LLC Protection for Members' Personal Debt in Colorado
Last updated: 2/12/2016
This article covers what actions judgment creditors can take against a limited liability company (LLC) for a member’s personal debt under Colorado law. State laws on creditor rights against an LLC vary, with some more debtor-friendly states providing more protection from creditors for an LLC and its owners than other states. Colorado law gives LLCs much less protection from LLC member’s personal creditors than that of many other states.
Creditors Not Limited to Charging Orders
In many states, the general 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 obtain a charging order against the LLC. A charging order is an order issued by a court directing the LLC to pay to the debtor-owner’s personal creditor any distributions of income or profits that would otherwise be distributed to the debtor-member. But if there are no distributions, the creditor gets nothing. In most states, 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. Frequently, creditors who obtain charging orders against LLCs end up with nothing because they can’t order any distributions and the LLC can choose not to make any.
Like all states, Colorado allows creditors of LLC members to obtain a charging order to collect on a judgment obtained against an LLC member. But, unlike many less creditor-friendly states, Colorado also allows a creditor with a charging order to have a court appoint a receiver to oversee the profits or other money due or to become due to the debtor-member. The receiver can access the LLC’s financial records to ensure that no money is paid to the debtor-member without the creditor knowing about it.
In addition, unlike many states, Colorado’s LLC law does not provide that a charging order is the exclusive remedy of LLC members’ personal creditors. Rather, it allows a creditor to foreclose on the debtor-creditor’s LLC interest. Under this procedure, a court can order that the debtor-member’s financial rights in the LLC be sold. The buyer at the foreclosure sale—often the creditor—becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC or obtain a share of the LLC’s assets if it is dissolved.
A creditor’s rights over a Colorado LLC member-debtor don’t necessarily end with foreclosure. Colorado’s LLC law gives courts broad flexibility to issue orders necessary under the circumstances to enforce a creditor’s judgment against an LLC member. This means that a creditor might be able get a court to order that an LLC member-debtor surrender or assign his or her entire interest in the LLC to the creditor. This way, the creditor would become the full owner of the interest—that is, obtain the debtor’s management rights in the LLC as well as financial rights to receive distributions. As a practical matter, getting a member-debtor’s LLC interest foreclosed upon or assigned could be an expensive and difficult undertaking; but, the ability to do so gives a creditor more leverage in dealing with the debtor.
The reason personal creditors of individual LLC owners are limited to a charging order (in most states) or foreclosure of the debtor-owner's interest is to protect the other members of the LLC. It doesn’t seem fair that other LLC members should suffer because one member incurred personal debts that had nothing to do with the LLC. This rationale, however, disappears when the LLC has only one member. As a result, court decisions in some states—including Colorado—make a distinction between multi-member and single-member LLCs (SMLLCs). In a Colorado bankruptcy case, the court held that when the sole member and manager of an SMLLC files for bankruptcy, the member’s entire LLC interest becomes the property of the bankruptcy trustee who may sell it to pay off creditors. (In re Albright, 291 BR 538 (D. CO 2003)).
If you are really concerned about protecting the assets in your Colorado SMLLC against personal creditors, you should consider adding another member to your LLC. If you decide to do this, the second member must be 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 an SMLLC. 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 owned.
Should You Consider Forming Your LLC in Another State?
All of the foregoing makes Colorado one of the least attractive states in which to form an LLC as far as protection from personal creditors goes. However, 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 Colorado state taxes because your LLC will have to qualify to do business in Colorado and pay the same taxes as any other LLC. Indeed, your costs will increase because you’ll have to pay the fees to form your LLC in Nevada plus the fees to register to do business in Colorado. However, as a general rule, the formation state’s LLC law will govern your LLC. Thus, forming an LLC in a state with a favorable LLC law could provide you with more limited liability than forming it in Colorado.
So should you shop around for the state that provides the most limited liability to LLC owners? If limiting liability is extremely important to you, you may want to form your LLC in a state like Nevada, Delaware, or Wyoming that have very debtor-friendly LLC laws. However, there is no guarantee that Colorado or other courts in other states will always apply the law of the state where you formed your LLC, rather than the less favorable Colorado LLC law. 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, see Limited Liability Protection and LLCs: A 50-State Guide.