LLC Protection for Members' Personal Debt in North Carolina
In North Carolina, the general rule is that the money or property of a North Carolina 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 North Carolina 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 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 North Carolina.
Charging Order - Exclusive Remedy for Multi-Member LLCs
Effective January 1, 2014, North Carolina has a new LLC law. The new LLC law provides that a charging order is the sole and exclusive remedy available to personal creditors of an owner of a North Carolina LLC. 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. 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 subject to its charging order.
Example: The collection agency obtains a charging order from a North Carolina court ordering the North Carolina 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.
North Carolina’s new LLC law explicitly provides that the charging order is the exclusive legal procedure that personal creditors of North Carolina LLC members can use to get at an owner’s LLC interest. North Carolina’s prior law was not explicit regarding whether a charging order was the exclusive remedy for personal creditors of LLC owners so there was some uncertainty as to whether creditors could pursue other remedies like trying to foreclose on the owner’s LLC financial interest or getting a court to order the LLC dissolved and its assets sold. A recent North Carolina court case found that creditors' rights against an LLC owner were limited to a charging order and now this is also explicit under North Carolina's new LLC statute. (Chapter 57D, North Carolina Limited Liability Company Act.)
What About Single Member LLCs in North Carolina?
The reason many LLC state laws limit the remedies available for personal creditors of LLC owners to a charging order is to protect the other members (owners) of the LLC from personal debts of other members 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 owners of SMLLCs have been allowed to exercise remedies not available to creditors of multi-member LLCs.
To date, North Carolina has not made a distinction in how it handles cases involving single and multi-member LLCs. Thus, it appears that creditors of North Carolina SMLLCs are limited to the remedies described above. However, it's possible that a North Carolina court would do what a growing number of courts in other states have done and apply a different rule for SMLLCs, particularly in a case where the SMLCC owner files for personal bankruptcy.
Because of the uncertainty regarding SMLLCs, an LLC should have at least two members if you are concerned about liability protection from personal creditors. The second owner 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 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 North Carolina even if it is where you live or do business. You can form an LLC in any state--for example, even though your business is in North Carolina, you could form an LLC in Wyoming to own and operate it because it has more favorable LLC laws. However, there is no guarantee that the courts of North Carolina or other states where your LLC does business will apply the laws of the state where you formed your LLC instead of another state's LLC laws. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer if you are considering forming your LLC in another state with more favorable LLC laws.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.