California Limited Liability Companies
In California, a creditor of a member of a limited liability company (“LLC”) is unable to seize ownership of the member’s interest in the LLC. Instead, the third party creditor receives an order from the court (“charging order”) which instructs the LLC to give the creditor any distributions that would otherwise be paid to the debtor/LLC members.
The court generally will not have authority to order that distributions be made to the LLC member. In California, the charging order is the creditor’s exclusive remedy. The creditor has the right, under a charging order, to receive any distributions that would otherwise be paid to the debtor/LLC member, but does not allow the creditor to exercise any rights otherwise held by the debtor; i.e. the right to manage the LLC, to order LLC distributions. The creditor obtains no right to manage the LLC.
It is not established, under the law, whether a creditor with a charging order will be considered the owner of a LLC interest held by the debtor/LLC member for federal income tax reporting purposes.
Under IRS Rev. Rule 77-137, the debtor (limited partner) voluntarily gives the creditor an assignment of his limited partnership interest and the creditor becomes the owner for tax purposes.
The creditor may be subject to federal income tax on account of holding a charging order. Any distributions from the entity to the creditor may be treated as a reduction in the amount owed to the creditor by the debtor-owner of the LLC interest and under general tax principles the debtor-owner of the interest may have to recognize the income.
However, if the creditor seizes the LLC member’s interest under a charging order and LLC income is allocated to the LLC member but remains undistributed, the creditor has the risk of being taxed on income that is never received (i.e. “phantom income” tax liability). The creditor will owe a tax on the LLC distribution without an LLC cash (or property) distribution with which to pay the tax.