LLC Protection for Members' Personal Debt in Kansas
In Kansas, like in most states, the general rule is that the money or property of a Kansas limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Burt, and Gina form a Kansas LLC to operate their sunflower sales 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 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 Kansas.
Charging Order - Exclusive Remedy for Multi-Member LLCs
Kansas, like all states, permits personal creditors of an owner of a Kansas 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 Kansas 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 a Kansas court ordering the Kansas 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.
Foreclosure and Dissolution
Kansas’s LLC law says that the charging order is the only legal procedure that personal creditors of Kansas LLC members can use to get at an owner’s LLC interest. Thus, unlike some other states, Kansas 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 Kansas a more friendly state for people who want to form LLCs to protect their assets from personal creditors.
Creditors of SMLLCs Obtain Management Rights
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.
Kansas is one of the states that makes a distinction in the remedies available to personal creditors of multi-member and SMLLC owners. Under Kansas LLC law, personal creditors of SMLLC owners can obtain management rights to the LLC. When a SMLLC interest is assigned to a creditor, the creditor steps into the shoes of the SMLLC owner and obtains the right to participate in the management of the SMLLC (Kan. STAT. ANN. 17-76, 112). Thus, personal creditors of SMLLC owners are not limited to a charging order remedy like creditors of multi-member LLCs. Creditors of a SMLLC can obtain management rights which means they could order financial distributions or could seek to have the LLC dissolved.
To obtain the type of limited liability protection that other LLCs have under Kansas law, the LLC should have at least two members. The second member can be a spouse or relative if 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.
Should You Consider Forming Your LLC in Another State?
You do not have to form your LLC in Kansas 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 Kansas, you could form an LLC in Nevada because it has a more favorable LLC law. Doing so will not save you Kansas state taxes because your LLC will have to qualify to do business in Kansas and pay the same taxes as a Kansas LLC.
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 courts will 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.