Last updated: 11/1/2016
This article covers what actions judgment creditors can take against a limited liability company (LLC) for a member’s personal debt under Pennsylvania law. State laws on creditor rights against an LLC vary, with some more debtor-friendly states providing more protection from creditors for an LLC and its owners than other states. Pennsylvania has enacted a new LLC law effective April 1, 2017. Under the new law, unlike most states, Pennsylvania treats creditors of a single-member LLC (SMLLC) differently than creditors of multiple member LLCs. SMLLC owners receive much less protection from personal creditors than owners of multi-member LLCs. This makes Pennsylvania among the least debtor-friendly states for SMLLCs.
When it comes to multi-member LLCs, Pennsylvania is like most states. The general rule is that the money or property of a Pennsylvania multi-member LLC cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Like all states, Pennsylvania allows creditors of LCC members to obtain a charging order to collect on a judgment obtained against an LLC member. A charging order directs the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the LLC member/debtor. Like most states, creditors with a charging order in Pennsylvania only obtain the owner-debtor’s financial rights and cannot participate in the LLC’s management.
To obtain a charging order, the creditor must have a judgment against the LLC member personally. After the judgment is entered, the creditor can apply to the court for a charging order. Since a creditor with a charging order cannot participate in the LLC’s management, it cannot order the LLC to make a distribution or that the LLC be sold to pay off the debt. Frequently, creditors who obtain charging orders against LLCs end up with nothing because they can’t order any distributions and the LLC can choose not to make any.
Although a charging order is often a weak remedy for a creditor, it is not necessarily toothless. The existence of a charging order can make it difficult or impossible for an LLC owner/debtor or the other owners (if any) to take money out of an LLC business without having to pay the judgment creditor first. To avoid this, the LLC owner/debtor may seek to pay off or settle the debt.
Unlike most other states, Pennsylvania’s LLC law does not provide that a charging order is the exclusive remedy of LLC members’ personal creditors. Rather, it allows a personal creditor of a member of an LLC with multiple owners to foreclose on that owner’s LLC ownership interest. To do so, the creditor must show that distributions under a charging order will not pay off the debt within a reasonable time.
Under this procedure, a court orders that the debtor-member’s financial rights in the LLC be sold. The buyer at the foreclosure sale—often the creditor—becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC or obtain a share of the LLC’s assets if it is dissolved. However, they buyer may not participate in the management of the LLC or order that any distributions of money or property be made.
As a practical matter, getting a member-debtor’s LLC interest foreclosed upon can be an expensive and difficult undertaking; but, the ability to do so gives a creditor more leverage in dealing with the debtor. Often, the debtor/member or other LLC members will settle the claim to prevent the foreclosure.
Like most states, Pennsylvania does not permit personal creditors of a multi-member LLC member to have a court order that the LLC be dissolved and its assets sold to pay off the creditor.
The reason personal creditors of individual LLC owners are limited to a charging order or foreclosure 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. Pennsylvania’s new LLC law, which is effective April 1, 2017, recognizes this fact. The new law provides that the charging order is not the only remedy a judgment creditor may use against an SMLLC owner. A creditor must first obtain a charging order. But, if as is typically the case, the order proves ineffective to collect the judgment within a reasonable time, the creditor may obtain a court order that the SMLLC interest be sold at a foreclosure sale. Moreover, unlike in most states, the purchaser of the SMLLC interest at a foreclosure sale obtains the debtor-member’s entire SMLLC interest, not just the right to receive distributions. In effect, the purchaser becomes the new sole owner of the SMLLC and can do whatever they want with the SMLLC, including dissolving it or selling its assets. The debtor ceases to be a member of the LLC. This gives creditors of owners of Pennsylvania SMLLCs a very powerful remedy to collect their judgments.
Example: John establishes a Pennsylvania SMLLC to own and operate a custom furniture business. John personally guaranteed a $100,000 bank loan he obtained for another business he owned through a different company. His bank obtains a $100,000 court judgment against John personally and has a charging order placed against his SMLLC. When it collects nothing with that order because John makes no distributions to himself, the bank obtains a court order that the SMLLC be sold at a foreclosure sale. The bank purchases the SMLLC at the sale and is now the sole owner of the SMLLC—the bank now owns the furniture business. John is no longer a member of the SMLLC.
All of the foregoing makes Pennsylvania one of the least attractive states in which to form an SMLLC as far as protection from personal creditors goes. To avoid application of Pennsylvania’s SMLLC rules and obtain the fullest limited liability possible, a Pennsylvania LLC should have at least two members. The second member can be a spouse or relative as long as 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 SMLLC. 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.
Alternatively, you could form your SMLLC in a state other than Pennsylvania that has a more debtor-friendly LLC law, such as Nevada, Delaware, or Wyoming. You do not have to form your SMLLC in Pennsylvania even if it is the state where you live, do business, or own property. However, there is no guarantee that Pennsylvania courts (or other state courts) will always apply the law of the state where you formed your SMLLC, rather than the less favorable Pennsylvania LLC law. This is a complex legal issue with no definitive answer. Moreover, forming your SMLLC outside Pennsylvania will increase your costs: Your LLC will have to qualify to do business in Pennsylvania and pay the same taxes as any other LLC, as well as the fees to form your LLC in Nevada, Delaware, or another state. Consult an experienced business lawyer for more information.
Pennsylvania’s prior LLC law remains in effect until April 1, 2017. The old law was unusual because it did not establish the rules for creditors’ remedies against LLC owners for personal debts. Instead, these were established by case law written by Pennsylvania state courts. These cases provided that a personal creditor of an LLC owner could obtain a charging order against the LLC that was limited to the owner’s financial rights. However, it was unclear whether such creditors could foreclose on a LLC owner’s economic interests, or whether owners of SMLLCs should receive less protection than owners of multi-member LLCs. These questions have been resolved by the state’s new LLC law.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.