Taxation Without Representation: Lenders Should be Wary of Accepting an LLC Membership Interest as Collateral
by Jeremy B. P. Hagan and William T. McCartan, Attorneys
April 2011 -- Banks and other lenders will often accept a pledge of corporate stock or LLC membership interest as collateral to secure a debt. The adoption of Iowa’s new LLC statute and the associated new charging order provisions that are a part of the modified law make it more challenging (and even risky) to accept a pledge of an LLC membership interest as collateral.
Charging Orders
Lenders must realize that taking a security interest in an LLC membership interest is now even more complicated compared to accepting a pledge of corporate stock. A creditor of a corporate shareholder that holds a pledge of the shareholder’s stock is typically allowed to foreclose on the corporate stock. The creditor is also then generally permitted to purchase the pledged stock at a foreclosure sale by making a bid consisting not of new funds, but of the debt owed by the shareholder. This allows the purchasing creditor then to “step into the shoes” of the former shareholder (the debtor) and become a full owner of the purchased shares. At the end of this process, the creditor acquires the right to vote on corporate business just like any other shareholder and also gains the right to receive the same distributions that are paid to other shareholders.
The process and the results are different in the case of an LLC and the differences can leave the lender disappointed.
In the case of an LLC, rather than foreclosing on the LLC membership interest, the creditor of a member is likely to be limited to obtaining a mere “charging order.” To obtain a charging order, a creditor must first obtain a judgment from a court. This is because a charging order is only available to “judgment creditors.”
A charging order is more similar to a garnishment (and is different than a foreclosure); it does not permit the creditor to reach the LLC membership interest itself, but rather permits the creditor only to reach the judgment debtor/LLC member’s interest in the distributions that the LLC makes. By obtaining a charging order, the creditor does not obtain the governance rights originally associated with the membership interest. Thus, although entitled to receive distributions from the LLC, the creditor would likely be unable to force the LLC to actually pay anything out.
After obtaining a charging order, the creditor may also take a further step and foreclose on the LLC member/judgment debtor’s “transferable interest.” The term “transferable interest” means the right to receive distributions from a limited liability company in accordance with the LLC’s operating agreement.
Whereas a charging order is a temporary remedy that has the effect of assigning income from the LLC over to the creditor until a judgment is paid, a foreclosure is a permanent transfer of the transferable interest from the LLC member/judgment debtor to the party that purchases the transferable interest at a foreclosure sale. The foreclosure sale purchaser acquires only the LLC member/judgment debtor’s economic right to distributions. This means that the party purchasing the transferable interest at the foreclosure sale becomes the owner only of the transferable interest. Thus, just as in the case of the charging order, the holder of a foreclosed transferable interest would likely still be unable to compel distributions of income or a dissolution of the LLC and distribution of its assets.
Unforseen Tax Consequences
It may be troubling enough to lenders that a judgment creditor obtains only a potentially toothless transferable interest as a result of a debtor’s pledge of a membership interest. Additionally, though, a judgment creditor holding a charging order may be treated as a “partner” for federal income tax purposes. A judgment creditor that takes the additional step of foreclosing upon the LLC member/judgment debtor’s transferable interest is very likely to be treated as a partner for tax purposes. This would mean that if the LLC recognized income for a year, the holder of the charging order might be liable for tax on a part of that income – even though the LLC may not have paid out any cash to the holder of the charging order. It also means that the holder of a transferable interest, acquired at a foreclosure sale, would quite likely be allocated a share of any taxable income of the partnership (again, even if the LLC has not paid out any distributions to the holder of the transferable interest).
The law on this point is not entirely clear. However, in Revenue Ruling 77-137, 1977-1 CB 178, a partnership agreement provided that assignees of limited partners could not become substitute limited partners in the partnership without the written consent of the general partners. Nevertheless, the IRS held in that situation that an assignment of profits and the right to receive partnership distributions shifted the partnership interest for tax purposes. The assignee was therefore treated as a substitute limited partner, obligated to pay tax on the LLC’s profits, even absent the consent of the general partners.
Despite this ruling, a judgment creditor holding a charging order (prior to foreclosure) may be able to maintain that a mere charging order does not involve a transfer of the ownership of the membership interest, such that the LLC member/judgment debtor rather than the creditor should continue to be allocated the partnership income, gain, losses, deductions, and credits. Particularly since the LLC member/judgment debtor will still receive the benefit of the distributions that are paid to the creditor – in the form of a reduced debt to the creditor that holds the judgment lien – the creditor would have a basis to resist any allocation of income. However, after a creditor forecloses upon its charging order lien (completing an assignment of the transferable interest) then the purchaser of the LLC member/judgment debtor’s transferable interest would likely be deemed a partner of the LLC for tax purposes.
Conclusion
Under Iowa’s new LLC statute, potential lenders should carefully consider whether and how to extend financing secured by LLC membership interests. Creditors holding a security interest in LLC membership interest are now generally limited to a charging order remedy. As a result, a security interest in LLC membership interest may be unduly cumbersome to administer. Moreover, when trying to realize value from this collateral, a creditor will likely have no ability to force payments by the LLC against its judgment. Even worse, the creditor may find itself taxed on a share of the LLC’s income even if the creditor has not received distributions of cash to pay the tax liability.