LLC Charging Orders – An LLC’s Limited Liability from Its Members
It is axiomatic that a member of an LLC is not personally liable for the debts and obligations of the company; this is the fundamental principle of limited liability that underpins LLCs, corporations, and limited partnerships (excluding the general partner in that context). However, an LLC similarly is protected from the debts and obligations of its members, preventing their personal debts and obligations from damaging the company’s business and operations. Such a remedy makes sense as a matter of fairness, preventing other members of an LLC from seeing it plundered to satisfy the obligations of one debtor member.
When creditors obtain a judgment against a member, the creditor’s sole means of pursuing the LLC is through a “charging order.” Charging orders are addressed in Section 18-703 of the Delaware Limited Liability Company Act. Such an order allows the creditor to receive economic distributions that would otherwise be made to the member, but does not allow the creditor to exercise any voting, veto, management, or other rights the member may have. As a remedy, the charging order allows the creditor to obtain the economic benefit of the membership interest without adversely affecting the LLC’s operation. Such an order is the only way by which a creditor can pursue a creditor’s interest in an LLC, even in the case of a single-member LLC. Only a handful of states, including Delaware, provide charging order protection to LLCs.
The member continues to exercise his or her management rights, absent some provision to the contrary in the operating agreement. Courts are mindful of the potential for gaming distributions and management of the LLC in some cases, particularly where, as with Delaware, single-member LLCs are protected by charging orders in addition to those with multiple members. The LLC must continue to operate and, if applicable, make any required distributions in accordance with the company’s operating agreement, and the creditor can bring an action if it appears that distributions are not being made or are being manipulated to frustrate the charging order.
Generally, in a multi-member LLC, distributions are made among the members either pro rata or based on some formula provided in the operating agreement. This gives the creditor some comfort that other members will want distributions, and the creditor will benefit as a result. In a single-member LLC, however, where distributions are discretionary and in the control of the debtor, a waiting game may begin as the creditor has no right to demand distributions. A single member of an LLC, however, often cannot simply cease operating the company or it will fail and the charging order creditor will simply take the residual assets after repayment of liability.
Charging orders do not implicate the LLC’s operating agreement and, importantly, do not implicate change of control or other provisions under leases and other contracts. An LLC charging order does not constitute a transfer or an assignment of a membership interest, which often are restricted or prohibited under LLC operating agreements, nor is it a lien on any LLC asset. In the assignment context, a charging order does not change ownership of the membership interest. Instead, it is an attachment on any economic distributions that would otherwise be made to the member. Further, it is not a lien on any LLC asset, which may be prohibited. The creditor obtaining a charging order has no direct right over the assets of the company; the creditor simply stands in the shoes of the member for purposes of distributions.
Notably, the member remains responsible for any tax payments to be made upon distributions, even though the distributions go to the creditor benefiting from the charging order. The IRS issued this guidance in IRS Revenue Ruling 77-137 (1997-1 C.B. 178).
Charging orders protect members of an LLC from the debts of another member, which makes sense given the separate legal “personhood” of the LLC. Just as it can sue, be sued, hold assets, and act in its own name, without a member facing personal liability, so the LLC is similarly protected from personal liability for the debts and obligations of its members.
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