LLC Protection for Members' Personal Debt in Arizona
In Arizona, like in most states, the general rule is that the money or property of an Arizona limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Meghan, and Louis form an Arizona LLC to operate their website design business. John, a big spender, owes $38,000 on his personal credit cards. When he doesn’t pay, the accounts are turned over to a collection agency which obtains a $38,000 court judgment against him. While the collection agency can attempt to collect on the debt from John’s personal assets, it cannot take money or property owned by the LLC. For example, it cannot get any of the money held in the LLC’s bank account.
Even though creditors can’t collect directly from an LLC for an owner’s personal debts, there are other ways creditors might try to go after the LLC for the owner’s personal debt. These include:
1) obtaining a charging order requiring that the LLC pay the creditor all the money distributed to the debtor-owner
2) foreclosing on the debtor-owner’s LLC ownership interest, or
3) getting a court to order the LLC to be 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, in addition to obtaining a charging order, 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 are available.
This article will look at what type of actions creditors of LLC owners are allowed to take against an LLC in Arizona. To see the rules about personal creditor’s rights against LLC owners in other states, see Single-Member LLCs and Asset Protection: A 50-State Guide.
Charging Order -- The Exclusive Remedy
Arizona’s LLC law says that the charging order is the only legal procedure that personal creditors of Arizona LLC members can use to get at an owner’s LLC interest. Thus, unlike some states, Arizona does not permit an LLC owner’s personal creditors to foreclose on the owner’s LLC financial interest or get a court to order the LLC dissolved and its assets sold. This makes Arizona a more friendly state for people who want to form LLCs to protect their 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. Like most states, creditors with a charging order in Arizona 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 because they can’t order any distributions. Thus, they are not a very effective collection tool for creditors.
Example: The collection agency obtains a charging order from an Arizona court ordering the website design LLC to pay to it any distributions of money or property the LLC would ordinarily make to John until the entire $38,000 judgment is paid. However, if there are no distributions, there will be no payments.
The charging order remedy without any right to order distributions is so weak many creditors don’t even try to use it.
What About Single-Member Arizona 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. By making a charging order the exclusive remedy, personal creditors can't 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. This rationale about protecting other LLC owners 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.
Arizona's LLC law makes no distinction between multi-member and single-member LLCs. Thus, it appears that creditors of Arizona SMLLCs are limited to the charging order remedy described above. However, even when the LLC law states that charging orders are the exclusive remedy, courts in some states have applied a different rule for SMLLCs, particularly in cases where the SMLLC owner has filed for personal bankruptcy. It's possible that an Arizona court would do the same with SMLLCs in Arizona. It is also possible that in some cases the laws of another state would be applied to an Arizona LLC--for example, where an Arizona LLC does business or owns property in another state.
To obtain the fullest limited liability possible in all states, an Arizona LLC should have at least two members. The second member must be 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.