LLC Protection for Members' Personal Debt in Washington DC
Last updated: October 26, 2016
This article covers what actions judgment creditors are allowed to take under the District of Columbia’s limited liability company (LLC) law against a District of Columbia LLC for an LLC owner’s personal debt. Like the 50 states, the District of Columbia has its own LLC law. However, unlike most states, the District of Columbia 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 in the District of Columbia.
Multi-Member District of Columbia LLCs
When it comes to multi-member LLCs, the District of Columbia is like most states. The general rule is that the money or property of a District of Columbia multi-member LLC cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners.
Like all the 50 states, the District of Columbia 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 District of Columbia 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, the District of Columbia’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, the 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, the District of Columbia 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.
Single-Member District of Columbia LLCs
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. The District of Columbia’s LLC law recognizes this fact: It provides that the charging order is not the only remedy a judgment creditor may use against a 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 he or she wants with it, including dissolving it or selling its assets. The debtor ceases to be a member of the LLC. This gives creditors of owners of District of Columbia SMLLCs a very powerful remedy to collect their judgments.
All of the foregoing makes the District of Columbia one of the least attractive places in which to form a SMLLC as far as protection from personal creditors goes. To avoid application of the District of Columbia’s SMLLC rules and obtain the fullest limited liability possible, a District of Columbia 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 one of the 50 states--many have LLC laws that are much more debtor-friendly LLC laws than the District of Columbia's law. Such states include Delaware, Nevada, or Wyoming. You do not have to form your SMLLC in the District of Columbia even if it is the place you live, do business, or own property. However, there is no guarantee that the District of Columbia courts (or other courts in any of the 50 states) will apply the law of the state where you formed your SMLLC, rather than the less favorable District of Columbia LLC law. This is a complex legal issue with no definitive answer. Moreover, forming your SMLLC outside the District of Columbia will increase your costs: Your LLC will have to qualify to do business in the District of Columbia and pay the same taxes and as any other LLC, as well as the fees to form your LLC in Nevada, Delaware, or elsewhere. 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.