Another Circumvention of the Charging Order Remedy

My April 20, 2010 blog discusses how the IRS avoids being subject to the charging order remedy when seeking to collect from an LLC in which the debtor taxpayer is a member. Unfortunately, the IRS has still another offensive weapon when chasing members of LLC’s for money.

If the debtor member works for the LLC, such as a partner of a law firm or accounting firm, the IRS will seek to levy the income earned by the debtor member. If the LLC fails to honor the levy, the IRS has the right to go into court and obtain a court order to enforce its levy. If the LLC refuses to honor the levy, it is liable for an amount equal to the property levied upon, or the taxpayer’s debt, whichever is less, plus collection costs and interest plus, if reasonable cause is not present, a penalty equal to 50% of the amount the LLC would be liable for.

You may be wondering what all of this has to do with a charging order (see section 450.4507 of the Michigan Limited Liability Company Act). Consider that Partner A has a draw of $4,000 month and profit distributions of varying amounts which are generally paid at the end of each quarter. The IRS levy will seek to reach both of these potential distributions. Now consider that upon receipt of the IRS levy, the LLC decides not to make any profit distributions but in compliance with the levy pays over the draw amount to the IRS. The IRS may very well take the position that the amount normally paid out as profit distributions should have been paid over to the IRS as property payable to the taxpayer as salary, wages or other income and the LLC’s failure to pay subjects it to liability.

In my opinion, this approach by the IRS is a direct violation of the charging order rules. Such rules provide that when a creditor is seeking to reach the assets of an LLC to pay a member’s debts, it cannot go after the LLC’s assets directly but instead must obtain an order requiring the LLC to turn over to the creditor any distributions to which the debtor member is entitled. But nothing in the law requires the LLC to make a distribution.

Thus the IRS’ attempt to levy on undistributed profits is a circumvention of the charging order procedure. Of course, this situation would generally only be seen in LLC’s where the debtor taxpayer is also a working partner.