Asset Protection Series: How to Make a Creditor Cry "Uncle!"

We can end up in debt far more ways than just by being spendthrift with our cash or failing to pay bills. Real estate is a business, and as a result we expose ourselves to a myriad of liabilities -- lawsuits being the most common. Someday, you might end up as the judgment debtor for more money than you ever anticipated having to pay. A very basic asset protection strategy addresses this by advising you to place your assets and investments into an LLC. This article goes one step further and discusses gaining some negotiating power with the offending creditor by using a few tricks.

Luckily for us, there are a few ways to mitigate the risk, should we ever get to the point where a creditor tries to collect on a judgment lien. One of the more effective ways is by using a specially structured LLC, which ought to be set up before the judgment ever comes down the pike. It involves a creditor being on the hook for tax liabilities of the LLC before receiving any distributions. The peculiarities of partnership tax law, combined with the charging order, presents us with a unique planning opportunity for creditor protection.

Here is the basic fact pattern:

1. The client forms a multi-member LLC with a friendly partner, whose members appoint a manager. The operating agreement of the LLC specifies that the manager may only be removed or appointed by unanimous consent.

2. A judgment creditor, who has obtained a judgment against the client personally, uses the charging order to become an "assignee" of that membership interest. Under most state laws, this is the extent to which the creditor may claim rights in the LLC -- and will be entitled to receive distributions only.

3. After the "assignment" of the debtor's membership interest, the LLC elects to stop making distributions (in accordance with the operating agreement). This leaves the creditor with no option but to wait until a distribution is made.

4. The debtor formally assigns any voting rights he had to the creditor, and now the creditor has voting power, or "dominion and control" over the membership interest.

5. NOW, the creditor now must report his distributive share of income, gain, loss, deduction and credit attributed to the assigned membership interest. This means that the creditor will owe a tax bill for the LLC's profits at the end of the year, even though he has received no money from the LLC!

6. The creditor cannot replace the manager because the "friendly partner" in Item 1 refuses to remove the manager.

According to Revenue Ruling 77-137, a limited partner may assign his limited partnership share to another party, and the IRS will treat that assignee as a substitute limited partner. Since LLCs taxed as partnerships are treated similarly to limited partnerships, it's reasonable to assume that the IRS will come to the same conclusion. The creditor, now with dominion and control over the membership interest, has to report his share of the LLC's income. He cannot compel distributions from the LLC because he has no power to remove the manager of the LLC, because the operating agreement requires unanimous consent to remove the manager.

This nuanced planning strategy can stick the creditor with a substantial tax bill without anything to pay for it. When that K-1 goes out, that liability can cause the creditor to cry "Uncle!" and rush to settle with the debtor. For pennies on the dollar, the debtor can now settle the creditor's claims and regain the membership interest.

This is an advanced planning strategy, so don't try this at home. Of course, consult your favorite tax and legal professionals before setting up a structure like this.