Recent Changes - Search:
Site /

Tax Treatment Of Charging Order

Topic Tax TopicsTaxDistribution




PAGE SUMMARY

This page explains how charging orders allow judgment creditors to reach a debtor’s transferable interest in an LLC or partnership while generally limiting the creditor to economic rights (a lien on distributions) and withholding management or control; courts may appoint a receiver, permit redemption, and—if distributions are inadequate—order foreclosure, where the buyer typically acquires only the transferable interest (though single-member LLCs may allow transfer of full membership rights). It then surveys key federal tax issues for charging-order creditors and foreclosure purchasers, emphasizing that distributions received are generally treated as paid to the debtor (raising possible discharge-of-indebtedness consequences), while allocations of entity income to the creditor are uncertain because creditors often lack the “dominion and control” needed to be treated as owners for tax purposes. The paper outlines principal tax events and authorities: potential COD income in debt-for-equity exchanges measured by the fair market value of the transferred partnership interest under IRC §108(e)(8) and Treas. Reg. §1.108-8 (flowing through as ordinary income to partners, with partner-level insolvency relief under §108(d)(6)); creditor-transferee basis rules under §742 and potential §743(b) adjustments when a §754 election (or built-in loss rules) applies; capital gain/loss treatment on transfers under §741 subject to §751 ordinary-income recharacterization for “hot assets”; liability-share changes and resulting deemed distributions under §752 (with possible gain under §731); and creditor information-reporting duties for foreclosures under §6050J. Finally, it highlights practical timing and compliance considerations, including tracking liability shifts and basis adjustments.

Charging Orders And Taxable Distributions

Overview

Despite a wealth of misinformation about the subject found on the Internet, taxable distributions in the charging order context are quite simple:

  • Creditor Holds A Charging Order Lien: Even though the creditor gets the economic distribution, the taxable distribution goes to the debtor/member who gets to pay it (and not the creditor).
  • Charging Order Lien Has Been Foreclosed: The purchaser at the judicial sale of the debtor/member's (now-former) interest becomes an assignee of the interest (albeit an involuntary assignee with no management, voting or information rights, etc.), and thus the taxable distributions go to the purchaser.

Introduction

A charging order is the exclusive judicial remedy by which a creditor may reach a debtor’s transferable interest in an LLC or partnership to satisfy a judgment. It constitutes a lien on the debtor’s interest, entitling the creditor to distributions the debtor would otherwise receive but not to management rights or control of the entity. The court may appoint a receiver to collect distributions subject to the charging order and, if distributions will not satisfy the debt within a reasonable time, may order foreclosure of the lien. The purchaser at a foreclosure sale acquires only the transferable interest and typically does not become a member or partner or gain the power to participate in management without consent of other members or partners. Redemption of the charged interest before foreclosure is generally permitted by the judgment debtor or by other members or partners with necessary consents. In single-member LLCs, foreclosure may transfer full membership rights to the purchaser, dissociating the original member.

Regarding federal tax consequences, a creditor’s receipt of distributions under a charging order is generally viewed as payment to the debtor, who may have income from discharge of indebtedness. However, allocations of partnership or LLC income and deductions to a creditor assignee are uncertain and depend on whether the creditor qualifies as a real owner under federal law—often requiring control and dominion over the interest, which charging order creditors typically lack. Foreclosure purchasers, as assignees, may face similar limitations. Income items are ideally taxed to the debtor partner or member, with the creditor treated as a recipient only to the extent of distributions received, potentially returning capital or ordinary income (e.g., interest) to the creditor 9 LACIVL § 1:44. The partnership interest basis and recognition of gain or loss on foreclosure or sale are governed by general partnership tax principles, including applicable Section 751 and Section 704 regulations SECTAXAHB § 2A:5.

Creditors holding charging orders against partnership or LLC interests, and purchasers acquiring such interests at foreclosure auctions, face several distinct federal tax consequences. The primary tax events include: (1) potential discharge of indebtedness income to the partnership when interests are transferred to creditors in satisfaction of debt, measured at fair market value under IRC Section 108(e)(8); (2) cost basis determination for creditors under IRC Section 742; (3) capital gain or loss treatment under IRC Section 741, except for portions attributable to unrealized receivables and inventory items under Section 751; (4) deemed distributions from liability adjustments under IRC Section 752; and (5) information reporting obligations under IRC Section 6050J for foreclosure transactions.

Tax Consequences for Partnerships Transferring Interests to Creditors

When a partnership or LLC transfers an interest to a creditor in satisfaction of debt, Treasury Regulation Section 1.108-8 provides that "for purposes of determining income of a debtor from discharge of indebtedness (COD income), if a debtor partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of its recourse or nonrecourse indebtedness (a debt-for-equity exchange), the partnership is treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the partnership interest." IRS TD 2011-51 I.R.B. 855. This discharge of indebtedness income is includible in gross income under IRC Section 61(a)(11) and flows through to the partners as part of their distributive share of partnership gross income under IRC Section 61(a)(12). 26 USCA § 61.

The Tax Court in Kohn v. Commissioner confirmed that "Income realized by a partnership under section 61(a)(12) must be recognized by the partners as ordinary income under section 702(a)(8). See Gershkowitz v. Commissioner, 88 T.C. 984, 1008–1009 (1987). The recognition of such income provides each partner with an increase in the adjusted basis in his partnership interest under section 705." Kohn v. Commissioner of Internal Revenue, T.C. Memo. 2017-159 (2017). The Tax Court noted that the recognition of discharge of indebtedness income provides each partner with an increase in the adjusted basis in their partnership interest.

