Suppose that you get sued personally and lose. The judgment creditor (the entity that won the suit and was awarded a judgment against you) decides to go after your business and investment assets. Or perhaps you have a retail store plus several real estate investments, and you get successfully sued for something related to the store and the judgment creditor decides to attach your real estate. Maybe someone owes you money. You sue to collect and win, but the debtor offers you pennies on the dollar to settle. If you refuse, the debtor just laughs, and you don’t get your money because the debtor’s assets are protected. In each of these potential scenarios, you can cry, “Unfair!” all day long, but it won’t matter if you have not taken the appropriate asset-protection steps.

An asset-protection tool that is frequently discussed is the charging order. By definition, a charging order is an order issued by a court to a judgment creditor, and essentially compels an entity of which the debtor is a partner or member to redirect to the creditor any distributions that would otherwise have been made to the debtor, until such a time as the judgment is satisfied (paraphrased from Asset Protection: Concepts & Strategies for Protecting Your Wealth by Jay Adkisson and Christopher M. Riser, McGraw-Hill, 2004).

This means that if you have an interest in a Charging Order Protected Entity (COPE) [entities for which creditors are limited to using charging orders as remedies in collecting debt, such as a Limited Partnership (LP), a Limited Liability Company (LLC), and certain others] and a creditor obtains a charging order compelling an entity to pay the creditor any money that would have gone to you, the creditor has no rights with respect to the ownership or management of the entity and, in most states, cannot force the entity to make a distribution.

The idea is to balance the rights of creditors with those of the non-debtor partners. The Uniform Partnership Act and LLC Act describe charging orders as “in the nature of a garnishment” from a business. Essentially, they are an assignment of a partner’s economic right to distributions from the partnership. Non-debtor partners are protected because the charging order does not allow the creditor to seize partnership assets or get involved in the affairs of the partnership.

Charging orders do not come into play with assets such as stock in a corporation or personal property, but in an entity such as an LLC, creditors of the individual investor/owners are treated differently than the creditors of the business itself. Legislators have taken steps to prevent creditors from attaching partnership or membership interests and essentially becoming partners or members themselves, because such a change in ownership could disrupt the operations of the entity. In the case of a Single Member LLC (SMLLC), state law varies, but case law [In re Albright, No. 01-11367 (Color. Bkrtp. April 4, 2003)] presumes that SMLLCs do not provide charging order protection because there are no non-debtor members to protect.

Where you do not have charging order protection by state law, consult with your attorney. You may be able to create a comparable level of protection through your business’s operating agreement.

How the debtor is protected

As long as the creditor has the charging order, the LLC can simply neglect to make any distributions and the creditor should not receive any money. For example, let’s say a visitor to your home slipped on the sidewalk, sued you, and won. As a judgment creditor, he decides to go after all of your assets and gets a charging order against the LLC that owns your real estate investments. He or she typically can not collect anything until the LLC makes a distribution, and you and the other members of the LLC are perfectly within your rights to decide to not make any distributions for as long as you like. Because of this, creditors with charging orders are often willing to negotiate a settlement to get at least a portion of their money and be done with the situation.

Another issue that often prompts judgment creditors to settle charging orders quickly is the potential for tax liability. If the creditor is entitled to the distribution at the time it is made, he may also be obligated to pay taxes on that income even though it hasn’t yet been received. It is possible for the members of the LLC to issue a K-1, which is the tax form used to report a member’s share of an LLC’s income, potentially making the creditor liable for taxes on profits even though he hasn’t received any money. Because case law is not definitive on the issue, creditors may be reluctant to take a chance that they could be held liable for taxes on profits they haven’t received and may never receive.

The protection offered by charging orders may be circumvented in a number of ways, depending on the state in which the entity operates and your individual circumstances. If judges suspect defendants are attempting to abuse charging order protection, they can make exceptions to the statutes and the protection can be set aside.
Be aware that simply forming a partnership or LLC does not automatically protect your assets. Charging order protected entities are some of the strongest and most acceptable asset protection tools available, but to be effective, they must be properly structured and carefully drafted according to your particular requirements and the laws of your state.

If you find yourself in the position of a creditor attempting to recover monies owed from someone whose assets are in COPEs, consult with an attorney experienced in the representation of creditors in situations involving charging orders before you proceed with legal action.

Jacquelyn Lynn (www.jacquelynlynn.com) is a business writer and speaker, and the author of The Entrepreneur’s Almanac.