Nevada Charging Order Protection
There is good news for small Nevada corporations. As of July 1, 2007, C-Corporations and S-Corporations with 75 shareholders or less now have the same Charging Order protection that was previously only available to LLCs.
What does that mean for Nevada corporations?
Basically it means that judgment creditors will want to negotiate with the corporate debtors for a settlement. Otherwise the creditor will be paying taxes on the income from the judgment, even though they may not ever receive the funds. This could be enough of a disincentive to stop the lawsuit before it gets started.
It's another great reason to Incorporate in Nevada.
What is a Charging Order?
In essence, a Charging Order allows a judgment creditor to receive such distributions from certain forms of companies (e.g., partnerships, limited-liability companies and now, Nevada corporations) as a judgment debtor would have received. It is important to note that a judgment creditor does not have access to the company's assets and has no management or voting rights.
There are important points relating to Charging Orders:
Charging Orders and Single Member LLCs
In "In re: Ashley Albright," a Bankruptcy Court in Colorado held that the charging order protection does not apply to single-member LLCs since, the Court held, charging orders were intended to protect non-debtor "partners," and in single-member LLCs there is no one to protect. As the language of the Colorado LLC statutes does not exempt single-member LLCs from the protection of the charging order and so, many practitioner's are uncertain as to the true applicability of Albright.
In community property states, a Court following Albright would probably treat a married couple as a single member and thus would likely not afford the owners of the charging order protection.
Charging Order v. Piercing the "Corporate Veil"
There is not much case law on this point, but many practitioners believe it likely that, if an entity's protection from liability is pierced, the Charging Order protection becomes moot. Accordingly and as always, it is recommended that company formalities be followed to make sure that the "corporate shield" is as impenetrable as possible.
Pre-foreclosure of Charging Order
Until the charging order is foreclosed upon, it is a lien on the debtor's transferable interest and can be compared to a garnishment. If the entity makes distributions to the creditor, then the tax consequences to the creditor are determined with reference to the underlying judgment.
Distributions made pursuant to a charging order are in satisfaction of a judgment. Judgments are taxable based on the underlying cause of action, according to the "origin of the claim" test.
The debtor may be able to obtain a deduction for any distributions made by the entity to the creditor, if the judgment relates to the debtor's business, and paying it off would be deemed an "ordinary and necessary" business expense.
Post-foreclosure of Charging Order
Once a creditor forecloses on the interest, the charging order lien is converted into an actual economic interest in the entity. For federal tax purposes, the creditor acquires a property right in the economic interest, and is now treated as the owner of such interest.
The tax consequences to the creditor depend on two factors: (1) whether distributions are being made, and (2) the federal income tax treatment of the entity.
If distributions are being made, then if the entity is taxed as a sole proprietorship (because it is disregarded for tax purposes), as a partnership, or a subchapter S corporation, both the debtor's share of the income of the entity and the character of the income being generated by the entity will pass through to the creditor. If the entity is a subchapter C corporation, its distributions will be taxed to the debtor as dividends.
If distributions are not being made to the creditor and if the entity is taxed as a sole proprietorship, partnership or subchapter S corporation, the creditor is still taxed on its share of the income of the entity, causing the creditor to generate phantom income. If the entity is a subchapter C corporation, the creditor will not be taxed on the income of the entity until it is distributed.
As a practical matter, creditors rarely chose to pursue charging orders. A charging order is not a very effective debt collection tool. The creditor may find itself holding a charging order, without any ability to determine when the judgment will be paid off. Practitioners should remember that any uncertainty surrounding charging orders is uncertainty for both the debtor and the creditor. This uncertainty forces most creditors to settle the judgment with the debtor, on terms more acceptable to the debtor, rather than pursue the charging order remedy.
Printed with Permission from E. Alan Tiras, Esq.
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The 2007 Nevada Legislature passed SB 242 which adopts Charging Order protection for small corporations. In pertinent part, Section 43.5 of SB 242, which became effective on July 1, 2007, provides:
1. Chapter 78 of NRS is hereby amended by adding thereto a new section to read as follows:
1. On application to a court of competent jurisdiction by a judgment creditor of a stockholder, the court may charge the stockholder's stock with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the stockholder's stock.
2. This section:
(a) Applies only to a corporation that:
(1) Has more than 1 but fewer than 75 stockholders of record at any time.
(2) Is not a subsidiary of a publicly traded corporation, either in whole or in part. (3) Is not a professional corporation, as defined in NRS 89.020.
(b) Does not apply to any liability of a stockholder that exists as the result of an action filed before July 1, 2007.
(c) Provides the exclusive remedy by which a judgment creditor of a stockholder or an assignee of a stockholder may satisfy a judgment out of the stockholder's stock of the corporation.
(d) Does not deprive any stockholder of the benefit of any exemption applicable to the stockholder's stock.
(e) Does not supersede any private agreement between a stockholder and a creditor. This innovative piece of legislation effectively echoes the Charging Order protection rules for Nevada partnerships and limited-liability companies and provides that the Charging Order is the exclusive remedy available to judgment creditors of small corporation stockholders. This "outside-in" form of asset protection benefits ALL shareholders from a judgment creditor to any one of them.
Ref1: In re: Ashley Albright, No. 01-11367 (Bkrptc. D. Col. 04/04/2003), United States Bankruptcy Court for the District of ColoradoNevada Corporations Provide the Same Protection from Liability as Partnerships or LLC's