Under current law, IRC Section 108(d)(6) provides that the insolvency exception applies at the partner level, not the partnership level. This means individual partners may exclude their distributive share of discharge of indebtedness income if they are personally insolvent, regardless of the partnership's financial condition. Each partner must separately determine whether they qualify for exclusion under IRC Section 108(a)(1)(B) based on their individual solvency.

Basis Determination for Creditor-Transferees

Creditors acquiring partnership or LLC interests through foreclosure or charging order enforcement obtain their basis under IRC Section 742, which provides that "the basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O (sec. 1011 and following)." 26 USCA § 742. This typically results in a cost basis equal to the amount paid or the fair market value of the interest at acquisition, providing creditors with a stepped-up basis compared to the original partner's adjusted basis.

Under IRC Section 743(b), if the partnership has a Section 754 election in effect or has a substantial built-in loss, the creditor-transferee may receive a special basis adjustment to partnership property. 26 USCA § 743. The IRS Chief Counsel Advice in CCA 201726012 explains that "basis adjustments required by § 743(b) constitute an adjustment to the basis of partnership property with respect to the transferee only; importantly, such adjustments are segregated and allocated solely to the transferee partner for whom the adjustment is made." IRS CCA IRS CCA 201726012.

Character of Gain or Loss on Partnership Interest Transfers

IRC Section 741 governs the character of gain or loss recognition, stating that "in the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items)." 26 USCA § 741. This capital asset treatment applies to both the transferring partner and generally to creditors who subsequently dispose of acquired interests.

However, IRC Section 751 creates an exception for portions of the partnership interest attributable to unrealized receivables and inventory items, which are treated as ordinary income or loss. 26 USCA § 751. Proper characterization of the transaction requires careful analysis of all elements of the transfer, including whether multiple tax consequences may arise from a single economic transaction.

Liability Adjustments and Deemed Distributions

IRC Section 752 creates significant consequences for both transferring partners and creditor-transferees through liability adjustments. Section 752(b) provides that "any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership." 26 USCA § 752. Conversely, Section 752(a) treats increases in liability shares as deemed contributions. 26 USCA § 752.

The Sixth Circuit in Babin v. Commissioner illustrated these consequences when it held that "because petitioner was insolvent at the time the Partnership received $2,420,019 in income as a result of Cleveland Trust's agreement to forgive that amount, petitioner did not receive his distributive share of that taxable income of the Partnership. ... Since petitioner did not receive any taxable income, there was no distributive share of taxable income of the Partnership within the meaning of 26 U.S.C. § 705(a)(1)(A) which would have entitled petitioner to increase the adjusted basis of his interest in the Partnership. Accordingly, petitioner is not permitted to increase the adjusted basis of his interest in the Partnership. ... [P]etitioner is not paying tax on the discharge of indebtedness income, but rather, he is paying tax on the deemed distribution of money as a result of the decrease in the Partnership's liability." Babin v. C.I.R., 23 F.3d 1032 (1994). Under IRC Section 731(a), partners recognize gain to the extent that deemed distributions exceed their adjusted basis in their partnership interest. 26 USCA § 731.

Information Reporting Requirements

IRC Section 6050J imposes reporting obligations on creditors who foreclose on partnership or LLC interests used as security. The statute requires "Any person who, in connection with a trade or business conducted by such person, lends money secured by property and who--(1) in full or partial satisfaction of any indebtedness, acquires an interest in any property which is security for such indebtedness" to file information returns. 26 USCA § 6050J. These returns must include the borrower's name and address, a description of the property and indebtedness, the amount of indebtedness at acquisition, and the amount satisfied. 26 USCA § 6050J.

The reporting requirements extend to governmental units, which are treated as "persons" under the statute, with the trade or business requirement waived for government entities. 26 USCA § 6050J. Creditors must also furnish written statements to borrowers by January 31 following the calendar year for which the return was made. 26 USCA § 6050J.

Practical Implications

The timing of tax recognition proves critical for both partnerships and creditors, as tax events typically occur upon completion of the foreclosure or transfer, not when charging orders are initially obtained. Creditors benefit from potential basis step-ups under IRC Section 742, which may provide advantages over the original partner's adjusted basis. However, creditors must carefully track liability adjustments under Section 752, as these can trigger unexpected deemed distributions and gain recognition under Section 731.

Partnerships should consider the discharge of indebtedness income consequences when transferring interests to creditors, particularly the flow-through of ordinary income to remaining partners. The insolvency exception provides relief at the partner level under IRC Section 108(d)(6), but requires careful analysis of each partner's individual financial condition. Administrative burdens include tracking Section 754 elections and potential Section 743(b) basis adjustments, which affect both current and future tax consequences for acquired interests.

Recent Developments

Treasury Decision 9557 (2011) implementing IRC Section 108(e)(8) continues to be the controlling guidance for debt-for-equity exchanges involving partnership interests, with specific rules for calculating discharge of indebtedness income when partnerships transfer interests to creditors. IRS TD 2011-51 I.R.B. 855. This regulation provides the framework for measuring the fair market value of transferred interests and determining the resulting tax consequences.

TAX TREATMENT ARTICLES

TAX TREATMENT OPINIONS