Treatment of Limited Liability Companies

Overview

The Uniform Limited Liability Company Act treats the interests of members of the LLC as having no property interest in the LLC. Instead a member has only a “Distributional Interest”, and if the member has a judgment creditor the court can enter an order charging that Distributional Interest., which order basically constitutes a lien on the Distributional Interest that can be foreclosed upon by further court order. The charging order is the exclusive remedy available to the creditor, although (as with limited partnerships) the court can grant various relief and even appoint a receiver to ensure that the creditor’s rights to distribution are protected (this has the potential for the to substantially interfere with the operations of the LLC, depending on how it is structured). Notably, the ULLCA provides for redemption by the LLC of the charged member’s interest, which further makes great meticulousness and forethought in the drafting of the operating agreement a necessity if the fullest creditor protective value of the LLC is to be achieved.

See Litchfield Asset Management vs. Howell -- Corporate veil of LLC pierced.

Special Case of the Single-Member LLC

Most states’ LLC Acts now provide for the Single Member LLC (SMLLC), primarily because many planners like to utilize them as an entity which is “disregarded” by the IRS for tax purposes.

Outside Liabilities – The text of the statutes that allow SMLLCs do not differentiate the charging order remedy between SMLLCs and those having multiple members. Thus, a dispute quickly arose between two camps of planners: (1) Those who believed that the plain language of the state statute’s allowing SMLLCs that the SMLLC are protected by charging orders means precisely that; and (2) Those who believed that because the historical purpose of the charging order was to protect one partner from being forced into partnership with another partner’s creditors, and this is nonsensical in the context of a single-member entity, that charging order protection would not apply to SMLLCs.

It was the latter viewpoint that prevailed in In re Ashley Albright wherein the U.S. Bankruptcy Court for the District of Colorado held:

“The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions made on account of her LLC member interest. However, the charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties' interests affected.” [footnote 9]

However, the Albright court indicated in footnore 9 that even a minimal membership interest held by another might be sufficient for charging order protection to be respected:

“Footnote 9. The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to Colo. Rev. Stat. § 7-80-702, if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, 7-80-702 does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with "peppercorn" co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. § § 544(b)(1) and 548(a).”

Inside Liabilities – As of the date of this writing, there have been no cases testing the protection afforded to the single member from the liabilities of the SMLLC. Many planners contend that SMLLCs should provide no worse protection than sole-shareholder corporations. We don’t want to be the test case. Until the law is settled, we advise avoiding SMLLCs until their effectiveness against inside liabilities is validated by case law.

Summary – If an LLC is meant to provide creditor protection, it should not be a SMLLC – especially since it is relatively easy to add another member.

Offshore Limited Liability Companies

Several traditional offshore jurisdictions have adopted Limited Liability Company Acts, which when utilized correctly can cause unique problems for creditors

State-by-State Coverage

View each state’s Limited Liability Company Act and browse each state’s charging order cases:

ARTICLE 5 of Uniform Limited Liability Company Act (1996)

[The Uniform Limited Liability Company Act has been adopted by Alabama, Hawaii, Illinois, Montana, South Carolina, South Dakota, Vermont, West Virginia, and the U.S. Virgin Islands, and it can be anticipate that most states will eventually adopt ULLCA or some variation or it.]

SECTION 501. MEMBER'S DISTRIBUTIONAL INTEREST.

(a) A member is not a co-owner of, and has no transferable interest in, property of a limited liability company.

(b) A distributional interest in a limited liability company is personal property and, subject to Sections 502 and 503, may be transferred in whole or in part.

(c) An operating agreement may provide that a distributional interest may be evidenced by a certificate of the interest issued by the limited liability company and, subject to Section 503, may also provide for the transfer of any interest represented by the certificate.

Drafters’ Comment to Section 501

Members have no property interest in property owned by a limited liability company. A distributional interest is personal property and is defined under Section 101(6) as a member's interest in distributions only and does not include the member's broader rights to participate in management under Section 404 and to inspect company records under Section 408.

Under Section 405(a), distributions are allocated in equal shares unless otherwise provided in an operating agreement. Whenever it is desirable to allocate distributions in proportion to contributions rather than per capita, certification may be useful to reduce valuation issues. New and important Internal Revenue Service announcements clarify that certification of a limited liability company will not cause it to be taxed like a corporation.

SECTION 502. TRANSFER OF DISTRIBUTIONAL INTEREST.

A transfer of a distributional interest does not entitle the transferee to become or to exercise any rights of a member. A transfer entitles the transferee to receive, to the extent transferred, only the distributions to which the transferor would be entitled.

