LLC Protection for Members' Personal Debt in Delaware
This article covers what actions judgment creditors can take against a limited liability company (LLC) for a member’s personal debt under Delaware law. State laws on creditor rights against an LLC vary, with some more debtor-friendly states (like Delaware) providing more protection from creditors for an LLC and its owners than other states.
General Rule: LLC is Not Liable for Members’ Personal Debts
The general rule in all states is that the money or property of an LLC cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners. Similar to corporations, the money or property held in an LLC belongs to the LLC, not the member/owners individually, and may not be applied by creditors to pay a member’s individual debts. This protection from personal creditors is one of the key reasons people form LLCs. In addition to providing LLC members with personal liability protection from the LLC’s business debts, the LLC also protects the business and its owners from exposure to any debts or personal liability the other LLC members/owners may incur that are unrelated to the LLC’s business.
Delaware LLCs and Charging Orders – Exclusive Remedy
In Delaware, a charging order is the only legal procedure that personal creditors of a Delaware LLC member can use to get at a member/debtor’s LLC ownership interest. A charging order directs the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the LLC member/debtor. Like most states, creditors with a charging order in Delaware only obtain the owner-debtor’s financial rights and cannot participate in the LLC’s management.
To obtain a charging order, the creditor must have a judgment against the LLC member personally. After the judgment is entered, the creditor can apply to the court for a charging order. Since a creditor with a charging order cannot participate in the LLC’s management, it cannot order the LLC to make a distribution or that the LLC be sold to pay off the debt. 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.
Example: Larry and LaVerne form a Delaware LLC called Sports Memories LLC, to operate their sports memorabilia business in Wilmington. The business is quite successful and has $50,000 in its bank account. Unbeknownst to Larry, LaVerne has a gambling problem and owes $100,000 to the Lady Luck Casino. Lady Luck Casino gets a $100,000 court judgment against LaVerne and has a Delaware court issue a charging order in that amount against LaVerne’s 50% ownership interest in Sports Memories 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. Lady Luck can’t participate in the LLC’s management or order that any payments be made.
Although a charging order is often a weak remedy for a creditor, it is not necessarily toothless. The existence of a charging order can make it difficult or impossible for an LLC owner/debtor or the other owners (if any) to take money out of an LLC business without having to pay the judgment creditor first. To avoid this problem, the LLC owner/debtor may seek to pay off or settle the debt.
Foreclosure and Dissolution Not Allowed
Delaware’s LLC law says that the charging order is the exclusive legal procedure that personal creditors of Delaware LLC members can use to get at their LLC ownership interest. Thus, unlike some other states, Delaware 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 Delaware a particularly friendly state for people who want to form LLCs to protect assets from personal creditors.
Delaware SMLLCs and Charging Order Protection
The reason many state laws limit the remedies available for personal creditors of LLC owners to a charging order is to protect LLC members (owners) from the personal debts of other members that are unrelated to the LLC and its business. Without charging order protection, LLC members could be forced into sharing management and control of the LLC with a member's personal creditor. Charging orders avoid this outcome by giving creditors the right to distributions only.
With an SMLLC, there are no other members to protect so the rationale for limiting creditors to a charging order disappears. Recognizing this, some states have adopted special rules for SMLLCs allowing personal creditors of an SMLLC owner to take over the debtor/owner's entire SMLLC interest, not just the right to receive distributions. Other states have adopted laws specifically recognizing an SMLLC’s right to the same charging order protection afforded to multi-member LLCs.
Delaware changed its law in 2013 to make clear that the charging order protection provided to LLCs applies to both SMLLCs and multi-member LLCs. This helps make Delaware one of the most friendly states for those who want to protect their assets by forming an LLC or SMLLC.
This is an evolving area of law and different rules regarding SMLLC owner’s protection from creditors could apply in a bankruptcy. Some bankruptcy courts have held that when an SMLLC owner files for bankruptcy, the SMLLC becomes part of the bankruptcy estate and the bankruptcy trustee may dissolve it and sell its assets to pay the bankrupt owner's creditors.
If you are really concerned about protecting the assets in your SMLLC against personal creditors, you might want to consider adding another member to your Delaware LLC. This will give you more protection in the event you file for bankruptcy, or if you or your LLC become subject to the LLC laws of a state that provide less protection to SMLLCs. 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.
Will Delaware Law Apply?
It's important to keep in mind that even if your LLC is formed in Delaware, the laws of another state might apply in a creditor action against the LLC for a member/owner’s personal liability. This could occur, for example, if your LLC owns property or does business outside of Delaware, or a member/owner lives outside the state.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.