New Twist on Charging Orders

It is not surprising that in the world of asset protection planning we have written extensively about charging orders. This is the collection remedy employed by creditors against debtors owning a membership interest in a limited liability company or a partnership interest in a partnership. These laws are fairly consistent throughout the United States and provide, in the case of a member of an LLC, that a court of competent jurisdiction may charge the member’s interest with payment of the unsatisfied amount of the judgment plus interest. The charging order works in this fashion. Assume the LLC has 3 members each owning 1/3 of the company and Member A has a judgment against him for $10,000. The LLC is making a $6,000 distribution ($2,000 to each member). If there is a charging order in effect against Member A’s interest, his $2,000 distribution must be paid directly to the creditor. Future distributions due Member A will likewise be paid directly to the creditor until the judgment is paid in full.

In United States v. Alexander, a 2016 Arizona Federal District Court case, the member against whom the creditor was attempting to obtain a charging order raised an interesting defense. The debtor was the sole member of the LLC and claimed that all of the income of the LLC was derived from his personal services. The court acknowledged that the entering of a charging order does not deprive a member of any exemptions to which he would otherwise be entitled under applicable law. Arizona law (like Michigan) limits garnishments to 25% of disposable earnings. Disposable earnings are gross earnings less statutory deductions (Federal and state withholdings). Because in this case all of the distributions from the LLC to the debtor member was derived from his personal services, the charging order was limited to the maximum amount that a creditor could obtain if a garnishment order was entered – 25% of disposable earnings.

To qualify for the exemption a member will have to demonstrate the extent to which a distribution is a result of services provided by that member as opposed to a return on invested capital or income generated through the efforts of others. The important takeaway is that debtors have available to them an interesting defense under the appropriate circumstances.