A Member of a South Carolina Limited Liability Company can transfer the right to receive “distributions” from the limited liability company. This transfer of a “Distributional Interest” does not entitle the transferee to become or exercise any of the rights of a Member. The transfer entitles the transferee to receive, to the extent transferred, only the distributions to which the transferor would be entitled.
Judgment creditors of a Member of a limited liability may “charge,” through a court proceeding the Distributional Interest of a Member until the Judgment is satisfied. A judgment creditor following the imposition of a charging order may also seek to have the lien imposed by the charging order foreclosed. The purchaser of the Distributional Interest at the foreclosure sale acquires the rights of a “transferee” of the “Distributional Interest.” As a “transferee” the purchaser of the “Distributional Interest” will have only the right to receive distributions with no right to vote, participate in the management of the Company or have any right to receive information on Company transactions or to inspect Company records. It is unclear whether a transferee will be subject to Company obligations such as Capital Calls.
The tax treatment of “Distributional Interests” is somewhat confusing as the holder of the “Distributional Interest” is not a Member and holds only limited rights as a “transferee”. Further, a creditor who has “charged” a debtor’s membership interest is not interested in paying taxes on distributions which are to her simply the payment of money owed (a nontaxable event).
From the Company’s point of view a Member who has transferred a “Distributional Interest” by way of a gift or as a mechanism utilized to pay a debt through a charging order or otherwise remains a Member and as such should receive a K-1.
When, however, a Judgment Creditor forecloses on a Member’s Membership following the imposition of a Charging Order the incidence of taxation changes. As stated in Rev. Rul. 77-137, 1977-1 C.B. 178 when an assignee of a membership interest irrevocably acquires the right to share in profits and losses of the Company and to receive distributions, including liquidating distributions the incidence of taxation will shift from the Member to the owner of the “Distributional Interest.”
This shift in the incidence of taxation will, as a practical matter, keep most creditors from foreclosing on a Membership Interest if the Company generates taxable income. (Because the Creditor acquires only a “Distributional Interest” with no right to vote or require the Company to make distributions the market for such interests is limited.)
In the case of a gift, if the donor assigns irrevocably to the donee the right to share in all profits and losses of the Company and the right to receive all distributions, including liquidating distributions the incidence of taxation should pass from the donor to the donee.
Please contact one of HSB’s corporate tax attorneys for more information.