Asset Protection for Limited Liability Companies Asset Protection for Limited Liability Companies (LLCs)

‘LLCs v. Corporations’ — Creditor’s rights, Judgment Creditor and Charging Order, and Tax

An LLC can have the limited liability that a corporation affords its shareholders and the single level tax that a partnership affords its partners. In a nutshell, an LLC can have the best of both worlds of a corporation and a partnership. An LLC is a great form of business entity for closely held business owners.

Generally, members, managers and managing members of an LLC are not liable for the debts, obligations or liabilities of the LLC, although these can be expanded and stipulated in the LLC operating agreement.

Rights of Judgment Creditors:

Corporations: Creditors of individual shareholders of a corporation can legally foreclose and obtain full ownership of the debtor-shareholder’s stock in the corporation and possibly control the management power and liquidate the corporate assets. Also, if the creditor foreclose on the debtor-shareholder’s stock and if the corporation was making an S corporation election for tax purposes, an ineligible S corporation shareholder that forecloses on the stock (for example, a non-resident alien forecloses on the debtor shareholder’s stock, etc.) will terminate the S election and subject the corporation to be classified as a C corporation and incur double taxation (taxed at the corporate level and taxed at the shareholder level again).

LLCs: Judgment creditors of an LLC member generally obtain only a “charging order” against the debtor-member’s interest in the LLC. “Charging Order” means that a court orders that distributions of the debtor-member’s distributions and profits be paid to the judgment creditors.

Under Washington’s LLC statute, a judgment creditor’s remedy is not limited to charging order. It is also possible for a judgment creditor to receive remedies such as foreclosure of LLC member interest just like foreclosure of corporate shares of a debtor-shareholder. However, “charging order” is the preferred remedy by the court, and the possibility for a judgment creditor to get a remedy for foreclosure of member interest is not as high as in the case of a corporation (either a C corporation or an S corporation). Even with a foreclosure sale, the buyer will not have the right to become a member of the LLC and participate in management without the consent of all other members unless the operating agreement permits it, which is very unlikely if the operating agreement was drafted by a competent attorney. Even if the debtor-member’s LLC interest is sold through judicial sale, the buyer also has no right to obtain information regarding the LLC’s transactions or accounting information, or to seek dissolution of the LLC (with a limited exception). The LLC can operate its business without interference from the buyer or creditor which obtained the charging order.

Since most judgment creditors in Washington get a “charging order” as a remedy or a “foreclosure of charging order”, this is a rather unattractive remedy for judgment creditors and might enable the debtor-member to settle disputes with creditors on more favorable terms than would be available to the debtor-shareholders of a corporation.

As I mentioned, Washington statute does not treat a “charging order” as the sole remedy of a judgment creditor. There are few states under the statute of which, the charging order is the sole remedy of the judgment creditors and do not permit foreclosure of the charging order or member interest. Some of these states are Delaware, South Dakota, Alaska, etc, so if anyone operates a business in Washington under the Washington LLC statute, it might provide extra asset protection if he/she creates a layered LLC structure combining a Washington LLC with a master, for example, Delaware LLC. However, we still do not have case law which holds that the state statue of the LLC formation jurisdiction will control the debtor-creditor relationship if the major business operations take place in a state other than the LLC formation state. We will await for case law on this point. However, many estate planners believe that such a structure will provide favorable settlement terms if a dispute occurs with creditors.

Single Member LLCs:

Washington allows formation of Single Member LLCs. In the case, In re Albright, the bankruptcy court held that a charging order protection is not afforded Single Member LLCs. The court held that a charging order is for the non-debtor members of the LLCs to protect their investment and right to manage the LLC business operations.

Although a Single Member LLC does not afford the single member a charging order, it still provides asset protection provided under the state statute if there is no fraud involved, the company is adequately capitalized and is not used to achieve fraudulent purposes, etc.

However, if it is possible to operate as a Multi Member LLC, with another member for 5-10% interest at minimum, I believe that a Multi Member LLC provide more asset protection for business owners than operating as an Single Member LLC.

Taxation:

Corporation: There is double taxation for a C corporation; once at the corporate level (about 34-35%) and second at the shareholder level at 15% qualified dividend tax rate as of 2009. After combining both taxes, approximately 44% of the corporate profits will go to the IRS as tax payments.

LLC: There is only a single level taxation at the member level. The rate is currently 35% at maximum.

Restriction on transferability:

Corporation: There is no restriction on the transferability of corporate shares.

LLC: There are restrictions on the transferability of interest to be taxed as a partnership.

Profit and Loss Allocations:

Corporation: distributions of profits and losses are in proportion to the shareholders’ contributions. For S corporations, non-pro rata distributions of profits and losses will create a second class of stock and terminate the S election.

LLC: flexible allocations of profits and losses are permitted with some restrictions prescribed by the Treasury Regulations.

Allocation of loss deduction:

Corporation: not available for corporate shareholders.

LLC: available for LLC members.

Appreciated assets:

Corporation: Death of a shareholder doesn’t result in a step-up in tax basis (both for C corporation and S corporation), and this can result in shareholder tax liability on liquidation.

LLC: An election (I.R.C. Section 743) can be made to step up the tax basis of the LLC assets on the death of an LLC member.

Eligible owners:

Although both S corporations and LLCs provide only a single level taxation and avoid the double taxation for a C corporation, LLCs have much more flexibilities than S corporations.

These are the restrictions imposed on S corporations while such restrictions do not apply to LLCs:

  • no more than 100 shareholders;
  • only individuals, estates, certain types of trusts and exempt organizations as shareholders;
  • cannot have non-resident alien shareholders;
  • 2 classes of stock are not permitted (very stringent rules to interpret whether certain rights constitute a second class of stock, thereby terminating the S election and subjecting the corporate profits to the C corporation’s double taxation);
  • may not own 80% or more of another corporation.

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category: Asset Protection

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