A debtor forms a two member LLC to operate a family business. A creditor obtains a judgment against the business owner and proceeds to get a charging lien against distributions allocated to the debtor’s share of his LLC. Is there a way for the debtor to obtain money from his LLC after the charging lien?
This is a question posed by many of my clients and website readers. Many clients ask whether the LLC can distribute money only to the non-debtor owner. In most cases, the answer is no because distributing disproportionate funds is a “special allocation” which is subject to detailed IRS rules and regulations. Also, a creditor might be able to sue the non-debtor owner as a recipient of a fraudulent transfer arguing that some of the money received is actually money payable to the debtor pursuant to the LLC agreement.
One option is to have the LLC pay salary to the debtor if the debtor can claim a wage exemption as head of household. The problem with this approach are the cases which refuse to recognize payments from a small business as salary or wages and characterize such payments as distributions, which would be subject to the charging lien.
Some LLC owners have attempted to circumvent charging liens by making “loans” to the debtor owner. If the loans were made periodically over time the creditor could argue that the loans are in fact periodic distributions. If the LLC made a “lump-sum” loan the debtor then would have to protect the loan proceeds received.
From the creditor’s point of view, a charging lien is not an effective collection tool unless the LLC is a large private or even a publically traded limited partnership or LLC where distributions are predictable and public. If is difficult for a creditor to monitor the financial activity of a small business. As a practical matter, a creditor would have to invest significant effort to determine when a small LLC paid money to the debtor which money could be characterized as a profit distribution.