Have you ever been out driving, listening to your radio, and you hear one of these ads extolling the benefit of having your own limited liability company (LLC) as it will save you from those terrible people known as creditors? As you will see below, that may be a bit of an overstatement, and we may be seeing a little crack in the wall developing in certain circumstances. Some brief observations follow.
LLCs have at least one advantage over corporations when it comes to liability protection for an owner. If you own corporate stock in a closely held business, and someone has a judgment against you and is trying to reach your assets to satisfy the judgment, your ownership of closely held stock is not immune from attachment. On the other hand, members of a limited liability company have the benefit in many states of a statutory charging order (analogous to a garnishment), which precludes a creditor taking your ownership interest in the LLC, but does enable them only to reach distributions from the LLC made with respect to your ownership interest.
There have been some fairly recent cases, particularly federal bankruptcy cases, where courts have chosen to ignore the charging order rule when they feel an injustice would have occurred if the statutory language is enforced. This occurred in decisions in Colorado and Florida. The bankruptcy courts have reasoned that the purpose of charging orders is to insure that where another person is involved in the ownership of the entity, it would work an injustice on that member to have the ownership interest of the other member attached by a creditor. But when there is only one member, that rationale does not exist.
Wyoming and Nevada have had recent decisions in the non-bankruptcy context. In the 2014 Wyoming Greenhunter case, the court essentially decided that every creditor has a reasonable expectation of repayment. And if someone is using the limited liability company structure to essentially defraud the creditor, that conduct will not stand and the person will be made responsible for the LLC’s debts.
Principally, in this case, the LLC was significantly underfunded to handle the debt it had incurred and was basically a shell when it came to assets. The parent company infused just enough cash to keep it going for a while and to cover the debts it wanted covered. The bookkeepers, accountants, and lawyers were exactly the same for both parent and subsidiary. In fact, the subsidiary had no employees of its own. So there was really no separateness between the entities.
The Wyoming court noted that corporations and LLCs are legally distinct from owners unless that causes an economic injustice or a fraud has been committed, among other factors taken into account. In this case, the parent company filed tax returns treating the LLC as a disregarded entity, which was not deemed in and of itself as a primary factor. But it may have been the proverbial straw that broke the camel’s back. So at the end of the day and after considering numerous factors, the court observed that the parent company had all of the benefits, but none of the risks. The court viewed the entire set of facts and circumstances as essentially a fraud on the creditor.
Does this mean that single member LLCs are not to be used? Certainly not. But if the accumulated facts and circumstances lead to the conclusion that the single-owner LLC was formed to defeat a creditor or creditors or with an obvious intent to not make good on the debt, then you may have a problem.
Michael W. Margrave
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.