Personal Assets With a Limited Liability Company

Inside protection insures that creditors of a LLC member cannot seize or force a sale of the member's interest, nor can a creditor of a member vote the interest of the debtor-member. The member's creditors can only obtain a charging order from a court to direct the LLC to pay to the creditor any income distributions that would otherwise flow to the debtor-member. This is similar to the charging order remedy that a limited partner's creditor has against an interest in a family LP. In both of these cases the creditor secures only the financial rights of the debtor-member and not control or ownership rights.

A charging order will not provide a creditor voting rights or force the LLC manager to pay distributions to a member or his creditor. The charging order only directs distributions to the creditor rather than the debtor-member; therefore the charging order is a futile creditor remedy for both LLC and family limited partnership.

If you manage your LLC you will be the only party to decide if and when a distribution should be made and due to the fact that a judgment creditor cannot replace you as the manager and has no voting power, you in effect remain in control of the business and its assets. By refusing to make any distributions you deny the creditor any chance of payment, but remain authorized and entitled to pay yourself a salary for services—and salaries cannot be seized through the charging order. A creditor is not able to garnish loans or other forms of compensation that you may pay to yourself as a manager or member.

The LLC also has tax liability (poison pill) features that can be used if necessary, causing the charging order creditor to pay your income tax on LLC profits. Because a limited liability company is ordinarily taxed as a partnership its tax liability automatically passes to its members. So, if there were profits and a charging order creditor was waiting for a distribution, under certain circumstances you could arrange for them to receive a tax bill for the debtor-member's share of LLC profits. This would force the member's creditor to pay taxes on the member's earnings, even if the creditor has not received any distributions. In such a case, a creditor would likely abandon all collection efforts.

Some tax professionals have proposed that the tax bill wouldn't apply to a charging order creditor unless they had the voting rights of the assigned membership interest. But a carefully drafted operating agreement will allow for an assignment of voting rights while simultaneously ensuring that the voting rights did not allow the creditor to replace the manager, force distributions, or in any other way compromise the LLC's protection. Given these circumstances, it would be highly probable that the creditor would receive a tax bill with no distribution to pay it.

In the view of certain states, the charging order is seen as an ineffective creditor tool and legislation has been passed (or proposed) allowing for the foreclosure of a member's LLC interest, wherein the assignment (charging order) could vest in perpetuity, even after the judgment debt has been resolved. In response to this legislation, other business-friendly states (including Alaska, Arizona, and Oklahoma) have passed legislation that forbids such foreclosure.

A properly organized LLC and operating agreement will provide a suitable defense against a foreclosure initiative by a creditor. A foreclosure would still not enable a creditor to receive anything other than a right to distributions from the LLC, which the creditor will likely never receive and a foreclosed interest would certainly be liable for the taxes on a distribution that will probably never be made. The likely result of such a situation would be a settlement where the foreclosure is set aside as if it had never happened. In conclusion, states that do not have LLC-friendly foreclosure provisions should be avoided to prevent any unnecessary exposure to creditor enforcement action.

One advantage to all of these charging order limitations is that they encourage most creditors to settle rather than fight when confronted with a well-formed LLC. The prospect of a fast settlement is frequently a catalyst for LLC-friendly negotiations that eliminate creditor claims.

A key consideration of the LLC (just like the family limited partnership) is that if assets are transferred to the LLC after you have a creditor, the creditor could recover assets under the pretense of fraudulent transfer, reinforcing the key to proper LLC design and implementation as a key factor in protecting your assets.

Another consideration is that if you do not control the LLC manager, it is possible that profits distributed to you (and hence a creditor) will be subject to creditor claim if your membership interests are owned by another LLC that you do control.

In the event that an LLC member is in bankruptcy, the bankruptcy trustee may have greater rights to claim a LLC ownership interest than could a judgment creditor holding a charging order. A meticulously drafted operating agreement may curb these greater powers by giving each member an ongoing obligation to render certain services to the company, making the operating agreement an executory contract, which in turn subjects the LLC to more favorable bankruptcy laws. Even with an immaculately structured LLC there is still no guarantee that the member declaring bankruptcy will retain his LLC interest.

Except for bankruptcy, we can improve the protection of your assets through a LLC by using the same strategies as we would use to maximize protection of your corporate shares or LP interests. It is possible to assess your membership interest, issue voting proxies or grant the LLC options to redeem your membership interest under certain circumstances. It is also possible to empower you to encumber or lien your membership interest or dilute your membership control by having the LLC sell additional ownership interests.

We can also protect the title to a membership interest by vesting it as tenants-by-the-entirety in those states where this form of marital ownership is creditor-protected. Also, an international trust can own the membership interests, much as we use international trusts as limited partners in a limited partnership. Or, a LP may be the member of a LLC, an effective arrangement in states that better protect a limited partnership interest than a limited liability company membership. A LP can also own a LLC to reduce estate taxes (expansion on this topic follows).

For optimal protection your LLC should have one or more members in addition to a member who is a lawsuit defendant. State courts are less likely to reinforce a creditor's remedy when other LLC members would be affected. Some courts have been known to liquidate an LLC for the benefit of a creditor when the debtor is the only member and no other members would be affected.

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