In South Dakota, like in most states, the general rule is that the money or property of a South Dakota limited liability company (“LLC”) cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Example: John, Margaret, and Leslie form a South Dakota LLC to operate their computer game development 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 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 South Dakota.
South Dakota, like all states, permits personal creditors of an owner of a South Dakota 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 South Dakota 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 a South Dakota court ordering the South Dakota 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.
The charging order remedy without any right to order distributions is so weak many creditors don’t even try to use it.
Foreclosure and Dissolution
South Dakota’s LLC law says that the charging order is the only legal procedure that personal creditors of South Dakota LLC members can use to get at an owner’s LLC interest. Thus, unlike some other states, South Dakota does not permit an LLC owner’s personal creditors to foreclose on the owner’s LLC financial interest or get a court to order the LLC dissolved and its assets sold. This makes South Dakota a more friendly state for people who want to form LLCs to protect their assets from personal creditors.
What About Single-Member LLCs?
The reason personal creditors of individual LLC owners 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. However, South Dakota is not one of these states. South Dakota's LLC law makes no distinction between multi-member and single-member LLCs. Thus it appears that creditors of South Dakota SMLLC owners are limited to the same remedies as those described above for multi-member LLCs.
Nevertheless, it is possible that in some cases the laws of these other states would be applied--for example, where a South Dakota SMLLC does business or owns property in another state. In addition, the protections that LLC state laws provide to SMLLCs may be ignored by the Federal Bankruptcy Courts if the SMLLC owner files for bankruptcy.
To obtain the fullest limited liability possible in all states and in the event of bankruptcy, a South Dakota 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.
For more information on LLCs and the limited liability protections they offer, see Limited Liability Protection and LLCs: A 50-State Guide.