LLC Protection for Members' Personal Debt in Alabama

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In Alabama, like in all states, the general rule is that an Alabama limited liability company's ("LLC’s") money or property cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.

Example: Larry and LaVerne have formed an Alabama LLC called Mobile Flowers, LLC, to operate their flower shop business in Mobile. The business has been quite successful and has $50,000 in its own bank account. Unbeknownst to Larry, LaVerne has a gambling problem and owes $100,000 to the Lady Luck Casino. While the casino can attempt to collect its debt from LaVerne’s personal assets, such as her personal bank accounts and personal property, it cannot take money or property owned by J&J to satisfy Laverne’s personal gambling debts--for example, it cannot get any of the money held in the LLC’s bank account.

However, there are other steps personal creditors of an LLC owner might try to take to collect against the LLC. These include:

  • obtaining a charging order requiring that the LLC pay the creditor all the money due from the LLC’ to the debtor-owner
  • foreclosing on the debtor-owner’s LLC ownership interest, or
  • getting a court to order the LLC dissolved and all its assets sold.

The laws on what creditors are allowed to do vary state by state. In some states, a charging order is the exclusive remedy for personal creditors of an LLC owner. The rationale for limiting a creditor’s remedies to a charging order is to protect the other LLC owners from having an outside creditor step into the shoes of the debtor member and share in the management and control of the LLC. In other states, charging orders are allowed but creditors are either expressly allowed to foreclose on their debt or seek dissolution of the LLC, or the law is silent as to what other remedies creditors can pursue. 

This article will look at what type of actions a personal creditor of an LLC owner is allowed to take against an LLC in Alabama.

Charging Order- The Exclusive Remedy

Alabama’s LLC law expressly provides that a charging order is the only legal procedure that personal creditors of Alabama LLC members can use to get at their LLC ownership interest. Thus, unlike some other states, Alabama does not permit an LLC owner’s personal creditors to foreclose on the owner’s LLC ownership interest or get a court to order the LLC dissolved and its assets sold. This makes Alabama a particularly friendly state for people who want to form LLCs to protect assets from personal creditors.

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. But if there are no distributions, the creditor gets nothing. Alabama law makes clear that the creditor only gets 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.

Example: The Lady Luck Casino gets an Alabama court to issue a charging order in the amount of $100,000 against LaVerne’s 50% ownership interest in the Mobile Flowers LLC. This means that any distributions of money or property the LLC would ordinarily make to LaVerne must be given to the Casino instead until the entire $100,000 is paid. However, if no distributions are made, the creditor gets nothing.

What About Single-Member Alabama LLCs?

The reason personal creditors of individual LLC owners are limited to a charging order is to protect the other members (owners) of the LLC. It doesn’t seem fair that they should suffer because a member incurred personal debts that had nothing to do with their LLC. Thus, personal creditors are not permitted 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. This rationale disappears when the LLC has only one member (owner). As a result, the LLC laws and court decisions in some states make a distinction between multi-member and single-member LLCs ("SMLLCs") and don't limit personal creditors of owners of SMLLCs to the charging order remedy.

However, Alabama is not one of these states. Alabama's LLC law makes no distinction between multi-member and single-member LLCs. Thus it appears that creditors of Alabama SMLLCs are limited to the charging order remedy described above.

Nevertheless, it is possible that in some cases the laws of another states might be applied--for example, where an Alabama SMLLC does business or owns property in another state. In addition, the protections that state laws provide to SMLLCs can be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.

One way to avoid the potential liability problems that exist with SMLLCs is to add members to your LLC. However, any members you add must be legitimate co-owners of the LLC. If the additional LLC owner is 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 owned.

October 2012

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