Colorado law does not provide limited liability companies (“LLCs”) with as much protection from member’s personal creditors as do many states. In many states, the rule is that an LLC’s money or property cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners. Instead, creditors of LLC owners are limited to obtaining a charging order against the LLC. A charging order is an order issued by a court directing an LLC’s manager to pay to the debtor-owner’s personal creditor any distributions of income or profits that would otherwise be distributed to the debtor-member. Creditors with a charging order only obtain the owner-debtor’s “financial rights” and cannot participate in the management of the LLC. Thus, the creditor cannot order the LLC to make a distribution subject to its charging order. Very frequently, creditors who obtain charging orders end up with nothing.
Colorado allows creditors of LLC members to obtain a charging order to collect on a judgment obtained against an LLC member. However, Colorado LLC law does not provide that a charging order is the exclusive remedy for personal creditors of LLC members. Under Colorado law, creditors also can foreclose on a member's LLC interest. If this occurs, the creditor becomes the assignee and permanent owner of all the debtor-member’s financial rights. Although the creditor does not obtain LLC management rights in a foreclosure, the ability to foreclose and permanently own all the debtor's financial interest in the LLC puts a Colorado creditor in a stronger bargaining position than creditors in many other states where their remedies are limited to a charging order.
Special Rule for Single-Member LLCs
The reason many LLC state laws limit the remedies available for personal creditors of LLC owners to a charging order is to protect the other members (owners) of the LLC from personal debts of other members that are unrelated to the LLC and its business. LLC laws typically prevent personal creditors of an LLC member from being able to take over the debtor-member’s LLC interest and join in the management of the LLC or have the LLC dissolved and its assets sold without the other members’ consent. With a single member LLC ("SMLLC"), the rationale for limiting creditors' remedies disappears because there are no other LLC members to protect. As a result, in some states, personal creditors of owners of SMLLCs have been allowed to exercise remedies not available to creditors of multi-member LLCs.
Colorado is one of the states where a court in a bankruptcy case ruled that SMLLCs should be treated differently than multi-member LLCs. In that case, the banckruptcy court allowed the assets of a single-member LLC to be used to pay the personal creditors of a debtor-member who filed for personal bankruptcy (In re Albright, 291 B.R. 538, Bankr. D. Colo. 2003). The court reasoned that the charging order protection provided to LLCs under Colorado law should not apply in a SMLLC case where the only LLC member is the debtor.
Because of the uncertainty about SMLLC liability protection in Colorado and other states, an LLC should have at least two members for better liability protection. The second owner can be a spouse or relative, provided the second member is treated as a legitimate co-owner of the LLC. If the second owner is added merely on paper as a sham, the courts will likely treat the LLC as a single-member LLC. To avoid this, the co-owner must pay fair market value for the interest acquired and otherwise be treated as a "real" LLC member--that is, receive financial statements, participate in decision making, and receive a share of the LLC profits equal to the membership percentage.
Should You Consider Forming Your LLC in Another State?
You do not have to form your LLC in Colorado even if it is the state where you live or do business. You can form an LLC in any state--for example, even though your business is in Colorado, you could form an LLC in Nevada to own and operate it. Doing so will not save you Colorade state taxes because your LLC will have to qualify to do business in Colorado and pay the same taxes as any other LLC. However, forming an LLC in a state with more favorable LLC laws could provide you with more limited liability than forming it in Colorado.
Should you shop around for the state that provides the most limited liability to LLC owners? If limiting liability is extremely important to you and your state has an unfavorable law, you might consider forming your LLC in another state. However, there are other factors you should consider as well, such as how much it costs to form an LLC in the other state. Moreover, there is no guarantee that Colorado courts will apply the laws of the state where you formed your LLC instead of the less favorable Colorado LLC laws. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer for more information.
For more information on LLCs and the limited liability protections they offer in other states, see Limited Liability Protection and LLCs: A 50-State Guide.