In Kentucky, like in most states, the general rule is that the money or property of a Kentucky limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Jack, and Jake form a Kentucky LLC to operate their horse training 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 Kentucky.
Kentucky, like all states, permits personal creditors of an owner of a Kentucky 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 Kentucky 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 Kentucky court ordering the Kentucky 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 Kentucky, 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. However, the creditor cannot participate in the management of the LLC or force the LLC to make distributions.
A creditor’s ability to foreclose upon an LLC membership interest puts LLC owners’ personal creditors in a stronger bargaining position than they have under the LLC laws of states where creditors are limited to a charging order. Often, to avoid a foreclosure on the debtor/member's interest, the LLC and its members settle the debt with the creditor.
Example: The collection agency obtains a $38,000 judgment against John, co-owner of the Kentucky LLC, for his unpaid credit card debts. The agency obtains a charging order from a Kentucky 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.
The charging order and foreclosure remedies are the only remedies available to personal creditors of LLC members, Under Kentucky law, a personal creditor of an LLC member would not have the right to seek a court order to have the LLC dissolved and its assets sold to pay off the creditor.
The reason many LLC state laws limit the remedies available to personal creditors of an LLC owner is to protect the other members (owners) of the LLC from personal debts of a member 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 SMLLC owners can exercise remedies not available to creditors of multi-member LLC owners. Kentucky has not made a distinction in how it handles cases involving single and multi-member LLCs. Thus it appears that creditors of Kentucky SMLLCs are limited to the charging order and foreclosure remedies described above.
However, just because you form your LLC in Kentucky doesn't necessarily mean that Kentucky's LLC laws will always apply to it. It's possible that in some cases the LLC laws of other states would apply--for example, where an Iowa 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.
If you are concerned about liability protection from personal creditors. you should consider forming an LLC with two or more members. The second owner can be a spouse or relative, provided 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.
Should You Consider Forming Your LLC In Another State?
You do not have to form your LLC in Kentucky 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 Kentucky, you could form an LLC in Nevada because it has a more favorable LLC law. Doing so will not save you Kentucky state taxes because your LLC will have to qualify to do business in Kentucky and pay the same taxes as a Kentucky LLC.
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 Kentucky courts will always apply the law of the state where you formed your LLC instead of less favorable Kentucky law. 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 protection they offer, see Limited Liability Protection and LLCs: A 50-State Guide.