Larry and Harold, best friends and business partners for the past 20 years, operate their successful company as an S corporation. They started with nothing and built their business from the ground up, working hard to increase profits through the economy’s ups and downs. Their partnership is truly an American Success Story.
THE GOOD DEED:
Four years ago, Larry’s younger brother announced he was getting married. Larry was ecstatic with his brother’s new wife and asked what he could give the happy couple for their wedding gift. When his brother asked if Larry would be willing to co-sign a loan for a house, Larry didn’t hesitate. That’s what a good big brother does, right?
Unfortunately, four years of recession left Larry’s little brother unemployed and struggling to pay his bills. Larry had no idea how dire his brother’s situation had become until he received a notice in the mail that the bank was foreclosing on his brother’s house, which was now only worth half its mortgage.
Because of the personal guarantee Larry gave the lender, the bank comes after Larry for the remaining debt. After all, Larry willingly co-signed for the loan, leaving him responsible if his brother defaulted. Unfortunately, the bad economy also hit Larry’s pocketbook, and he doesn’t have the cash or personal assets to pay off the debt.
Luckily for the bank, Larry owns a successful business. Larry believes his business assets and cash flow are protected from his personal creditors. Unfortunately, that is not the case. Larry’s attorney chose the wrong entity when he formed the corporation, not realizing that corporate stock can quite easily be seized by a personal judgment creditor.
How does that happen?
Once the bank gets a judgment against Larry and his brother, the bank then receives a Writ of Attachment, allowing it to attach the debtor’s personal property. Under a Writ of Attachment, the bank can take over Larry’s shares of the corporation and force the company to liquidate its assets, which then go to the creditor as the new shareholder. The bank can also vote to remove the current management and run the business itself until it can find a buyer, all while keeping the operating profits.
In short, Larry will lose everything he worked so hard to build. It’s not good for Larry, his brother, Harold, or the business.
Paul and Steve’s lawyer established their company as an LLC, rather than an S or C corporation. Paul also co-signed for a relative’s loan, and the relative later defaulted.
Luckily, because his business was organized as an LLC, Paul’s judgment creditor’s right to seize the LLC interest is quite limited. In fact, state law only allows the creditor to obtain a Charging Order (CO) after securing the judgment, rather than a Writ of Attachment, because no Writ of Attachment is allowed for a LLC membership interest.
A Charging Order restricts judgment creditors to receiving future distributions from the debtor’s interest if and when such distributions are made by the manager. The judgment creditor is expressly prohibited from interfering with the business while it waits for the distributions to be made or the judgment to be paid. In fact, under state law, a judgment creditor that obtains a Charging Order is deemed to be an “assignee partner/member”. This allows the business to operate normally, without impeding the partners’ business decisions or personal relationships.
It is also important to note that under federal income tax law, the “assignee partner/member” is required to report all of the LLC’s income (whether or not actually distributed by the LLC to the member). This is known as “phantom income”. Because of phantom income, a judgment creditor will want to think twice before seeking to get the Charging Order registered against the LLC interest of the judgment debtor, as illustrated below.
Years ago, one of our clients was sued by a creditor and the creditor secured a Charging Order against our client’s LLC interest. Under Rev. Rul. 77-137, we advised our client to send the judgment creditor his K-1 each year. The creditor would not settle for less than the full amount of the judgment plus its fees and expenses of collection. By the 3rd year under the Charging Order, the LLC sold a property that produced a capital gain of $2.4M. The debtor’s LLC interest represented 90% of the total LLC, so pursuant to the IRS Ruling, the holder of the Charging Order was sent the K-1 representing 90% of the taxable capital gain, or $2.1M of taxable income. Shortly thereafter, the creditor settled the outstanding debt for 10% of the original amount of the debt.
As I have been known to say: The judgment creditor got KO’s with the CO.
The take-away from this lesson is that if one has the choice between operating their business as a Corporation (C or S) or an LLC, the LLC provides many more important options to consider. If you already own a C or S corporation, you can convert it to an LLC and elect to be taxed as a C or S corporation, as the case may be.
Despite the additional paperwork and costs, had Larry known about this choice, he would have gladly opted for this kind of business entity.
Don’t let a good deed punish what you’ve worked so hard to achieve. If you would like to know whether your corporation might qualify for this important benefit, contact us and we will gladly evaluate your situation for you.