Drafters’ Comment to Section 502

Under Sections 501(b) and 502, the only interest a member may freely transfer is that member's distributional interest. A member's transfer of all of a distributional interest constitutes an event of dissociation. See Section 601(3). A transfer of less than all of a member's distributional interest is not an event of dissociation. A member ceases to be a member upon the transfer of all that member's distributional interest and that transfer is also an event of dissociation under Section 601(3). Relating the event of dissociation to the member's transfer of all of the member's distributional interest avoids the need for the company to track potential future dissociation events associated with a member no longer financially interested in the company. Also, all the remaining members may expel a member upon the transfer of "substantially all" the member's distributional interest. The expulsion is an event of dissociation under Section 601(5)(ii).

SECTION 503. RIGHTS OF TRANSFEREE.

(a) A transferee of a distributional interest may become a member of a limited liability company if and to the extent that the transferor gives the transferee the right in accordance with authority described in the operating agreement or all other members consent.

(b) A transferee who has become a member, to the extent transferred, has the rights and powers, and is subject to the restrictions and liabilities, of a member under the operating agreement of a limited liability company and this [Act]. A transferee who becomes a member also is liable for the transferor member's obligations to make contributions under Section 402 and for obligations under Section 407 to return unlawful distributions, but the transferee is not obligated for the transferor member's liabilities unknown to the transferee at the time the transferee becomes a member.

(c) Whether or not a transferee of a distributional interest becomes a member under subsection (a), the transferor is not released from liability to the limited liability company under the operating agreement or this [Act].

(d) A transferee who does not become a member is not entitled to participate in the management or conduct of the limited liability company's business, require access to information concerning the company's transactions, or inspect or copy any of the company's records.

(e) A transferee who does not become a member is entitled to:

(1) receive, in accordance with the transfer, distributions to which the transferor would otherwise be entitled;

(2) receive, upon dissolution and winding up of the limited liability company's business:

(i) in accordance with the transfer, the net amount otherwise distributable to the transferor;

(ii) a statement of account only from the date of the latest statement of account agreed to by all the members;

(3) seek under Section 801(5) a judicial determination that it is equitable to dissolve and wind up the company's business.

(f) A limited liability company need not give effect to a transfer until it has notice of the transfer.

Drafters’ Comment to Section 503

The only interest a member may freely transfer is the member's distributional interest. A transferee may acquire the remaining rights of a member only by being admitted as a member of the company by all of the remaining members. New and important Internal Revenue Service announcements clarify that the transferability of membership interests of a limited liability company in excess of these default rules will not cause it to be taxed like a corporation. In many cases a limited liability company will be organized and operated with only a few members. These default rules were chosen in the interest of preserving the right of existing members in such companies to determine whether a transferee will become a member.

A transferee not admitted as a member is not entitled to participate in management, require access to information, or inspect or copy company records. The only rights of a transferee are to receive the distributions the transferor would otherwise be entitled, receive a limited statement of account, and seek a judicial dissolution under Section 801(a)(5).

Subsection (e) sets forth the rights of a transferee of an existing member. Although the rights of a dissociated member to participate in the future management of the company parallel the rights of a transferee, a dissociated member retains additional rights that accrued from that person's membership such as the right to enforce Article 7 purchase rights. See and compare Sections 603(b)(1) and 801(a)(4) and Drafters’ Comments.

SECTION 504. RIGHTS OF CREDITOR.

(a) On application by a judgment creditor of a member of a limited liability company or of a member's transferee, a court having jurisdiction may charge the distributional interest of the judgment debtor to satisfy the judgment. The court may appoint a receiver of the share of the distributions due or to become due to the judgment debtor and make all other orders, directions, accounts, and inquiries the judgment debtor might have made or which the circumstances may require to give effect to the charging order.

(b) A charging order constitutes a lien on the judgment debtor's distributional interest. The court may order a foreclosure of a lien on a distributional interest subject to the charging order at any time. A purchaser at the foreclosure sale has the rights of a transferee.

(c) At any time before foreclosure, a distributional interest in a limited liability company which is charged may be redeemed:

(1) by the judgment debtor;

(2) with property other than the company's property, by one or more of the other members; or

(3) with the company's property, but only if permitted by the operating agreement.

(d) This [Act] does not affect a member's right under exemption laws with respect to the member's distributional interest in a limited liability company.

(e) This section provides the exclusive remedy by which a judgment creditor of a member or a transferee may satisfy a judgment out of the judgment debtor's distributional interest in a limited liability company.

Drafters’ Comment to Section 504

A charging order is the only remedy by which a judgment creditor of a member or a member's transferee may reach the distributional interest of a member or member's transferee. Under Section 503(e), the distributional interest of a member or transferee is limited to the member's right to receive distributions from the company and to seek judicial liquidation of the company.