Let's more closely consider the LLC's inside protection. Creditors
of a limited liability company member cannot seize or force a sale of
the member's interest. Nor can the member's creditor vote the
interest of the debtor-member. The member's creditors can only obtain
a court charging order remedy to direct the limited liability company
to pay to the creditor any income distributions that would otherwise flow
to the debtor-member. This is the same charging order remedy that a limited
partner's creditor has against an interest in a family limited partnership.
The creditor gains only the financial rights of the debtor-member, not
control or ownership rights.
Note that the charging order will not 1) give your creditor voting rights
or 2) force the limited liability company manager to pay distributions
to a member or his creditor. The charging order only directs distributions
to the creditor rather than the debtor-member.
The charging order may thus be as futile a creditor remedy with the limited
liability company as it is with a family limited partnership. If you manage
your limited liability company, you will decide if and when you will make
distributions. Your judgment creditor cannot replace you as the manager
because your creditor cannot vote. And for as long as your creditor has
a charging order against you, you can refuse to pay distributions. Nevertheless,
you can pay yourself a salary for services and salaries cannot be seized
through the charging order. Also, your creditor is not able to garnish
loans or other forms of compensation that you may pay to yourself as a
manager or member.
You also have the same tax liability (poison pill) opportunities with
the charging order against a limited liability company interest. The charging
order creditor may be required to pay your income tax on LLC profits.
Since a limited liability company is ordinarily taxed as a partnership,
its tax liability automatically passes to its members. The charging order
creditor then, under certain circumstances, gets the tax bill for the
debtor-member's share of LLC profits. This forces the member's
creditor to pay taxes on the member's earnings, even if the creditor
has not received any distributions. That's a losing proposition for
Some professionals argue that the tax bill wouldn't apply to a charging
order creditor unless he or she also had the voting rights of the assigned
membership interest. A carefully drafted operating agreement, however,
will allow for an assignment of voting rights, while also ensuring that
these voting rights do not allow the creditor to replace the manager,
force distributions, or in any other way compromise the LLC's protection.
In this case, there is little doubt that the creditor will have a tax
bill and no distribution to pay it.
Some states view the charging order as a remedy that is inadequate from
a creditor perspective. And it is. As a result, they have passed legislation
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 settled. In response to this, other business-friendly states,
such as Alaska, Arizona, and Oklahoma, have passed legislation that forbids
In reality, the ability to foreclose membership interests is a remedy
with a lot of bark and little bite, provided that your LLC is set up properly.
A foreclosure will still not allow for a creditor to receive anything
more than a right to distributions from the LLC, which the creditor will
likely never receive. Furthermore, the receiver of a foreclosed interest
will certainly be liable for the taxes on a distribution he will probably
never see. This, in turn, will probably lead to a settlement where the
foreclosure is set aside as if it had never happened. Despite this fact,
the possibility of a problem that won't go away makes the avoidance
of LLC membership foreclosures desirable. Thus, you should form your LLC
in a state that forbids such foreclosure.
These charging order's limitations encourage most creditors to settle
rather than fight. Why would a creditor elect a remedy that gives them
no money, no control, and only a tax bill? When your assets are safely
titled to a limited liability company, you may reach a faster settlement
and avoid the expense, time, and hassle of defending the lawsuit.
Unfortunately, the limited liability company also has the same protective
deficiencies as the family limited partnership. For example, if you transfer
your assets to the limited liability company after you have a creditor,
your creditor may possibly recover the assets as a fraudulent transfer.
Profits may be distributed to you (and hence your creditor) when you do
not control the manager. You would then not rely on the limited liability
company, though your membership interest may then be owned by another
LLC that you do control.
And as an LLC member in bankruptcy, your bankruptcy trustee may have greater
rights to claim your limited liability company ownership interest than
could a judgment creditor holding a charging order.
Should a member file bankruptcy; recent case law has demonstrated that
the bankruptcy trustee may also have considerably greater rights to claim
the member's limited liability company ownership interest than could
be obtained by 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.
Such obligations make the operating agreement an executory contract, which
in turn subjects the LLC to more favorable bankruptcy law. Even an immaculately
structured LLC is no guarantee that the member declaring bankruptcy will
retain his LLC interest.
Aside from bankruptcy, we can improve your protection as a limited liability
company member by using the same strategies as we would use to maximize
protection for your corporate shares or limited partnership interests.
For example, we can assess your membership interest, issue voting proxies,
or grant the LLC options to redeem your membership interest. You may also
encumber or lien your membership interest or dilute your membership control
having the LLC sell additional ownership interests.
We can also comparably protectively title a membership interest. For instance,
limited liability company interests owned by a married couple may title
their ownership as tenants-by-the-entirety in those states where this
form of marital ownership is creditor-protected. Or an international trust
can own the membership interests, much as we use international trusts
as limited partner in a limited partnership. Or a limited partnership
may be the member of a limited liability company. This is a particularly
good arrangement in those states that better protect a limited partnership
interest than a limited liability company membership. We can also use
the limited partnership to own a limited liability company to reduce estate
taxes as we explain later.
Finally, for protection, your LLC should have one or more members in addition
to the one who is a lawsuit defendant. The courts are more hesitant to
expand upon a creditor's remedy when other LLC members would be affected.
Some courts will liquidate an LLC for the benefit of a creditor when the
debtor is the only member and no other members would be affected.
YES, YOU CAN LOSE EVERYTHING!
You may think that your wealth is safe and that you don't need protection.
But don't delude yourself and accept reality — for every 60
minutes you spend making money, spend 60 seconds thinking about how to