LLC Protection for Members' Personal Debt in Illinois
In Illinois, like in most states, the general rule is that the money or property of an Illinois limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Vic, and Bruno form a Illinois LLC to operate their construction 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 Illinois.
Illinois, like all states, permits personal creditors of an owner of an Illinois 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 Illinois 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 Illinois court ordering the Illinois 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 Illinois, a creditor who obtains a charging order can have the court order that the debtor-owner’s LLC membership interest be foreclosed upon. 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-owner and/or other LLC members would settle the debt with the creditor. If they don't, the debtor-owner will never be able to obtain any financial benefits from the LLC--for example, if the LLC is later dissolved, the debtor-owner will not be entitled to any share of the company's assets.
A creditor’s ability to foreclose upon an LLC membership interest can put an Illinois creditor 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 Illinois LLC, for his unpaid credit card debts. The agency obtains a charging order from a Illinois court ordering the LLC to pay over to it any profits it distributes to John up to $38,000. 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 $30,000.
Like most states, Illinois 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 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 same remedies as multi-member LLCs. To date, Illinois has not made a distinction in how it handles cases involving single and multi-member LLCs.
However, just because you form your LLC in Illinois doesn't necessarily mean that Illinois LLC law will always apply. It's possible that in some cases the LLC laws of other, less debtor-friendly, states would apply--for example, where an Illinois LLC does business or owns property in another state. In addition, the protections state LLC laws provide to LLCs may be ignored by the federal bankruptcy courts if a SMLLC owner files for bankruptcy.
To obtain the fullest limited liability protection from personal creditors in all states, an LLC should have at least two members. The second owner can be a spouse or relative, provided the second member 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.
Should You Consider Forming Your LLC in Another State?
You do not have to form your LLC in Illinois even if it is the state where you live or do business. You can form an LLC in any state--for example, even though your business is in Illinois, you could form an LLC in Nevada because it has a more favorable LLC law. Doing so will not save you Illinois state taxes because your LLC will have to qualify to do business in Illinois and pay the same taxes as a Illinois LLC. However, the formation state’s LLC law will govern your LLC. Thus, forming an LLC in a state with a favorable LLC law could provide you with more limited liability than forming it in your home state.
So, should you shop around for the state that provides the most limited liability to LLC owners? If limiting liability is extremely important to you and your state has an unfavorable law, you may want to consider forming your LLC in another state. However, there are other factors you should consider as well, such as how much it costs to form an LLC in the other state. Moreover, there is no guarantee that Illinois courts will always apply the law of the state where you formed your LLC. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer for more information.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.