LLC Protection for Members' Personal Debt in Alabama
In Alabama, like in all states, the general rule is that an Alabama limited liability company's (LLC) money or property cannot be directly 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. The casino sues LaVerne for the money it’s owed and obtains a $100,000 court judgment. While the casino can attempt to collect its judgment from LaVerne’s personal assets, such as her personal bank accounts and personal property, it cannot take money or property owned by Mobile Flowers, LLC to satisfy Laverne’s personal debts--for example, it cannot get any of the money held in the LLC’s bank account or take any of its property.
However, there are three other potential steps personal creditors of an LLC owner might try to take to collect against the owner’s LLC interest.
- obtaining a charging order requiring that the LLC pay the creditor all the money due from the LLC’s payments to the debtor-owner up to the amount of the judgment
- foreclosing on the debtor-owner’s economic interest in the LLC, or
- getting a court to order the LLC to be dissolved and all its assets sold.
To what extent are these allowed in Alabama?
Alabama, like all states, permits personal creditors of an owner of an Alabama LLC to obtain a charging order against the debtor-owner’s membership interest. An Alabama LLC must be served with an order by the creditor before having to honor it. 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 until the judgment is paid. But if there are no distributions, the creditor gets nothing.
Alabama law makes clear that the creditor who obtains a charging order only gets a lien against the owner-debtor’s “economic interest” in the LLC and cannot participate in the LLC’s management. 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 there are no distributions there will be no payments.
This makes the charging a weak remedy for a creditor. However, a charging order is not necessarily toothless. The existence of a charging order can make it difficult or impossible for an LLC owner-debtor to take money out of the LLC without having to pay his or her judgment creditor first. To avoid this problem, the debtor will often settle the debt.
Foreclosure and Dissolution
Alabama’s LLC law says that the charging order is the only legal procedure that personal creditors of Alabama LLC members can use to get at their LLC ownership interest. In fact, the state amended its LLC law in 2015 to make this clear by expressly prohibiting foreclosures. Thus, unlike some other states, Alabama does not permit an LLC owner’s personal creditors to foreclose on the debtor-owner’s economic interest in the LLC 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.
What About Single-Member Alabama LLCs?
The reason personal creditors of individual LLC owners are limited to a charging order or foreclosure 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 and foreclosure remedies described above.
Nevertheless, it is possible that in some cases the laws of these other states would 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 may be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.
To obtain the fullest limited liability possible in all states and in the event of bankruptcy, an Alabama LLC should have at least two members. The second member can be a spouse or relative as long as that person 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 owned.