In New Jersey, the general rule is that the money or property of a New Jersey limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Tony, and Carmine form a New Jersey LLC to operate their trash disposal 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 vary state by state. This article will look at what type of actions creditors of LLC owners are allowed to take against an LLC in New Jersey.
New Law--Charging Order Is Not the Exclusive Remedy
New Jersey passed a new LLC which gives personal creditors’ of LLC member/owners more rights than they had under the prior law. Under the new law, which becomes effective on March 18, 2013, personal creditors of an owner of a New Jersey LLC can 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 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.
Example: The collection agency obtains a charging order from a New Jersey court ordering the New Jersey 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.
Under New Jersey's prior law, a charging order was the exclusive remedy available to personal creditors of New Jersey LLC members. Thus, creditors were not able to foreclose on the LLC member’s LLC financial interest or get a court to order the LLC dissolved and its assets sold. This provided LLC members with strong liability protection against personal creditors of LLC members.
Under the new law (effective March 18, 2013), personal creditors of LLC members now have the right to foreclose on the LLC member/debtor interest. In addition to a charging order, creditors can seek to foreclose on the LLC ownership interest and have a court order the sale of the LLC member's interest. Thus, personal creditors have significantly more rights against LLC debtor/owners under the new law than they did under the prior law.
What About Single-Member LLCs?
The reason personal creditors of individual LLC owners in many states 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. New Jersey's LLC law makes no distinction between multi-member and single-member LLCs; thus, it appears that creditors of New Jersey SMLLC owners have the same remedies as those described above for multi-member LLCs. However, this is an unsettled and evolving area of law which you should consider carefully if you are forming a SMLLC and are concerned about liability protection.
To obtain the fullest limited liability possible in all states and in the event of bankruptcy, a New Jersey 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 New Jersey 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 New Jersey, you could form an LLC in Nevada because it has a more favorable LLC law. Doing so will not save you New Jersey state taxes because your LLC will have to qualify to do business in New Jersey and pay the same taxes as a New Jersey LLC. However, 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 New Jersey 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.