THE TROUBLE WITH SINGLE-MEMBER LLCs

by Jeff Smoot

A limited liability company (“LLC”) is a form of statutory entity commonly used for its tax benefits, as well as to shield owners from liability for potential debts of the company and to shield assets held by the LLC from creditors of the LLC members. Assuming the LLC is operated legally and not used for improper purposes, assets placed in an LLC are protected from creditors of individual members. While a creditor can still obtain a charging order against a debtor member’s economic interest in the LLC (i.e., the member’s right to receive distributions from the LLC), the creditor cannot touch property held by the LLC and cannot acquire any management rights in the LLC. The LLC form, like that of a corporation, provides a shield against execution by judgment creditors that can only be pierced through misconduct, overreaching, or failure to observe the LLC form. Unless, that is, the LLC is a “single-member LLC”. Court decisions have raised a question as to whether the member’s management rights or even the LLC form must be respected in the case of a single-member LLC. According to the majority of those decisions, the answer is “no”.

While there are no current Washington cases discussing the rights and protections of members and creditors regarding a single-member LLC, commentators have noted that courts are beginning to recognize that single-member LLCs are effectively “alter egos” of their sole members not entitled to the same protections as multiple-member LLCs, and several bankruptcy court decisions have treated single-member LLCs differently than they would have been treated if the LLCs had multiple members.

In the case of In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (the “Ashley Albright” case), a Colorado bankruptcy court ruled for the first time that the assets of a single-member LLC could be used to pay creditors of the debtor-member who filed bankruptcy. Colorado’s LLC statute is similar to Washington’s statute, granting creditors the right to charge a debtor member’s economic interest in the LLC but treating the charging order as an assignment and requiring consent of all other members to confer any management rights on the charging creditor. Colo. Rev. Stat. § 7-80-703. The requirement of a charging order, under Colorado law (and parallel Washington law), exists to protect other members of an LLC from having to involuntarily share management with someone they did not choose or to have to accept a creditor as a co-manager of the LLC. However, according to Albright, “[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.” Accordingly, “[t]he charging order protection serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.” Albright, 291 B.R. at 541. The court further noted:

[T]he Limited Liability Company Act requires the unanimous consent of “other members” in order to allow a transferee to participate in the management of the LLC. Because there are no other members in the LLC, no written unanimous approval of the transfer was necessary…

The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.

Albright, 291 B.R. at 540, 541.

Based on this rationale, the bankruptcy court allowed the Trustee, standing in the shoes of the debtor as a hypothetical judgment creditor, to cause the LLC to sell its property and distribute net proceeds to the debtor member’s bankruptcy estate, or distribute the LLC’s property to himself as Trustee and liquidate the property for the benefit of creditors.

The Albright decision has been followed by other bankruptcy courts, such as in In re Modanlo, 412 B.R. 715 (D. Md. 2006), which cited Albright favorably for the proposition that because there were no other members to protect, the purpose of preventing a creditor from becoming a substituted member of the LLC does not apply when the LLC is a single-member LLC. “[U]sing the principles of statutory construction and adopting the reasoning of the bankruptcy court in Albright…” the sections of the Delaware LLC Act regarding assignment of LLC interests and rights of assignees to become members “do not apply to single member LLCs.” Modanlo, 412 B.R. at 730.

One cannot simply substitute in someone else who is a stranger without affecting those (personal) relationships among [multi-member LLC] members. That reasoning, however, is substantially undermined, if not meaningless, in the context of single member limited liability companies. By definition, there can be no remaining members of a single member LLC … whose personal relationships (among members) could be compromised by being forced to accept substitute performance from a stranger…

Modanlo, 412 B.R. at 727.

The same reasoning was followed in In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho 2006), where an Idaho bankruptcy court dismissed a chapter 11 petition signed by the single member of the debtor LLC because he did not have authority to act on behalf of the LLC based on his own chapter 7 bankruptcy filing. The court stated that in a multi-member LLC, when a single member files bankruptcy, the bankruptcy estate is entitled only to receive the debtor members’ share of profits or other compensation and the return of contributions to which the debtor member would be entitled. However, when the debtor is the only member of the LLC, the bankruptcy trustee steps into the shoes of the debtor and can exercise management powers over the LLC to the same extent the single member could do.

Based on this growing line of cases, two arguments could be made by a Washington judgment creditor seeking to collect assets held by a debtor’s single-member LLC:

First, the provisions of the Washington LLC act regarding assignment of membership interests, charging orders, and limitations on assignees or judgment creditors becoming managers of the LLC do not apply to single-member LLCs because there are no other members to protect. A court accepting this argument might allow the judgment creditor to execute on and sell the entire LLC interest including the debtor member’s bundle of LLC rights (management and right to receive profits). While there is no appellate decision providing precedent for this, it happens as a matter of course in King County, where the sheriff routinely levies on and sells debtors’ membership interests in single-member LLCs under writs of execution.

Second, Washington’s LLC act permits appointment of a receiver in appropriate cases after entry of a charging order. A receiver could be appointed in the case of a single-member LLC to prevent the member debtor from controlling the LLC assets to his or her own advantage such as by preventing any disbursement under the charging order. By statute, upon appointment of a receiver, the single member of the LLC would be divested of his or her management rights. The receiver would be entitled to manage the LLC, and either sell its property and distribute the proceeds to the judgment creditor after payment of all partnership debts, or manage the LLC property and distribute the profits to the judgment creditor until the judgment was fully satisfied.

A common response to this potential problem is to add a new member or two to the LLC so that it is no longer a single-member LLC. While this may be appropriate in some cases, if it is done with intent to hinder, delay, or defraud creditors, or for less than fair consideration, the addition of token or “peppercorn” members to the LLC could be avoided by a bankruptcy trustee or as a fraudulent transfer by a state-court creditor. See Albright, 291 B.R. at 541, n.9. This would especially be true where the new member did not buy into the LLC for fair value, was a family member or other entity controlled by the debtor (such as a self-settled trust), or the addition of a new member was done at a time when the original member was faced with a lawsuit, preparing to file bankruptcy, or in financial difficulty.

What to do if you are forming a new LLC or have an existing single-member LLC and protection from creditors or bankruptcy trustees is your primary concern? First, make sure your LLC has more than one member. If you have an existing single-member LLC, you can add one or more new members, but be sure they are actual members and not just token members added merely as a roadblock for your creditors. The new member should also pay reasonably equivalent value for the membership interest. If the LLC’s value is $100,000 and you add a new 10% member, the new member should pay $10,000. If you add a new member for no consideration or considerably less than the value of his or her percentage interest, a creditor or bankruptcy trustee could potentially avoid that transfer. Of course, whenever forming a new LLC or adding new members to an existing single-member LLC, you should hire an experienced business lawyer to prepare a good operating agreement to best protect the members and the LLC assets from potential creditor claims.

On the other side of the equation, if you are a creditor trying to collect from a debtor who has placed his or her assets in an LLC, your collection lawyer should investigate the nature of the LLC to determine if it is a single-member LLC or has had new members added recently. If so, then the LLC assets may be fair game.

Finally, if you are a single-member LLC owner in financial difficulty or contemplating bankruptcy, you should consult with an experienced bankruptcy lawyer to help you determine how a bankruptcy filing will affect you and determine how, if possible, to protect your LLC interest.

This article is for informational purposes only, and should not be relied upon as legal advice. No attorney-client relationship is created or intended by publication of this article. If you desire legal advice or representation regarding the issues discussed in this article, please contact Highpoint Law Group PLLC.



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