LLCs are more popular than corporations for a few reasons, including flexibility in the management structure, taxation options, and the bonus of the “charging” order protection in most states.
When you operate a business, you need to consider what happens if your business is sued directly? Will your business liability insurance policy protect your business assets, will the plaintiff attempt to pierce the LLC veil and go after your personal assets? Most don’t consider the big question is what happens when you are sued personally for something non-related to your operating business? Will you lose control of your personal assets, including the ownership in your LLC?
The LLC has this built-in “charging order” protection, which makes it more challenging to take over the ownership of the LLC and therefore control its assets.
What is a “charging order,” and why is it important?
A charging order is an order which places a lien on your membership interest in the LLC. It is a request to the manager of the LLC to pay the creditor all of the profits and income that would have otherwise gone to you. It is usually limited to the dollar amount of the judgment and is similar to a garnishment of wages or income.
In about two-thirds of the states, the charging order is the exclusive (only) legal remedy personal creditors of LLC members have. However, in most states, creditors with a charging order 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.
The design of the charging order is to protect the non-debtor members against this forced and involuntary partnership with a creditor.
The significant issues come from the history of the charging order, which comes from partnership law, and some states do not recognize the benefit of the charging order with a single-member LLC.
The first case was in Colorado in April of 2003, and another one in Florida in 2010.
The result is that some believe you should always have a two-member LLC to have full advantage of the charging order.
What happens when you don’t have a partner? Some will suggest finding someone to be a 1% or 2% partner to solve this issue. But it is not that simple.
What do the courts look at when you add a partner, and what will the courts look to decide if the “charging order” should hold up for LLCs. There is a difference between a passive investment partner to make a two-member LLC vs. a partner who has a say in management. If you add a partner that is only passive as a member (assuming an LLC that is managed by managers), and that partner is 2% and has no say in management or voting rights, if a creditor takes that partner’s interest, that will NOT interfere with the operations of the LLC.
In the end, the judge may allow the creditor to levy against the 2% partner’s interest and sell it off. At the end of the day, if there was no adverse impact on the non-debtor member, the charging order will likely not protect that member’s interest.
Notable cases involving the single-member LLC and the charging order:
- Colorado In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003). A 2003 Colorado bankruptcy case, In re Ashley Albright, allowed a bankruptcy trustee to take control of a one-member LLC.
- Florida based upon a 2010 case. In Florida, the Supreme Court held that a judgment creditor who has a charging order against a single-member LLC might take full membership rights in the LLC in single-member LLCs. Not long after the Florida Supreme Court’s decision, however, the Florida legislature amended the applicable law to limit the rights of a judgment creditor to a charging order or foreclosure. Sec. 608.433, Fla. Stat.
- Lousiana in a case in 2020. First, The District Court held that the Louisiana charging order statute did not apply in the context of a single-member LLC owned by the debtor since, in that circumstance, that is no non-debtor member who has interests to protect from the creditor. On appeal, the Louisiana Court of Appeals reversed, essentially saying that Louisiana charging order statute has the effect of limiting the rights of a judgment creditor to “only the rights of an assignee of the membership interest,” i.e., what is known as an “involuntary assignee.” Because there has been no reverse piercing of the veil in this matter, we find that a plain reading of Louisiana’s charging provision for LLCs provides the exclusive remedy of a judgment creditor.
Bankruptcy courts are more open to allowing creditors, or a trustee, to exercise control over debtor membership interests. Bankruptcy courts look to Section 541 of the Bankruptcy Code and applicable state LLC Law on this question.
Some states clearly say the single-member LLC will provide the charging order protection as an exclusive remedy.
- South Dakota
Some states allow the charging order to LLC and foreclosure as an option for creditors:
After years of speculation and the lack of solid case law, the issue of whether single-member LLCs are afforded the protections of the charging order was finally addressed by a U.S. bankruptcy court in Albright, No. 01-11367 (Colo. Bkrpt. April 4, 2003). The
judge in Albright held that charging order protection does not exist for a single-member LLC because there are no non-debtor members to protect. The court granted full economic and noneconomic rights to the trustee, allowing the bankruptcy trustee to manage the debtor’s
LLC. The trustee subsequently sold the LLC’s property and distributed the net proceeds to the bankruptcy estate to satisfy creditors’ claims.
The Colorado Act provides that where the LLC has no members (such as in the case where the single-member loses her membership interest through foreclosure or as a result of a conveyance to a bankruptcy trustee upon filing a petition in bankruptcy), the non-member assignees “of the last remaining member” may, by the unanimous consent of the assignees, “be admitted as a member or members.” This would include a bankruptcy trustee, a creditor foreclosing on the single-member membership interest, or an heir upon death of the single-member.
Does this mean a single-member LLC is worthless in these states where the charging order does not protect the member from a lawsuit unrelated to the operating business? No.
The single-member LLC is still a valuable tool against internal liability, once that is against the operating company directly.
For example, if you own real estate and it is owned by a single-member LLC, and a tenant sues the LLC, if the single-member LLC is adequately capitalized, is not the alter ego of the sole member, and is not used to perpetuate a fraud, the tenant may not assert liability against the member. Often, we will structure multiple single-member LLCs owned by one LLC taxed as a partnership to get the best of both worlds.