The Ideal Reverse Asset Protection Tool For a Multi-Member LLC
The biggest reason business owners set up limited liability companies is to avoid having their personal assets at risk for business liability. Accordingly, properly structured and maintained limited liability companies protect owners from being personally liable in most cases. This is known as inside liability protection. The liability of business limited liability companies remains within the LLC itself.
However, limited liability companies have have another asset protection feature that applies to "outside" liability- the LLC Charging Order. Outside liability is the reverse of inside liability and it deals with what happens to limited liability companies when an owner is personally sued for something unrelated to the business of the limited liability companies he or she owns. This liability relates to one outside of the LLC business.
The LLC Charging Order protects the business of limited liability companies by insulating them from personal creditors of the owners of such limited liability companies.
Let's say you incur a personal liability unrelated to your LLC business. This could be one arising from a car accident where you are at fault or the entering into of a personal debt obligation in which you are personally liable for.
If you get sued personally and are found liable, the attorney for the other side is going to go after all of your personal assets including possibly your ownership interest in any limited liability companies. If you own an LLC interest, that interest is an asset of yours and the attorney will seek to take it over (known as an -attachment).
There is no similar protection with corporations to the LLC Charging Order. If you own your business through a corporation and the creditor takes over your shares through an attachment, you lose your ownership in that business. The creditor will now be the shareholder and have rights to vote your shares and keep the economic benefits. If you control that business, the creditor will now be the one who controls the business.
Even worse, if your corporation is an S corporation and the creditor is not a qualifying shareholder for an S corporation, your business could lose its S corporation status and experience disastrous tax consequences. As you can see, the LLC Charging Order protection creates a significant benefit to using limited liability companies for businesses over corporations.
If you own your business through a properly structured and maintained limited liability company, the LLC laws provide a special rule called an “LLC Charging Order” which can save you from losing your business!
First, the LLC Charging Order rules say that the creditor who attaches membership interests of limited liability companies does not receive the voting and management rights of the LLC membership interests only the right to any distributions of profits that are made. Accordingly, if you run and control your limited liability companies, you will still have the continuing rights to manage the business.
Second, the LLC Charging Order rules allow you to maintain control over the decisions of limited liability companies. Most LLC Operating Agreement require that Members have to approve any distributions. If you control the LLC, you can choose not to distribute the profits of the LLC out to holders of the membership interests and if so, the creditor will not have any rights to ever receive the profits of the limited liability companies you own- a great benefit of the LLC Charging Order! There are other planning ways to pull profits out to you (such as via a salary).
Third, the LLC Charging Order protection can actually make it worse for a creditor to want to attach membership interests of limited liability companies. In many states, if the LLC is profitable but chooses not to distribute profits out, there is still an income tax consequence to the holders of the LLC membership interests. If the creditor attaches the membership interests, it is the creditor and not you who may be liable for the tax from profitable limited liability companies. So, as a result of how the LLC Charging Order works, the creditor will not only receive no income from the LLC but will also be liable for potentially significant taxes!
Given these aspects of an LLC Charging Order, a creditor will almost never attach your membership interests in any limited liability companies you own. This means that your business will be saved from personal liability.
LLC CHARGING ORDER PROTECTION DOES NOT APPLY TO A SINGLE MEMBER LLC A 2003 federal bankruptcy court case (In Re Albright) has ruled that LLC charging order protection did not apply with respect to a single member LLC. Accordingly, until another case overrules this one, it is your safest bet to assume that LLC charging order benefits do not apply to a single member LLC.
LLC CHARGING ORDER LAWS VARY FROM STATE TO STATE The scope of LLC charging order protection varies by state. Not all states have specific LLC charging order provisions in their LLC laws so if this topic is important to you, you should seek more information from an attorney in our state.
LLC CHARGING ORDER PROTECTION MAY BE COMPROMISED IN BANKRUPTCY Also, if the member who has been found personally liable for a liability files for federal bankruptcy, the state based LLC charging order protection may be altered by a bankruptcy court. Accordingly, it is another safe presumption to conclude that if bankruptcy is involved, the federal court’s decision may supersede or alter the state charging order rules.