THE TROUBLE WITH SINGLE-MEMBER LLCs. by Jeffrey L. Smoot

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1 Jeffrey L. Smoot Oles Morrison Rinker & Baker LLP 701 Pike Street, Suite 1700 Seattle, WA (206) THE TROUBLE WITH SINGLE-MEMBER LLCs by Jeffrey L. 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 reach 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. Recent 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 against creditors of the owner or a bankruptcy trustee. According to the majority of those decisions, the answer is no. Federal courts generally treat LLCs the same as corporations. In the non-insider context, an LLC fits comfortably within the Bankruptcy Code s definition of corporation. Sherron Associates Loan Fund XXI (Lacey) L.L.C. v. Thomas (In re Parks), 503 B.R. 820 (Bankr. W.D.Wa. 2014) (quoting Gilliam v. Speier (In re KRSM Props., L.L.C.), 318 B.R. 712, 717 (9th Cir. BAP 2004) (where the court, considering whether an LLC was a person for purposes of the Code and thus eligible to be a debtor, held that an L.L.C. fits within the definition of corporation as used in 101(41)); see also Fed. R. Bankr. P advisory committee s note (regarding corporate disclosure statements, the identification of any corporation, includes listing membership

2 interests in limited liability companies and similar entities that fall under the definition of corporation in Bankruptcy Code 101 ). Washington courts have recognized that a limited liability company is a statutory business structure that is like a corporation in that members of the company are generally not personally liable for the debts or obligations of the company, although it can be similar to a partnership for tax purposes. Chadwick Farms Owners Ass n v. FHC, L.L.C., 166 Wn. 2d 178, , 207 P. 3d 1251 (2009); see also RCW (generally members of an LLC are not personally liable for the LLC s debts, obligations or liabilities, with listed exceptions). As such, in Washington, an LLC has a power or privilege that an individual or partnership does not have (i.e., personal liability protection of members not available to partners), and is in line with the federal definition of a corporation contained in 101(9)(A)(i). Parks, 530 B.R. at 829. It is notable that RCW (1)(d) provides that a person ceases to be a member of an LLC when he or she file for bankruptcy, unless the LLC agreement provides otherwise or unless all other members consent in writing to the debtor member s continuation as a member. Absent written consent of the other members or language in an LLC agreement to the contrary, RCW (1)(d) terminates a member s interest in an LLC when he or she files for bankruptcy. Further, that member s economic interest becomes property of the bankruptcy estate. Parks, 503 B.R. at 832. Under 541(a)(1), property of the estate is defined as all legal or equitable interests of the debtor in property as of the commencement of the case. While federal law defines property of the estate, state law determines the nature and extent of a debtor s interest in property. Butner v. United States, 440 U.S. 48, 54-55, 99 S. Ct. 914 (1979). A debtor s interest in an LLC becomes property of his bankruptcy estate upon commencement of his case, and a chapter 7 trustee acquires all of the rights the debtor had in the LLC upon his bankruptcy filing, including his management rights. Parks, 503 B.R. at 832 (citing Fursman v. Ulrich (In re First Protection, Inc.), 440 B.R. 821, 830 (9th Cir. BAP 2010) (where the Ninth Circuit Bankruptcy Appellate Panel held that when a debtor is the sole member of an LLC, all of the debtor s rights in the LLC become property of the estate, including both economic and management rights)). Parks, a recent bench opinion from the Western District of Washington, follows a line of cases recognizing 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 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 2

3 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 3

4 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. In 2010, the Ninth Circuit Bankruptcy Appellate Panel addressed the issue in Fursman v. Ulrich (In re First Protection, Inc.), 440 B.R. 821 (9th Cir. BAP 2010). In First Protection, the debtors conceded that their economic interest in their LLC was property of the estate, but contended that their non-economic rights, such as their right to manage and control the LLC, did not become property of their estate, arguing that the trustee s rights are only as an assignee or as a judgment creditor with a charging order under Arizona law. The BAP agreed with the result in Albright, and held that all of the debtors rights in the LLC were subject to the trustee s control, but reached its conclusion by way of another path : We conclude that all of Debtors contractual rights and interest in [the LLC] became property of their estate under 541(a)(1) by operation of law when they filed their petition. Section 541(c)(1)(A) overrides both contract and state law restrictions on the transfers or assignment of Debtors interest in [the LLC] in order to sweep all their interests into their estate. 541(c)(1)(A). Accordingly, the restrictions Debtors point to under the operating agreement or the Arizona LLC Act did not prevent the vesting of their contractual rights in their bankruptcy estate As a result, the trustee was not a mere assignee, but stepped into Debtors shoes, succeeding to all of their rights, including the right to control [the LLC]... For this same reason, we are not persuaded by Debtors argument that relegates the trustee to the role of a judgment creditor and the remedy of a charging order under Ariz.Rev.Stat (A). First Protection, 440 B.R. at 830. The BAP also considered whether the LLC agreement was an executory contract under 365, which, the debtors contended, would govern the trustee s rights rather than 541(c)(1). Noting that the definition of an executory contract presumes that there are other parties to the contract besides Debtors, and the debtors were the sole members and 100% owners of the LLC, the BAP held that application of an executory contract analysis in this context does not make sense. Debtors could decide to have [the LLC] withhold profits and distributions and otherwise control the underlying assets, thereby hamstringing the chapter 7 trustee into a perpetual stalemate at the expense of their creditors. Executory contract law does not work to produce such an absurd result. First Protection, 440 B.R. at 830 (noting that 365 was designed to protect non-debtor third parties, and in the absence of non-debtor third parties, 365 was not applicable, citing Modanlo, 412 B.R. at 727). In the bankruptcy context, then, case law is clear that all of a debtor s rights and interests in a single-member LLC, including all economic interests and management rights, become property 4

5 of the estate subject to the control of a bankruptcy trustee upon the filing of the petition. How this might apply to a state court judgment creditor is less clear. Based on the bankruptcy case law, 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. This argument would have the court treat the LLC as a partnership, which, by definition, consists of two or more people; there is no such thing as a partnership of one ; thus, the LLC is merely the debtor s alter ego and the LLC form can be disregarded. 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 singlemember 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 for the debtor 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 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. Adding a spouse or other close family member is not 5

6 impermissible, but will be more heavily scrutinized, and an LLC owned by a married couple is effectively treated the same as a single-member LLC in a jointly filed chapter 7 bankruptcy case. 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, divorce and bankruptcy 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, or at least an argument can be made that the LLC form can be disregarded and its assets applied to satisfaction of a judgment against a 100% owner. 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 from creditors or a bankruptcy trustee. -o0o- This article was updated in 2014 to include updates on developing case law. Copyright 2014 by Jeffrey L. Smoot. Published for informational purposes only, and may not be reproduced in whole or in part without the author s express written consent. 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 the author. 6