Limited Liability Company May Protect Your Assets from
Creditors
Careful Planning Can Minimize Your Risk
By: Beth S.
Cohn
A large
component of asset protection planning is designed to help protect
your business and investment assets from claims by your personal
creditors. If you have a corporation and a creditor gets a
personal judgment against you, the creditor can seize the stock of
your corporation. If you are the sole owner and your business
is held in a corporation, it can be taken over and operated,
managed or dismantled by your personal creditors.
Because of these risks, some business
owners have both their business and/or investment assets held in a
limited liability company ("LLC"). Under
Arizona law, your personal creditors may not be able to seize your
membership interest in the LLC, which will be discussed in detail
in this article. Additionally, there are substantive matters
to consider before your LLC is structured that could further limit
a creditor's ability to reach your assets.
Why is a LLC preferred
over a Corporation?
Under Arizona law, if a creditor gets a
judgment against you personally, instead of seizing your membership
interest in the LLC the creditor is required to obtain a charging
order, which designates the creditor as an "assignee" of the
member's membership interest. This means that the creditor's
interest is only an economic interest. The
creditor must wait for either the member(s) or the manager(s) of
the LLC to make distributions to apply towards satisfaction of its
judgment. With a properly drafted operating agreement for the
LLC, the following are likely scenarios of what would
occur:
- The member(s) or the manager(s) of the LLC are given the
absolute discretion to make or not to make distributions from the
LLC.
- Distributions are not made and the money is kept in the LLC for
operations of the business or to acquire additional investments in
the LLC. For this to be an effective strategy, the member(s)
need to have other assets outside of the LLC so they do not rely on
income from the LLC to pay their personal expenses.
- The creditor has incentive to settle for either a reduced
amount or collection may be indefinitely delayed.
- The creditor gets nothing from the LLC while it is waiting for
the distributions. However the creditor can be taxed on the
net income allocated to the member whose interest is subject to the
charging order.
- The creditor does not get a charging order as it neither wants
to wait for payment nor does it want to be taxed on its debtor's
share of the net income from the LLC.
While this would appear to be a
green light to immediately form a LLC, there are theories of law
that can benefit creditors. The concept of charging orders
comes from old English common law governing partnerships. The
theory is that when a partnership owns an asset, if a creditor of
one of the creditors can attach the asset of the partnership in
satisfaction of its claim against only one partner, it would
adversely impact the rights of the other partner in that
partnership asset. For equitable purposes, the courts
followed this principle and established the charging order to
protect the interest of the non-debtor partner in the partnership's
property.
Caution - Recent
Florida Supreme Court Ruling
These same
concepts have been adopted by many states including Arizona.
There is a minority of states that do not provide that the charging
order is the exclusive remedy for a creditor to proceed against the
assets and interests of a member in a single member
LLC. These states include Colorado and
Florida. In a recent case, the Florida Supreme Court
distinguished Florida law from Arizona law in allowing creditors to
proceed directly against the assets of a single member LLC, rather
than obtaining a charging order. The Arizona law states that
the charging order is an exclusive remedy for the creditor.
We do not believe that the Arizona courts will follow the Florida
Supreme Court. If a creditor obtains a judgment
against you in a state where the Courts follow the law set by the
Florida Supreme Court, the creditor may claim that it can proceed
against the assets of your single member LLC.
Bankruptcy Courts May
Be Able to Reach Assets of a Single Member LLC
Even in states that
have laws similar to Arizona's statute, there needs to be
caution. In the Bankruptcy Courts, there have been a series
of cases where the judges do not follow the applicable state law
where a member in a single member LLC files personal
bankruptcy and claims that the only remedy available to
the creditor is a charging order. In these cases, the
bankruptcy trustee has attacked the LLC claiming that the assets of
the LLC belong to the individual member's bankruptcy estate to pay
its creditors, rejecting the claim that the charging order should
be exclusive. The Bankruptcy Courts have ignored the
principles from the old English common law to rule that the assets
of the single member LLC belong to the member's bankruptcy estate
and the member's creditors can proceed against the assets of the
LLC. The Bankruptcy Courts have reasoned that because there
is only one member, there is no other party's interest that will be
impacted by a creditor proceeding against the assets of the
LLC.
It is my opinion that the result would
not be the same if there was another member in the LLC.
Wherever possible, my recommendation is to have more than one
member in a LLC. If there are two or more members, it is
possible to tax the LLC as a partnership for federal income tax
purposes. The IRS has ruled that a creditor of an
entity that has a charging order against a member of a LLC that is
taxed as a partnership is taxed on that "partner's" share of the
net profits. Although we believe that this theory
applies to a creditor that obtains a charging order against a
member in a single member LLC, the IRS has not definitively ruled
that for this purpose a creditor of a single member LLC is taxed
the same as a creditor of a LLC that is taxed as a partnership by
the IRS.
Other legal
theories may allow creditors to proceed against the assets of a
LLC, including successor liability and fraudulent transfer.
The discussion of these theories in detail is beyond the scope of
this article, other than to say that it is difficult to
successfully transfer assets from one entity to another or from an
individual to an entity for the sole purpose of avoiding creditors'
claims. If you have a situation where you are considering
transferring assets, you will need to consult with an attorney to
properly plan your transaction to minimize your risk.
None of these techniques are
completely fail safe to protect one LLC member from the attack of
the other member's creditors. Using a properly
structured LLC in your planning can be a significant deterrent to
creditors attacking your net worth. Although a LLC cannot
eliminate all of your risk, it certainly can limit a large part of
the risk.
About the author: Beth S.
Cohn is a
shareholder at the Phoenix law firm of Jaburg Wilk. She chairs the
business
law department and is a State Bar of Arizona certified tax
specialist and a CPA. Beth can be reached at or
602.248.1030 or at bsc@jaburgwilk.com.
This article is not intended to provide legal advice and
only relates to Arizona law. It does not consider the scope of laws
in states other than Arizona. Always consult an attorney for
legal advice for your particular situation.
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