LLCs and Bankruptcy

For the business owner who has a lot of debt but can’t pay, creditors may threaten legal action against the owner personally. How much creditors collect depends on how an entrepreneur organizes the business.

If a business is organized as a limited liability company (LLC), an owner’s personal assets are generally protected from creditors. However, business owners may give up their right to limited personal liability when they provide personal guarantees and/or security to landlords for offices or creditors for loans.

For personal debts, the LLC is a convenient shelter for making specific assets out of the reach of an owner’s personal creditors. A creditor holding a valid judgment against an owner of an LLC often is not able to collect when the owner’s assets are titled in the name of the LLC.

Creditors may resort to “charging orders” to collect their debts from individuals who have attempted to shelter their personal assets in an LLC. Charging orders give creditors a right to collect distributions, not from the individual assets the business owner places in the LLC, but on the owner’s membership interest in the LLC. To get a charging order, the creditor must obtain a judgment against the owner personally. The creditor then must apply to a court for an order charging the owner’s membership interest with payment of all judgment amounts.

Once the charging order is entered by a court, the creditor can receive and recover all distributions from the LLC to which the owner would otherwise be entitled. LLC distributions are transfers of cash or other property to owners of an LLC on account of membership interest. With a judgment, when a distribution is made, the LLC must pay the creditor with a charging order all funds that would go to the business owner. Failure of the LLC to pay funds directly to the creditor violates charging order and can result in liability to the LLC, including fines.

A charging order does not entitle the creditor to collect all funds paid by the LLC to the owner. Funds paid as compensation for employment or personal services may be off-limits. Usually, the charging order allows the creditor to collect amounts paid by the LLC on account of the owner’s membership interest in the LLC analogous to a dividend to a corporation shareholder. These are “profits” paid to owners of the LLC. If the LLC makes no distribution of profits, the charging order is an ineffective collection tool.

When in debt, look to an experienced New York bankruptcy attorney.

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