Tax Consequences of Charging Orders

Is the K.O. by K-1 K.O.’d by the Code?

by Christopher M. Riser, J.D., LL.M.
Published in the Asset Protection Journal, Winter 1999

There is a common belief among many, if not most, practitioners in the fields of estate planning, business planning, and asset protection planning that a judgment creditor who obtains a charging order against the membership interest of a debtor limited liability company (LLC) member or against the partnership interest of a partner in a partnership will be taxed on the debtor’s distributive share of income to the extent charged, regardless of whether the governing LLC or partnership act provides that an assignee receives the creditor-assignor’s share of items of income, gain, loss and deduction.(1) This belief that the creditor will be “K.O.’d by the K-1” is apparently the prevailing view among practitioners, judging from the number of such assertions in the professional literature and the dearth of assertions to the contrary.(2) However, a review of the relevant law as well as tax policy rather clearly indicates that it is inappropriate for a creditor who obtains a charging order to be taxed on the debtor member’s share of taxable income.

The argument that a judgment creditor who obtains a charging order against a partner’s interest is taxable on the distributive share of income attributable to such interest is usually based on Rev. Rul. 77-137(3) andEvans v. Commissioner.(4) In Rev. Rul. 77-137 and inEvans, a partner assigned his interest to a third party assignee, and the assignee was held to be taxable on the distributive share of income attributable to the distributive share of the assignor’s partnership interest. However, neither Rev. Rul. 77-137 nor Evans dealt with the situation of a judgment creditor and a debtor partner. Rather, each dealt with the situation of a partner who fully assigned his partnership interest (i.e., his assignable economic rights) to a third party and irrevocably agreed, or was compelled as a fiduciary, to exercise his residual rights as a partner in favor of the assignee.

Rev. Rul. 77-137 and Evans

Rev. Rul. 77-137 stands for the proposition that assignees of partnership interests are required to report distributive shares of partnership income or loss attributable to the assigned interests, even though they do not become substituted limited partners, when they acquire dominion and control over those interests. The assignor partner in Rev. Rul. 77-137 irrevocably agreed to exercise his residual rights in favor of the assignee. The assignee was taxable rather than the assignor, because the assignee was essentially the owner of the assigned interest. However, to the extent that assignors retain substantial rights with respect to those interests that are not required to be exercised solely on behalf of the assignees, assignees do not have the requisite dominion and control and are not required to report distributive shares of partnership income or loss attributable to the assigned interests.(5)

The Evans case involved the assignment of a partner’s partnership interest (his right to income and capital) in a partnership in which capital was a material income-producing factor to the assignor’s wholly-owned corporation. The court found that, after the assignment, the assignor, in his capacity as an officer and director of the corporate assignee, continued to do the work he had done for the partnership in his capacity as a partner prior to the assignment. The assignor was obligated as a fiduciary to exercise his residual rights as a partner in favor of the corporation.(6) Thus, Evansstands for the proposition that where a partner has “not simply assigned income but… also his entire equitable interest,” the assignor retains only “naked legal title” to his partnership interest, “the income from which is computable in the same manner and on the same basis as any other property, the legal title to which is in a naked trustee.”(7)

Thus, the key to whether an assignee’s interest is taxable is the extent of the assignee’s dominion and control over the assigned interest and the extent of the assignor’s retention of rights. If an assignor makes a complete assignment of his beneficial interest in a partnership, and if there is an express or implied agreement to exercise any residual, non-assignable rights in favor of the assignee, the assignee will be taxed on the assignor’s distributive share of partnership income. If an assignor retains substantial rights with respect to the assigned interest, and if there is no express or implied agreement to exercise any residual non-assignable rights in favor of the assignee, the assignee will not be taxed on the assignor’s distributive share of partnership income.

A Charging Creditor’s Dominion and Control is Typically Insufficient to Indicate Taxability

A judgment creditor who obtains a charging order against a partner’s interest or an LLC member’s interest has the rights of an assignee to the extent that the interest is charged. An assignee does not participate in the management and affairs of the partnership or LLC without the consent of the other partners or members. An assignee is not a proper party to an action affecting the assignor’s retained (non-economic) rights as a partner.(8) An assignee is owed no fiduciary duties by general partners or managers other than the duty to pay the assignee those amounts which the assignor would otherwise be entitled.(9) An assignee may not become a partner or member without the consent of the non-assigning members or partners.(10)

So, what is the interest of a judgment creditor who has obtained a charging order against a the interest of a partner or LLC member? A judgment creditor who obtains a charging order is something less than an assignee.(11) Without further agreement between the debtor and judgment creditor, or without an additional equitable order by the court, the judgment creditor who has obtained a charging order will have no right except the right to future partnership distributions, to the extent of the judgment plus interest, and the debtor partner will retain all of the rights as a partner that he had before the issuance charging order except the right to future partnership distributions to the extent of the charging order.(12)

In fact, a charging creditor’s right to distributions in respect of a debtor partner’s interest is so weak as to be subordinate to subsequent liens by partnership creditors.(13) Surely such a limited interest in a partner’s partnership interest does not vest a charging creditor with sufficient dominion and control to require him to be taxed on the debtor partner’s distributive share. Neither does a charging order leave a debtor partner with such an insubstantial residual interest that he should not be taxed on his distributive share.

