ARTICLE UPDATE- 6.30.22
Starting in the early 1990’s, states began passing statutes permitting businesses to be organized as limited liability companies (an “LLC”). Today, LLC’s are widely accepted and regularly used. Over the past two decades, the IRS, state taxing agencies and the courts have resolved a number of issues regarding LLC’s, and the rules governing LLC’s are now well settled.
Or are they?
In 2010, a Florida court held that a judgment obtained against an owner of an LLC (a “member”) could be the basis for that creditor to obtain the ownership interests of the member-debtor. That was a departure from thousands of cases across the nation that limited a creditor’s reach into an LLC’s assets by applying “charging order” protection for the LLC and its debtor-member. It appears that the Florida case represents the first decision in the nation permitting a creditor to obtain the ownership interests of a member for claims arising “outside” the operations of the LLC, and now a handful of other states have case law that follows the Florida case decision. The Florida decision was limited to circumstances in which there is only one member, and the decision relied exclusively on the interplay between two Florida statues. However, those statutes are not unique to Florida and are quite common in most states. In fact, the GRIFFITH XIDIAS LAW GROUP compared the Florida statutes to Indiana law, and the two sets of statutes are nearly identical. Additionally, the Florida decision is well reasoned. It makes sense, given what the statutes say. So, it would be logical for an appellate court in Indiana or some other state with similar statutes to reach the same conclusion reached by the Florida courts. Consequently, this article should be carefully read and considered by anyone who holds investments or operates a business as a single-member LLC.
“Outside-In” Protection
At issue in the Florida case was something lawyers call “Outside-In” Asset Protection. That refers to liabilities asserted against a member of an LLC for activities unrelated to the LLC itself. Outside-In Asset Protection concerns both the members of an LLC and the LLC itself. In other words, the law, generally speaking, shields the ownership interests of the members of an LLC and the LLC itself from claims involving a member in an unrelated lawsuit (i.e., a lawsuit that is not related to the business or actions of the LLC). This article focuses on the law governing Outside-In Asset Protection, when a creditor seeks to acquire the interests a member holds in an LLC.
By the way, “Inside-Out” Asset protection concerns personally shielding the owners of a business from entity-level liabilities. While there are similarities as to how the law applies Inside-Out and Outside-In Asset Protection to shareholders, corporations, members and LLC’s, there are significant differences. This article only addresses Outside-In Asset Protection for LLC’s.
Charging Orders
An LLC has its roots in partnership law. An LLC is often described as a partnership with corporation protection. That is not a precise definition of an LLC, but there is some logic to that description. What is significant here is that most LLC’s prohibit a creditor of a member from being added to an LLC as a new member without the permission of some or all of the other members. While a creditor of a member cannot replace the member, the creditor can obtain a “charging order” against the debtor-member and the LLC. Here is an example to illustrate the point:
Jack (60%) and Ed (40%) are members of an LLC, worth $400,000. Jack forgets to pay his car insurance and causes an accident, seriously injuring someone. Jack’s victim (Betty) sues Jack, gets a judgment and then asks a court to force Jack to relinquish all his ownership interests in the LLC (60% of $4000,000 = $240,000 in value). However, Ed objects. And by the terms of the Operating Agreement governing the LLC, Ed can veto Betty’s efforts to become a member of the LLC. Why? Because LLC’s are akin to partnerships in this sense, and Ed can decide whom he wants to have as his “partner” in the LLC.
Betty is not completely out of luck, however. Betty can obtain a “charging order,” which requires the LLC to pay to Betty any monies that would have been distributed to Jack as an owner of the LLC. Betty has essentially acquired Jack’s financial or economic interests in the LLC, but cannot exercise membership rights, such as voting rights. So, when the LLC distributes $10,000 to its members, Betty, through her charging order, would receive Jack’s 60% share or $6,000.
Single-Member LLC’s
But what if the LLC in our example only had one member? What if Ed is not a member, and only Jack holds ownership interests in the LLC? In other words, what if Jack’s company is a single-member LLC? Can Betty obtain a court order to replace Jack and become the only member of the LLC? Or, is Betty limited in her recourse by the charging order?
The Florida court said: Yes, a creditor of a member can obtain all of the ownership interests held by a debtor in a single-member LLC. The logic is that there is no other member to object to or “veto” the creditor becoming a member of the LLC. So, if Betty has a judgment against Jack (the only member of an LLC), Betty can take all of Jack’s ownership interests in the LLC. Betty would not be limited to the benefits of a charging order. That would enable Betty to sell the LLC, sell its assets, license any intellectual property held by the LLC, or do whatever she wanted to do with the LLC and its assets. The LLC would belong to Betty.
While, as of 2022, there is no case law in Indiana on this issue, it is not difficult to imagine that Indiana and other states with similar statutes as those in Florida will eventually adopt the application of the Florida decision.
The Future of the Single-Member LLC
Even in Florida after that important appellate decision, there are benefits to the single-member LLC. For example, the Inside-Out Asset Protection of an LLC is available and worth consideration. Also, there are tax considerations sometimes favoring an LLC over a corporation, for example, and other circumstances in which an LLC is preferable over other entity structures. Another way to read the Florida decision is that the single-member LLC is no longer different from the single-shareholder corporation, in terms of Outside-In Asset Protection. Shareholders in a corporation have never enjoyed “charging order protection.” In that sense, the Florida decision merely clarifies that single-owner entities do not enjoy charging order protection.
What Does This Mean for You?
If you hold assets or operate a business as a single-member LLC, we recommend that you schedule a consultation with your business attorney to discuss your particular circumstances. Converting a single-member LLC to some other structure or even adding another member to your business might not be wise or advisable. Your circumstances are unique to you, and it is generally bad business to make important business or legal decisions based on what you have read an article.
