Creditors Can Claim Income from LLC Interest
By Wayne M. Pecht, CPA, LLM
Pennsylvania Superior Court gave creditors another avenue for collecting debt with its December 2008 decision in Zokaites v. Pittsburgh Irish Pubs LLC and its interpretation of the Pennsylvania Limited Liability Company Law’s limiting of the rights of a creditor to satisfy a judgment against a member of a limited liability company.1
Before the issue was appealed to the Superior Court, the creditor in Zokaites had obtained a judgment against Pittsburgh Irish Pubs LLC and attempted to collect his judgment by presenting to the trial court a “Motion to Compel” that requested Colm McWilliams, a member of Pittsburgh Irish Pubs, be ordered to transfer his 20.5 percent member interest in Pittsburgh Irish Pubs to the Allegheny County Sheriff for levy and sale. The trial court had granted the motion and ordered the transfer. Upon Pittsburgh Irish Pubs’ “Motion to Reconsider,” the trial court then denied the Motion to Compel.
The Superior Court placed great emphasis on the language of the Limited Liability Company Law as well as comments made during its drafting. The court concluded that a plain reading of Section 8924 directs that “a membership interest in a limited liability company encompasses both economic rights (flow-through of monies and tax consequences) and governance rights (participation in the management of the business).”2 Unless there is a unanimous agreement otherwise, a member is only permitted to freely transfer his economic rights. The transfer of a member’s economic rights to a creditor entitles that creditor to receive the distributions and return of contributions that the debtor member would ordinarily receive. The court went on to say that while a transfer of the debtor member’s “actual certificates and rights to participate in the management” of Pittsburgh Irish Pubs would not be appropriate, the proper remedy is for the plaintiff to seek a court order for the distributions and the return of contributions that would otherwise be the property of the debtor member.3
The court did not order the outright transfer of the member’s interests, but its ruling in Zokaites gives creditors an avenue to enforce a judgment against a debtor member of an LLC. In accordance with the decision, a creditor may seek a court order to collect the distributions and the return of contributions to which the debtor member would ordinarily be entitled, but not the actual governance rights. Many times, LLC operating agreements provide minimum distributions to members to pay taxes. That is, the LLC will typically distribute money so members can cover their income tax liability. Now, a creditor can collect those distributions. The debtor/owner, however, will still bear the tax consequences of the imputed income, perhaps creating an unfunded tax liability. The creditor, however, seems only entitled to distributions that the member would have otherwise received. The creditor does not have a right to force a distribution.
In accordance with the definition of “interest” in 415 Pa. C.S.A. 8924(a), operating agreements should still be drafted to restrict and prohibit the transfer or assignment of all member rights, both governance rights and economic rights, unless unanimous consent is obtained from all LLC members. Under the terms of the operating agreement, members should be able to decide when to take distributions and when to defer them. A judgment creditor would not be able to influence this decision or force a distribution of funds since it does not have voting rights. The deferment of distributions, however, cannot continue indefinitely, and it may result in unfavorable tax consequences. A deferment could actually result in the LLC being “… deemed to have made distributions even though the LLC has not actually paid the distributions to the members. The members will then be liable for tax on distributions they did not actually receive.”4
The court did say a member who has a nonapproved transfer maintains the rights to participate in management, including the rights to vote, obtain information, and compel dissolution of the company, and that none of those rights will be available to a judgment creditor. However, prudent action demands that any operating agreement clearly address the limitations of judgment creditors in situations where there is not unanimous approval by members or there is a court order. An operating agreement could include an indemnification provision where the member will be indemnified by the LLC. Assuming the debtor-member satisfies the conditions of the indemnification clause, the judgment creditor may seek to have the LLC distribute the funds of the indemnification amount to it.
1 962 A.2d. 1220; 15 Pa.C.S.A. Section 8901
Wayne M. Pecht, CPA, LLM, is an attorney with Pecht & Associates PC in Mechanicsburg. He can be reached at firstname.lastname@example.org.
LAST UPDATED 6/1/2010