Tax Asymmetry

Where an interest charged is not foreclosed, a charging order is similar to a garnishment.(14) When a debtor’s wages are garnished, the debtor is taxed, not the creditor.(15) The debtor is treated as having received the wages, then as having used the wages received to pay the creditor. The same rule should apply to the typical charging order situation. A debtor partner or member should be treated as being entitled to her distributive share of income, which, if distributed, is used to pay the creditor.

Note the potential for tax asymmetry when a charging creditor is taxed. The tax treatment of the receipt of proceeds of a judgment depends on the nature of the claim which gave rise to the judgment. Generally, contract damages are taxable, to the extent they represent the payment of items which would have been included in the creditor’s taxable income.(16)Compensatory damages resulting from personal injury tort claims are generally not taxable.(17)

If a judgment creditor with a charging order were treated as a partner for tax purposes, then there would be no way to account for the satisfaction of judgment debts for tax purposes. While tax would be payable on the distributive share of partnership income (as it would if there were no charging order), a contract creditor, for example, would never report taxable contract proceeds as income and the debtor partner would never deduct the payment of the debt.

If a judgment creditor were somehow taxable on charging order proceeds, then perhaps to the extent that a judgment creditor actually received distributions (thereby relieving the debtor of the obligation to pay the creditor to the extent of the actual distributions), the debtor would have discharge of indebtedness income. This tax scenario would be the reverse of what it should be — the creditor would be taxed on the partnership income and the debtor partner would be taxed on the creditor’s contract proceeds. This would be confusing and unnecessary. It is simply more reasonable for the debtor to be taxed as having received the distribution and then having paid the creditor.

Consider also the example of a charging order obtained to enforce a judgment for arrearages related to an earlier order for child support. Should the parent who is entitled to the child support payments be taxed on the paying parent’s distributive share of income when it is entirely possible that little or nothing will be realized from the charging order, and when amounts paid under the child support order would not otherwise be taxable? Of course not.

Conclusion

It seems inappropriate and illogical to tax a charging creditor on a debtor partner’s share of partnership income. The holdings in Rev. Rul. 77-137 and the Evanscase should be understood to be limited to their narrow facts. Where extent of the assignee’s dominion and control over the assigned interest is like that of a partner, and the extent of the assignor’s retention of rights is limited or nonexistent, a charging creditor is taxable on the debtor partner’s share of partnership income to the extent of the judgment plus interest. Otherwise, a charging creditor is not taxable on the debtor partner’s share of partnership income.

ENDNOTES

1. The partnership and LLC acts of nearly every U.S. jurisdiction provide in some manner that, on application to a court of competent jurisdiction by a judgment creditor, the court may charge a debtor partner or member with payment of the unsatisfied amount of the judgment with interest, and that to the extent so charged, the judgment creditor has only the rights of an assignee of the debtor’s partnership or LLC interest. See, e.g., Uniform Partnership Act § 28; Revised Uniform Partnership Act § 504; Revised Uniform Limited Partnership Act § 703; Uniform Limited Liability Company Act § 504.

2. See, e.g., Arthur A. DiPadova & Kevin A. Kilroy, “How Family Limited Partnerships Help Protect Assets,” 137 N.J. L.J. 11, 44 (1994); Lewis D. Solomon and Lewis J. Saret, Asset Protection Strategies: Tax and Legal Aspects, § 3.23, at 62 (1999).

3. Rev. Rul. 77-137, 1977-1 C.B. 178. GCM 36960 (Dec. 20, 1976) provides a detailed analysis of the law on which the ruling is based.

4. Evans v. Commissioner, 447 F.2d 547 (7th Cir. 1971).

5. Rev. Rul. 77-137, supra.

6. See Robert R. Keatinge, “Partnerships Revisited: New Rules, New Entities, Old Issues, New Solutions.” Q249 ALI-ABA 195, at 197.

7. Evans, supra, at 52.

8. Dixon v. American Industrial Leasing Corporation, 157 W. Va. 735, 205 S.E.2d 4 (1974).

9. Kellis v. Ring, 92 Cal. App. 3d 854, 155 Cal. Rptr. 297 (1979).

10. An interesting question is how this rule will be applied in the context of charging orders obtained against the membership interest of the sole member of a single-member LLCs.

11. Perhaps the court in Bank of Bethesda v. Koch put it most entertainingly:

[A charging order] is nothing more than a legislative means of providing a creditor some means of getting at a debtor’s ill-defined interest in a statutory bastard, surnamed partnership, but corporately protecting participants by limiting their liability as are corporate shareholders… Since the statutory offspring is unique, the rights of creditors against partnerships were necessarily peculiar as well; hence the charging order is neither fish nor fowl. It is neither an assignment nor an attachment. But unlike many such questionable offspring, it resembles both progenitors in some of the characteristics.  44 Md. App. 350, at 354, 408 A.2d 767, at 769 (1979).

12. It is unlikely that there would be such an agreement between the debtor and the judgment creditor nor a court order requiring the debtor to exercise his retained rights in favor of the judgment creditor, because both such situations would require the affirmative action of the judgment creditor to bring about. Such action is unlikely if it would cause the judgment creditor to be taxable on the debtor’s distributive share of partnership income.

13. Shirk v. Caterbone, 201 Pa. Super. 544, 193 A.2d 664 (1963).

14. See Keatinge, note 7, supra.

15. I.R.C. §§ 61(a)(1), 83(a)

16. I.R.C. § 61, e.g., contract damages representing the payment of principal on a loan would not be taxable while that portion of the damages representing the payment of interest on the loan would be taxable.

17. I.R.C. § 104 (a)(2)