Most post-judgment enforcement remedies employed by creditors result in easily understood and predictable tax consequences to the parties involved. A charging order is different, however, because it peculiarly combines two remedies; namely, an involuntary lien (attachment) against the debtor's interest in an LLC or partnership, and a non-wage garnishment of the income stream from that interest such that the creditor receives the distributional income and not the debtor. To add to the confusion, in the majority of states the charging order lien may be foreclosed by way of a judicial sale at which the creditor or a third-party may be the winning bidder. All of these actions may result in unforeseen tax consequences to the affected parties as the following article demonstrates.
Once a charging order has been entered, certain tax issues arise.[1] As will be discussed, the treatment of these issues differs between the stage at which the charging order has simply been issued but prior to foreclosure (preforeclosure) and after the creditor’s charging order lien has been foreclosed upon by the creditor (post-foreclosure). Due to the fact that these issues may impact the creditor, the debtor, the entity itself, and the buyer at a judicial sale (who might not be the creditor), consideration of the effect upon these parties at each phase is likewise necessary.[2]
Here, we must be reminded that a charging order is merely the legal vehicle by which a lien is placed by the creditor upon the debtor’s economic right to distributions from the entity. Foreclosure of a charging order correspondingly means that the creditor has liquidated its lien only in the debtor’s economic right to distributions, and whoever ends up owning that interest merely takes that right without more.
Pre-Foreclosure
Tax Implications to the Creditor
After the issuance of a charging order, the creditor becomes a mere lienholder of the debtor’s economic right to distributions;—no more, no less.[3] As such, the creditor will treat the cash received as a result of the charging order lien no differently than other money the creditor might receive as a result of other collection efforts. In other words, if the creditor would be taxed on the money that it receives through other collection efforts (such as arising from an action sounding in contract), then it will be taxed on the money that it receives pursuant to a charging order as well. Conversely, if the creditor would not pay tax on the money that it receives (such as from a personal injury award), then it should not be taxed on the charging order money either.
As a mere lienholder, the creditor in the preforeclosure stage is not an “assignee” of the interest for tax purposes and therefore for tax purposes is not treated as a partner. As discussed further below, this treatment will change if the creditor obtains the debtor’s interest through foreclosure.
It is not uncommon in charging order proceedings, however, for the entity or the judgment-debtor to attempt to treat the judgment-creditor as a partner for tax purposes preforeclosure, and to send the creditor a K-1 for the moneys that the creditor received pursuant to the charging order. In such an event, the creditor must take action to advise the IRS that the K-1 has not been properly issued to it.
Tax Implications to the Debtor
For the debtor in the preforeclosure phase, the debtor remains the partner for tax purposes and remains responsible for his or her allocated share of the entity’s tax items, including income and gain, even if he or she never receives a distribution, it being diverted to the judgment-creditor by the charging order.[4] It is the debtor who properly receives the K-1 showing the allocation of income from the LLC and is responsible for the tax liability generated thereby.[5]
Even as the debtor recognizes the allocated portion of the LLC’s income and other tax items, in certain circumstances the judgment-debtor may also have a deduction in the amount diverted to the creditor consequent to the charging order.
Tax Reporting Implications for the Entity
At the preforeclosure stage, the entity essentially takes no notice of the creditor for tax purposes and continues to issue K-1s to the debtor in the normal course, even though distributions are redirected to the creditor. At this stage, the entity must reject the almost-inevitable entreaties by the debtor that the K-1 be issued to the creditor. The entity must reject those requests; issuing the K-1 to the creditor would be improper.
Post-Foreclosure
Tax Implications to the Creditor
The foreclosure of the interest presumably will result in a cash payment to the creditor (otherwise, as discussed in Chapter 18 relating to foreclosures, there really is little incentive to even seek foreclosure in the first place). The cash payment received by the creditor should be treated for tax purposes as any other payment received from the debtor, i.e., it may or may not be taxable to the creditor because of the nature of the underlying dispute, but that has nothing to do with the charging order or foreclosure.
While there is essentially no guidance specifically with respect to the foreclosure of a charging order, the creditor should undertake a careful analysis before making a credit bid at a foreclosure sale. For example, if the credit bid is below market, is there a non-taxable bargain purchase? If the LLC has made a Code § 754 election, how will that apply? The creditor should consider Form 1099 reporting obligations with respect to the receipt of the foreclosure proceeds. Also, a creditor purchasing at a foreclosure sale, whether pursuant to a credit bid or otherwise, should consider in advance the implications of a subsequent sale of the interest at fair market value.
