The IRS gets a favorable ruling on charging orders.
A charging order creates a lien on the interest of a debtor who owns an interest in a limited liability company and an order that distributions will be paid to the creditor until the judgment is satisfied. Many states have modified their LLC laws to prevent that lien from being foreclosed and the interest sold. One of those states is New Jersey, the LLC Act of which also provides that a court may not order a debtor’s LLC interest to be foreclosed upon. But how will that stand up to an enforcement action by the IRS?
We find our answer in the opinion in U.S. v. Driscoll, Case No. 18-11762 (D.N.J., Unpublished, Jan. 6, 2025). The debtor was a dentist who owed the IRS about $475,000 in unpaid taxes. Among the debtor’s assets was his 50% interest in an LLC which encapsulated a dental practice, with the other 50% owned by another dentist who did not owe the IRS. The IRS first placed a tax lien on the debtor’s 50% LLC interest. Then, the IRS moved the U.S. District Court for the District of New Jersey to foreclose the debtor’s 50% LLC interest even though the New Jersey LLC statute prohibited that.
The debtor argued that the IRS was bound by New Jersey law which, it will be recalled, prohibited the foreclosure of a charging order lien. But the District Court disagreed, essentially ruling that the ability of the IRS to foreclose its lien under federal law, specifically 26 U.S.C. § 7403, was supreme to contrary New Jersey law. The District Court thus ordered the IRS lien on the debtor’s 50% interest in the dental practice LLC to be foreclosed.
ANALYSIS
The ruling in this case is based upon the premise that federal judgment enforcement law pre-empts state entity law, such as the New Jersey LLC statute here. Federal law allows the U.S. as a creditor to foreclose on the debtor’s property and contrary state law is irrelevant to this determination. Thus, where the U.S. is a creditor, foreclosure of an LLC interest will take place and there is nothing that a state legislature can do to prevent it.
The question then becomes, however, exactly what the U.S. as a creditor is foreclosing upon. That answer is determined by state law and under state law the debtor owns something known as a transferable interest. Sometimes also known as the economic interest or the distributional interest, what this means is that the only thing that a member owns that can be assigned (voluntarily or involuntarily) to somebody else is the member’s right to distributions.
The right to distribution has basically two components: Ongoing distributions while the entity is operating, and liquidating distributions when the entity is finally dissolved. When the interest is foreclosed upon, a judicial sale is held and the purchaser at the judicial sale obtains the right to distributions, both operating and liquidating.
What is likely to happen here if the debtor’s interest is foreclosed by the IRS? The debtor himself no longer has any incentive to keep working in the dental practice, and the non-debtor 50% other member has no incentive to do 100% of the labor to benefit the IRS. It is possible the other 50% member who is not a debtor will cause the LLC to be liquidated and divide up the hard assets with the IRS. How much second-hand dental equipment sold at auction is worth is anybody’s guess, but apparently the IRS thinks that it is worth the effort to foreclose. It is also possible that the non-debtor member will show up at the auction and try to buy the debtor’s interest on the cheap. Who knows?
Changing gears, the debtor in this case also argued that foreclosing on his 50% interest violated the due process rights of the LLC, because the LLC was not a party to the proceeding. This argument never works.
When a charging order is entered, it creates a lien on the debtor’s interest in the LLC plus an order that distributions be paid to the creditor instead. The lien element does not require that the LLC be a party. The order to pays is binding on all parties who have notice of the order, even if they are not a party to the litigation. Also, the order to pay is binding upon the debtor such that if the debtor were to receive a distribution, the debtor would have to pay it over to the creditor.
The best analogy here is to a stock share. An order that a debtor’s dividends be paid over to the creditor does not require the corporation to be a party.
Anyway, the opinion here confirms yet another exception to charging order exclusivity. There are now so many identifiable exceptions to charging order exclusivity that such exclusivity should not be presumed.
Until next time.
