LLC Protection for Members' Personal Debt in California
In California, like in most states, the general rule is that the money or property of an California 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 a California 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 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 varies state by state. This article will look at what type of actions creditors of LLC owners are allowed to take against an LLC in California.
California, like all states, permits personal creditors of an owner of an California LLC to obtain a charging order against the debtor-owner’s membership interest. 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 California 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 so they usually are not a very effective collection tool for creditors.
Example: The collection agency obtains a charging order from an California 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.
In California, a creditor who obtains a charging order but is not paid by the LLC can have the court order that the debtor-owner’s LLC membership interest be foreclosed upon. Changes to California's LLC law that take effect in 2014 provide that in order to get a court to order such a foreclosure, the creditor must show that the debtor-owner will not be able to pay the debt within a reasonable time--for example, because the LLC's earnings have continually been withheld for reinvestment instead of distributed to its members. Thus, depending on the circumstances, the creditor must wait some period of time before foreclosure can be ordered.
What happens if the debtor-member's LLC interest is foreclosed upon? The court will order that the debtor's financial rights in the LLC be sold. They would likely end up in the hands of the creditor, since it's doubtful anyone else would want to purchase these rights at the foreclosure sale. If this occurs, the creditor becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC. However, the creditor cannot participate in the management of the LLC. Thus it can’t force the LLC to pay money to it or anyone else. It’s quite possible, however, that before any such foreclosure occurred, the debtor-member and/or other LLC members would settle the debt with the creditor. If they don't, the debtor-member will never be able to obtain any financial benefits from the LLC--for example, if the LLC is later dissolved, the debtor-member will not be entitled to any share of the company's assets. A creditor’s ability to foreclose upon an LLC membership interest puts a California LLC owners’ personal creditors in a stronger bargaining position than creditors have under the LLC laws of many other states where their remedies are limited to a charging order.
Example: The collection agency obtains a $38,000 judgment against John, co-owner of the web design LLC, for his unpaid credit card debts. The agency obtains a charging order from a California court ordering the LLC to pay over to it any profits it distributes to John up to $50,000. However, the LLC need not, and does not, make any distributions, so the agency gets nothing. The agency then obtains a court order for the foreclosure on John’s interest in the LLC. To avoid this, the LLC settles John’s personal debt with the agency for $38,000.
Like most states, California does not permit personal creditors of an LLC member to have a court order that the LLC be dissolved and its assets sold to pay off the creditor.
What About Single Member California 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.
To date, California has not made a distinction in how it handles cases involving single and multi-member LLCs. Thus, it appears that creditors of California SMLLCs are limited to the remedies described above. However, it's possible that a California court would do what a growing number of courts in other states have done and apply a different rule for SMLLCs, particularly in a case where the SMLCC owner files for personal bankruptcy.
Because of the uncertainty regarding SMLLCs, an LLC should have at least two members if you are concerned about liability protection from personal creditors. The second owner 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 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 California even if it is where you live or do business. You can form an LLC in any state--for example, even though your business is in California, you could form an LLC in Wyoming to own and operate it because it has more favorable LLC laws. However, there is no guarantee that the courts of California or other states where your LLC does business will apply the laws of the state where you formed your LLC instead of another state's LLC laws. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer if you are considering forming your LLC in another state with more favorable LLC laws.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.