What Is a Delaware Charging Order?
One of the main goals that entrepreneurs have when forming a Delaware limited liability company is asset protection. Sophisticated entrepreneurs understand Delaware LLCs are spectacular for protecting an owner’s personal assets from business liabilities when the business gets sued.
But what happens when the inverse occurs? What happens when an LLC owner gets personally sued apart from the business? That’s where the Delaware charging order comes into play.
Picture this: A business owner gets sued for a car accident where the insurance company denies liability coverage. The injured party brings a multi-million dollar lawsuit and wins against the business owner who caused the accident. That victim is now a judgment creditor. To collect on the judgment, the creditor asks questions of the business owner in post-judgment discovery. Furthermore, to collect on the judgment, the creditor seeks to attach the assets of the business owner who is the defendant debtor.
For example, what if the business owner has an LLC that manufactures top-notch cat litter? How does their ownership interest in the cat litter business become an asset available to the judgment creditor? Can the accident victim take over the cat litter business due to individual negligence while the owner drives a personal vehicle on a personal trip? Interestingly, entrepreneurs who use Delaware LLCs can protect their companies from these personal creditors.
If a business owner is personally sued and loses, the business owner’s LLC interest may be subject to attachment by the judgment creditor if the business was not formed as a Delaware LLC. A Delaware LLC is unlike the LLC of most states. By statute, a Delaware LLC limits the creditor to just a single remedy, to collect on a business owner’s interest in an LLC. This charging order is built as a firewall that protects personal assets from business risks.
Under Delaware law, a charging order prevents the “reverse pierce” of the corporate veil. This is a specialized shield for LLC defense, protecting and preventing personal creditors from foreclosing on the ownership interest of a business owner. This prevents a judgement creditor from liquidating an entire business.
What Is a Delaware Charging Order & How Does It Protect an LLC?
A charging order is a legal mechanism built into the Delaware LLC Act under section 18-703. This specific business tool is a specialized, court-issued legal claim that is only a lien placed directly onto an individual’s financial interest in an LLC to allow for dividends that are declared to be paid to the creditor until that creditor is paid in full, without a foreclosure. It is up to the management to declare a dividend.
That business owner is often himself the judgment debtor who is looking to “starve out” the judgment creditor. Knowing the creditor will recover little to nothing from a charging order often deters the creditor from trying to use it; Instead they pursue other judgment collection strategies. The charging order limits a creditor’s legal claims and focuses solely on their economic rights to distributions from the company. It allows the charging order holder to receive any cash distributions if and when they are paid to the debtor by the LLC.
As a matter of fact, a charging order only gives a creditor economic status in an organization without voting rights. In other words, the holder receives only the specific passive financial rights assigned to them. They do not become an official member in the company. Because they are not legally owners, they gain no management rights, no voting power in company decisions, no access to the company’s internal books, and no power to force a cash distribution.
Furthermore, charging orders separate an owner’s personal legal judgment from the actual daily operations of the business. It prevents creditors from seizing physical company equipment, raiding company bank accounts, or forcing a liquidation of the business. If the debtor owner of the LLC decides to reinvest all company profits back into the business rather than collecting the cash for themselves, the creditors may walk away completely empty handed.
Ultimately, this leaves the cat-litter LLC completely insulated from the personal debts of its owner. This is two-way liability protection not found in most states outside Delaware.
What Are the Limitations of Charging Order Protection?
While charging orders are amazing in many aspects, blindly relying on them is a risky move for business owners. Their protections do have a few legal vulnerabilities that must be looked out for while forming a company.
Historically, charging order protections were created to protect innocent co-owners from being forced into business with a stranger. This is under the principle known as “pick your partner”. In this sense, the charging order can protect a multi-owner cat litter business from being forced into a partnership with an aggressive creditor who wants to sell the entire cat litter factory. In Delaware, this charging order protection also extends to a single-member LLC.
How Does This Impact Taxes?
To clarify from the start, an LLC defaults to a pass-through entity for tax purposes. This means profits and losses avoid being taxed at the corporate level and end up directly on the owners’ Schedule K-1 tax forms. This is where charging orders turn into a legal convolution due to their interaction with federal tax law under IRS Revenue Ruling 77-137.
Under IRS guidelines, an individual who holds an economic right to an LLC’s profits risks being treated as a substituted partner for tax reporting purposes. Their share of the entity’s taxable income is reportable to the IRS whether or not that cash was actually distributed to them in real life.
This creates a risk known as “phantom income.”
Imagine your Purrfect Litter LLC earns $363,000 in net profit this year selling premium odor-control litter. As the manager, you decide to give out $0 in cash payouts to your owners. Instead, the money is kept inside the company’s bank account. Under Revenue Ruling 77-137, the IRS can still expect that $363,000 of taxable income to be reported by the holder of economic interest in the company. Due to the Delaware charging order being in effect, the creditor is arguably the one who is liable to report taxable income.
This leaves the creditor to risk receiving a Form K-1 on taxable income not received. Sometimes the creditors are forced to pay income tax out of their own pockets based on profits they never actually touched.
The phantom income problem often discourages creditors from seeking a Delaware charging order.
The Takeaway
The charging order statute in Delaware is historically one of the strongest asset protection laws in the United States. It helps keep things predictable and safe for multi-member businesses, real estate tycoons, and other startups looking for ways to protect their company operations from the personal liabilities of its members. It even works in Delaware with single-member LLCs.
Overall, a Delaware LLC remains an amazing safehouse that turns an owner’s personal problems into a waiting game that personal creditors cannot afford to win. Protecting your own legal liability and safeguarding your business.