defuse it.
For the past 15 years or so, the Limited Liability Company (the “LLC”) has been the preferred business entity for tax and business purposes. The LLC has gained widespread use because it is a simpler tax and business structure to hold title to assets such as real property, business equipment and operating businesses. Although the LLC is owned by one or more Members, it can be managed by one or more of its Members or by someone who is not a member.
Like the limited partnership (the “LP”), the LLC has grown in popularity as a vehicle for asset protection. Under current law, when a Member of a LLC is sued, and a subsequent judgment is rendered against the Member, the remedy available to the holder of the judgment is called a “Charging Order” (the “CO”). The CO is unique to LLCs and limited partnerships, in that it restricts the judgment creditor’s ability to reach assets inside the LLC or LP. The judgment creditor cannot force the entity to sell assets or even make distributions. The judgment creditor only obtains a lien against future distributions that may be made to the Member against whom the judgment has been issued. The protection from the CO is that it prevents the judgment creditor from reaching inside the LLC and attaching its assets. Therefore, the CO limitation has made the LLC one of the most popular forms of business entity for planners who seek to provide protection from lawsuits and other third party claims for their clients.
However, in all but five states,1 a court can go beyond the CO and fashion a remedy to aid the judgment creditor in collecting on its judgment. For instance, a Court may grant the judgment creditor the right to foreclose on the Member’s LLC interest.2 Although the foreclosure would allow the judgment creditor to take over ownership of the Member’s LLC interest, the judgment creditor remains unable to reach inside the LLC or in any way interfere with the assets of the LLC itself. For the Member who loses his or her LLC Membership interest to a foreclosure proceeding, the consequences can be devastating. Beside the Member losing his or her capital account, for income tax purposes, the foreclosure will be treated as a “sale or exchange” of the membership interest, triggering the reporting of capital gain, recapture or other income, all of which could have adverse tax consequences in the form of phantom income.
Thus, those who formed their LLC(s) in other than the aforementioned five “sole remedy” states may find themselves in the unenviable position of having to settle their lawsuit for a far larger sum or risk the unintended income tax consequences of losing their LLC interest(s) to the foreclosure remedy.
THE SOLUTION
There are five states (as mentioned above) that limit the CO as the “sole remedy” and do not permit the foreclosure of the Member’s LLC interest by the Member’s creditors. If an individual is a member of an LLC not domociled in one of the five “sole remedy” jurisdictions, then one solution would be for the LLC to change its jurisdiction to one of the five states that have the CO as the “sole remedy.”
Another and perhaps more practical solution would be for the Member to establish a newly formed LLC in Nevada (a sole remedy jurisdiction) and contribute the Membership interest to the Nevada LLC in exchange for the Nevada LLC Membership interest of equal value.3 If there are multiple Members of the non-Nevada LLC, each of the Members should consider exchanging their Membership interest for the Nevada LLC Membership interest.
A further reason to consider Nevada as the state of formation for your LLC is an amendment that took effect October 1, 2009. Steve Oshins, of the law firm of Oshins & Associates, LLC, and the firm to which this author is presently serving as Of Counsel, was responsible for the Nevada legislation. Senate Bill 350 was signed into law on May 29, 2009 and is effective as of October 1, 2009. A portion of the Bill creates a new form of business entity called a “Restricted Entity” (the “RE”). While the gift and estate tax planning opportunities are beyond the scope of this article,4 forming the LLC in Nevada as a RE would create a “business purpose” for the new NV LLC, an important element for successful asset protection planning. The new RE rules create a restriction on liquidating the LLC for up to 10 years, which, according to Mr. Oshins’ article, would result in additional transfer tax discounts of 10% to 30% or more, producing significant estate and gift tax benefits. If the Member of the NV LLC interest were sued and found liable, the judgment creditor would find itself applying Nevada law (regardless of the state the Member resides).5
Asset protection is generally one of the primary reasons for the formation of an LLC. Many individuals and their advisors, who have created the LLC, as the entity of choice, are unaware of the foreclosure remedy available to judgment creditors seeking to enforce their claims against Members of LLCs not otherwise formed in one of the five “sole remedy” states. This author offers a sensible and relatively easy solution to “defuse” this potential time bomb, should the Member find himself or herself involved in a nasty lawsuit and the LLC not domiciled in one of the States that has the “sole remedy” CO rules.
1 Nevada, Alask, Arizona, New Jersey, and Oklahoma.
2 The CO with respect to LP interests are generally protected from the foreclosure remedy. General Partnerships do not enjoy the protection of the CO at all.
3 Unless you live in Nevada, your Nevada LLC will require a Nevada registered agent. The Oshins & Associates, LLC law firm can serve as the resident agent of the Nevada LLC and ensure the LLC remains compliant.
4 For a detailed discussion on the new Restricted Entity law in Nevada and how it can be used to incorporate larger valuation discounts into your estate and gift tax planning, see: The New Nevada Restricted LLC and LP Legislation: A “Why” and “How to?” Guide: Communique, September 2009, by Steve J. Oshins, Esq.
5 Under the Full Faith and Credit laws of the US Constitution, despite the Member residing outside of Nevada, the Member’s state should apply Nevada law with respect to the CO rules.