Tax Implications to the Purchaser
The purchaser is the winning bidder at the judicial sale, which takes place as part of the foreclosure of the creditor’s charging order lien on the debtor’s interest. The purchaser may be the creditor (who can make a “credit bid” of part or all of the outstanding judgment, or pay in cash like any other bidder), or it can be some third-party buyer at the judicial sale who pays cash.
Regardless, the purchaser at the judicial sale becomes an “assignee” of the debtor’s now-former interest. As an assignee of the interest, the purchaser effectively becomes a partner of the entity for tax purposes, and this is so even though the purchaser is simply taking the debtor’s economic rights to distributions but does take any other rights, such as voting or management rights.[6] The upshot is that the purchaser at the judicial sale should thereafter receive a K-1 for taxable distributions from the entity so long as the purchaser holds that interest.
Tax Implications to the Debtor
Presumably, the foreclosure will as to the debtor be treated as a sale of a partnership interest, with the debtor recognizing gain or loss, and being treated as having surrendered the sale proceeds to the creditor in either partial or full satisfaction of the underlying judgment, with the tax treatment thereof the equivalent to any payment the debtor might make to the creditor of funds generated other than from the LLC and the charged interest.
Given that the judicial sale has the effect of entirely severing the debtor’s economic interest in the entity, the debtor should from that date no longer receive any allocation of entity tax items (income, gain, loss, deduction, or credit).
In considering the tax implications of the foreclosure, the debtor should consider a variety of factors including his/her/its basis in its interest, the deemed treatment of the proceeds of the foreclosure sale and the deemed distribution to the debtor resulting from the reduction in the debtor’s share of LLC’s liabilities.
Tax Reporting Implications for the Entity
As noted, following the judicial sale, it is the purchaser of the interest who is treated as a partner for tax purposes. The entity should therefore provide the purchaser with a K-1 reflecting appropriate tax allocations from that date forward. Correspondingly, the debtor should no longer receive tax allocations from that date, nor receive a K-1 for the post-judicial sale period.
The tax treatment of charging orders is among the myriad of procedural and substantive issues that confront LLC planners and litigators alike. This chapter is excerpted from the newly released Charging Orders Practice Guide, which discusses the most common such issues and their solutions.
[1]. For these purposes, it is assumed that the LLC in question is, for purposes of federal tax classification regulations, a “partnership” and not a “disregarded entity” or a “corporation.”
[2]. See also Thomas E. Rutledge & Sarah Sloan Wilson (now Sarah Sloan Reeves), An Examination of the Charging Order Under Kentucky’s LLC and Partnership Acts (Part II), 99 Ky. L.J. 107, 108–13 (2010–11).
[3]. See Ky. Rev. Stat. Ann. § 275.260(3) (charging order is not an assignment); accord § 362.285(4) (KyUPA); § 362. 481(3) (KyRULPA); § 362.1-504(4) (KyRUPA); § 362.2-703(3) (KyULPA).
[4]. See GCM 36960 (1977), Rev. Rul. 77-137, 1977-1 C.B. 178; see also Treas. Reg. § 1.704-1(e)(2)(ix); Robert R. Keatinge, Transfers of Partnership and LLC Interests-Assignees, Transferees, Creditors, Heirs, Donees, and Other Successors in Proceedings of the 32nd Annual Philip E. Heckerling Institute on Estate Planning (1998), at § 504.3; Priv. Ltr. Rul. 8434047 (where assignee of interests in limited partnership may vote and in so voting bind assignor to vote in accordance thereto, and assignees are otherwise granted rights to information, assignee treated as a “partner” for purposes of the Code); Priv. Ltr. Rul. 8440081.
[5]. See also Keatinge, supra note Ch.27, fn. 4. (“Where the charging order is similar to a garnishment, the debtor/partner will probably be treated as the partner, required to include the distributive share of income and loss and entitled to a deduction if the payment of the judgment would give rise to a deduction.”); Christopher M. Riser, Tax Consequences of Charging Orders, 1 Asset Protection J. 14 (Winter 2000); Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies-Tax and Business Law ¶ 8.07[1][a][ii].
[6]. Rev. Rul. 77-137, 1977-1 C.B. 178. See also Rev. Rul. 77-332, 1977-2 C.B. 483 (discussing non-CPAs in accounting firms who for state law purposes are not partners but who are partners for tax purposes). Assuming the foreclosure sale takes place during the LLC’s/partnership’s tax year, there will be issues as to how the allocations of tax items is over the course of that year allocated between the judgment-debtor and the acquirer by foreclosure. The treatment of the debtor’s right to participate in the venture’s management is as provided for in the controlling agreement and organizational act.