Can creditors take your business assets to pay off your personal debts? It depends on the type of business entity you've chosen and where it is located. LLCs provide particularly good—but not perfect—protection from such outside liability.
Example: John and Meghan operate a website design business together called Acme Design. 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 personally. The collection agency can attempt to collect on the debt from John’s personal assets, such as his personal bank accounts and real estate. But can it take money or property owned by Acme Design, such as the money held in Acme's own bank account?
If Acme is a corporation, John’s personal creditors cannot directly take over ownership of the corporation’s assets, such as its bank accounts, to pay off a judgment against him. However, they can obtain ownership of John’s stock in the corporation. In this event, they step into John’s shoes and become co-owners of the incorporated business. They'll be entitled to John's share of the corporation's profits and to participate in the corporation's management. If they obtain ownership of 51% of more of the corporate stock, they can have the corporation liquidated and its assets sold to pay off John's debt.
If Acme is an LLC instead of a corporation, things will work out differently for John and his creditors. Just as with corporations, an LLC’s money or property cannot be taken by personal creditors of the LLC’s owners to satisfy personal debts against the owner. However, unlike with corporations, the personal creditors of LLC owners cannot obtain full ownership of an owner-debtor's membership interest. Instead, all states as part of their uniform LLC laws have adopted provisions limiting what action creditors can take against LLC owner/members for their personal debts. As a result, LLC owners in most states are never at risk of having another LLC member’s creditor step into the shoes of an LLC debtor/member and share in the management and control of the LLC.
In all states, personal creditors of an LLC owner/member are limited to one or more of the following remedies:
In a majority of states, obtaining a charging order is a creditor’s exclusive remedy. These states are the most debtor friendly; they provide the greatest protection for LLC owners against personal creditors. This protection extends to both the debtor/LLC member and any co-owners who would otherwise be at risk of having creditors take more aggressive action against the LLC, including possibly forcing a dissolution of their LLC.
Others states simply state that a charging order is an allowed remedy for creditors and also allow foreclosure or are silent as to what other remedies a creditor could pursue. Some states, by statute or caselaw, have special rules for SMLLCs. What liability protection you get with an LLC is an important issue that LLC owners and members should understand—particularly since the rules can vary state to state.
All states permit personal creditors of an LLC owner to obtain a charging order against the debtor-owner’s membership interest. In about two-thirds of the states, the charging order is the exclusive (only) legal remedy personal creditors of LLC members have.
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.
However, in most states, creditors with a charging order only obtain the owner-debtor’s financial rights and cannot participate in management of the LLC. Thus, the creditor cannot order the LLC to make a distribution subject to its charging order. Frequently, creditors who obtain charging orders end up with nothing because they can’t order the LLC to make any distributions.
Example: The collection agency obtains a charging order from a court ordering the Acme 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.
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.
In about one-third of the states, a creditor who obtains a charging order but is not paid by the LLC can have the court order that the debtor-owner’s LLC membership interest be foreclosed upon. If this occurs, the creditor becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC. However, the creditor cannot participate in the management of the LLC. Thus, it can’t force the LLC to pay money to it or anyone else.
Before any such foreclosure occurred, it’s likely that the LLC and its members would settle the debt with the creditor. A creditor’s ability to foreclose upon an LLC membership interest puts LLC owners’ personal creditors in a stronger bargaining position than they have under the LLC laws of states that don't permit LLC foreclosures.
Example: The collection agency's charging order against John's LLC interest proves useless because the LLC doesn’t make any distributions. So the agency obtains a court order for the foreclosure on John’s interest in the LLC. To avoid this, the LLC settles John’s personal debt with the agency for $30,000.
A handful of states permit personal creditors of LLC owners to obtain a court order that the LLC be dissolved. In this event, the LLC would have to cease doing business and sell all of its assets. This is the most extreme remedy allowed for personal creditors of LLC owners.
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. However, this rationale disappears when the LLC has only a single member (owner) because there are no other LLC owner/members to protect. Because of this difference with SMLLCs, some courts have applied different rules for SMLLC protection from creditors and in many states it remains unclear what type of protection they would receive.
Courts in a few states have found that the charging order protection that exists for LLCs does not apply with SMLLs because there are no co-owners to protect. These cases created a great deal of uncertainty in other states with similar charging order protection laws. In response, several states amended their LLC laws to make it clear that SMLLCs are entitled to the same protection from creditors as multi-member LLCs. These include Delaware, Nevada, and Wyoming—states that want to encourage businesses to form entities in their jurisdictions because they can earn money from the fees they charge and because they want to be considered business friendly. Their laws now specifically state that charging orders are the exclusive remedy for creditors of both multi- and single-member LLCs.
A few states, including Florida and New Hampshire, have gone the other way and changed their LLC laws to make it clear that a charging order is not the only remedy that can be used against an SMLLC. In these states, the SMLLC does not provide nearly as much liability protection as a multi-member LLC. Many states have still not addressed this issue either in the courts or by adopting laws specifically addressing SMLLC protection, so in those states it is unclear what type of protection an SMLLC would provide against an owner’s personal creditors.
If an LCC owner files for personal bankruptcy, all bets are off. The federal bankruptcy law says nothing about how LLCs should be treated. As a result, the bankruptcy courts are in the process of making up the rules as they go along. Several bankruptcy courts have held that when the owner of a SMLLC files for Chapter 7 bankruptcy the trustee appointed by the bankruptcy court becomes a substituted member of the LLC and can exercise all the owner's rights. This includes the right to manage the LLC and sell its assets (such as real estate) to pay off creditors. The protection afforded by the LLC form can simply be ignored by the bankruptcy court where there is only one LLC owner. It's possible that other bankruptcy courts would reach a different conclusion, but no one knows for sure.
It is also possible that the ownership interest of a member of a multi-member LLC could be taken over by a bankruptcy trustee. This is a rapidly evolving and unclear area of the law.
A simple way to avoid the potential creditor and bankruptcy problems with SMLLCs is not to have one. Instead, make sure your LLC has at least two members. The second member could be your spouse or another relative. However, the spouse, relative, or any other second member must be a legitimate co-owner of the LLC. If the second person is a member only on paper, it's likely that a court would disregard his or her interest and find that you have 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.
You do not have to form your LLC in your home state, even if it is the state where you live or do business. Thus, if your home state’s LLC law does not provide all the protection from creditors you would like, you could form your LLC in a more debtor-friendly state. For example, even though your business is in California, you could form an LLC in Nevada because it has a very debtor-friendly LLC law. As a general rule, the formation state’s LLC law will govern your LLC. Thus, forming an LLC in a state with a favorable LLC law could provide you with more limited liability. However, doing so will increase your costs because you’ll have to pay the fees to form your LLC in the other state plus the fees to register to do business in your home state.
So should you shop around for the state that provides the most limited liability to LLC owners? If limiting liability is extremely important to you, you may want to form your LLC in a state like Nevada, Delaware, or Wyoming that has very debtor-friendly LLC laws. But there is no guarantee that courts in your home state or courts in other states will always apply the law of the state where you formed your LLC, rather than the less favorable LLC law of your home state. This is a complex legal issue with no definitive answer. Consult an experienced business lawyer for more information.
It's very important for all LLC owners to draft and implement an operating agreement that takes into account the impact of a member filing bankruptcy or having a court judgment entered against him or her. For example, the LLC members may wish to include a provision in their operating agreement allowing for the expulsion of any member who files for bankruptcy; or allowing them to purchase the interest of any member who becomes subject to a charging order. A comprehensive operating agreement is particularly important for multi-member LLCs, since disputes may develop among the members.