LLC Protection for Members' Personal Debt in Pennsylvania
In Pennsylvania, like in all states, the general rule is that a Pennsylvania limited liability company's ("LLC’s") money or property cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: Larry and Sonia have formed a Pennsylvania LLC called True Blue Flowers, LLC, to operate their flower shop business in Hershey. The business has been quite successful and has $50,000 in its own bank account. Unbeknownst to Larry, Sonia has a gambling problem and owes $100,000 to the Lady Luck Casino. While the casino can attempt to collect its debt from Sonia’s personal assets, such as her personal bank accounts and personal property, it cannot take money or property owned by True Blue to satisfy Laverne’s personal gambling debts--for example, it cannot get any of the money held in the LLC’s bank account.
However, there are other steps personal creditors of an LLC owner might try to take to collect against the LLC. These include:
- obtaining a charging order requiring that the LLC pay the creditor all the money due from the LLC’ to the debtor-owner
- foreclosing on the debtor-owner’s LLC ownership interest, or
- getting a court to order the LLC dissolved and all its assets sold.
The laws on what creditors are allowed to do vary state by state. In some states, a charging order is the exclusive remedy for personal creditors of an LLC owner. The rationale for limiting a creditor’s remedies to a charging order is to protect the other LLC owners from having an outside creditor step into the shoes of the debtor member and share in the management and control of the LLC. In other states, charging orders are allowed but creditors are either expressly allowed to foreclose on their debt or seek dissolution of the LLC, or the statute is silent as to what other remedies creditors can pursue.
This article will look at what type of actions a personal creditor of an LLC owner is allowed to take against an LLC in Pennsylvania.
The Charging Order Remedy in Pennsylvania
Under Pennsylvania law, LLCs and their members are entitled to charging order protection. A creditor with a personal judgment against a member of an LLC based on a claim that is unrelated to the LLC’s business can obtain a charging order against the LLC. This order requires the LLC to distribute to the creditor any profits it would otherwise have distributed to the debtor/member. The creditor, however, is not entitled to levy on the debtor/member’s voting rights or other management rights.
Example: The Lady Luck Casino gets a Pennsylvania court to issue a charging order in the amount of $100,000 against Sonia’s 50% ownership interest in True Blue Flowers LLC. This means that any distributions of money or property the LLC would ordinarily make to Sonia must be given to the Casino instead until the entire $100,000 is paid. However, the Casino cannot order the LLC to make distributions.
If there are no distributions, the creditor gets nothing because the creditor only gets 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.
Pennsylvania is unusual because its rules on creditors’ remedies against LLC owners for personal debts are established by case law, as opposed to statute like most other states. The court in the case that established that creditors' rights were limited to financial rights under a charging order (and not management rights) did not address whether the economic rights obtained by a creditor are subject to foreclosure. (Zokaites v. Pittsburgh Irish Pubs, LLC, 962 A.2d 1220 (PA Super. 2008)). So it is unclear whether a charging order is the exclusive remedy in Pennsylvania or whether a creditor has the right to foreclose on the debtor/member's financial interest.
What About Single-Member Pennsylvania LLCs?
The reason personal creditors of an LLC owner 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. However, this rationale disappears when the LLC has only one member (owner) because there are no other members to protect. As a result, some states have made a distinction between multi-member and single-member LLCs ("SMLLCs") and have decided not to limit personal creditors of SMLLCs to the charging order remedy, even when that is the exclusive remedy provided for LLCs. While this issue has not yet been addressed in Pennsylvania, there is certainly a risk that a court would decide not to limit a creditor to a charging order remedy where the debtor is the sole owner of a SMLLC.
One way to avoid the potential liability problems that exist with SMLLCs is to add members to your LLC. However, any members you add must be legitimate co-owners of the LLC. If the additional LLC owner is 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.