Last updated: October 26, 2016
This article covers what actions judgment creditors can take against a limited liability company (LLC) for a member’s personal debt under California law. State laws on creditor rights against an LLC vary, with some providing more protection from creditors for an LLC and its owners than other states.
The general rule in all states, including California, is that the money or property of an LLC cannot be taken by creditors to pay off the personal debts or liabilities of the LLC’s owners. Similar to corporations, the money or property held in an LLC belongs to the LLC, not the member/owners individually, and may not be applied by creditors to pay a member’s individual debts. This protection from personal creditors is one of the key reasons people form LLCs. In addition to providing LLC members with personal liability protection from the LLC’s business debts, the LLC also protects the business and its owners from exposure to any debts or personal liability the other LLC members/owners may incur that are unrelated to the LLC’s business.
Like all states, California 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 California only obtain the owner-debtor’s financial rights and cannot participate in the LLC’s management.
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.
Example: John, Meghan, and Louis form a California LLC to operate their website design 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.
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.
Unlike many other states, California’s LLC law does not provide that a charging order is the exclusive remedy of LLC members’ personal creditors. Rather, it allows a creditor to foreclose on the debtor-creditor’s LLC interest. 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 or other members of the LLC--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.
Example: The collection agency obtains a $38,000 judgment against John, co-owner of the web design LLC, for his unpaid credit card debts. The agency obtains a charging order from a California court ordering the LLC to pay over to it any profits it distributes to John up to $50,000. However, the LLC need not, and does not, make any distributions, so the agency gets nothing. The agency then 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 $38,000.
Like most states, California does not permit personal creditors of an 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, such 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, court decisions and LLC laws in some states make a distinction between multi-member and single-member LLCs (SMLLCs). California is not one of these states. Nevertheless, whether, and to what extent, California SMLLCs are protected from outside creditors is not entirely clear. Moreover, in some cases the laws of other states that provide less protection to SMLLCs may be applied--for example, where a California SMLLC does business or owns property in another state. In addition, the protections that state LLC laws provide to SMLLCs might be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.
If you are really concerned about protecting the assets in your California SMLLC against personal creditors, you should consider adding another member to your LLC. If you decide to do this, the second member must be 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 an 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.
You do not have to form your LLC in California even if it is the state where you live or do business. You can form an LLC in any 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 protection than forming it in California. 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 California.
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 have very debtor-friendly LLC laws. But there is no guarantee that California or other courts in other states will always apply the law of the state where you formed your LLC, rather than the less favorable California LLC law. This is a complex legal issue with no definitive answer. 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.