A limited liability company (LLC) provides its members with personal asset protection from business debts. Creditors of an LLC typically cannot pursue the business owners’ personal assets for the business’s debts or obligations. For LLCs, there is also asset protection in the opposite direction: the business is protected from liability for its members’ debts or obligations.
Obtaining a charging order allows creditors to recover money owed to them by an LLC member without interfering with the LLC’s operations. As discussed below, state law varies regarding the degree of protection it provides.
How Does a Charging Order Work?
Because LLCs are legal entities separate from their owners, creditors cannot reach the LLC's assets to satisfy a member’s personal debt. The charging order provides a way for the creditor to obtain the debtor member's distributions from the LLC to satisfy the debt without forcing a sale of their interest or involving other members.
Here is how a charging order works in most states:
- Judgment ordered against LLC member: If an LLC member has a personal debt, and the creditor wins a court judgment, the creditor can ask the court to authorize a charging order, that is, a lien, against the debtor’s membership interest in the LLC, permitting the creditor to satisfy the debt by obtaining distributions the LLC makes to the member.
- LLC operations remain unaffected: A charging order does not permit the creditor to interfere with the LLC’s business or management, protecting the interests of other members.
- Creditors’ rights limited: The creditor receives distributions only if the LLC makes them to the debtor member. If the LLC does not distribute profits, which it is often not required to do, the creditor has little recourse.
The Degree of Charging Order Protections by State
Every state permits LLC members’ personal creditors to seek a charging order against a debtor member’s ownership interest. In some states, the charging order is the sole remedy available to LLC members’ creditors. Other states have laws that are more friendly to creditors, however, allowing them to foreclose on a debtor’s ownership interest or even dissolve the LLC.
State laws generally fall into three categories in terms of the remedies they provide to LLC members’ creditors and protections for the LLC:
- Strongest protection: exclusive remedy. In some states, charging orders are the exclusive remedy for creditors of LLC members.
- Medium protection: foreclosure allowed. In about one-third of states, a creditor can take the next step against a debtor-member and foreclose on their membership interest. Foreclosure means that the creditor becomes the permanent owner of the debtor-member’s ownership rights, entitling the creditor to receive distributions from the LLC without giving them management rights. However, it strengthens the creditor’s bargaining position to collect on the debt owed.
- No specific limitation: foreclosure and possible dissolution. A few states do not expressly limit a creditor’s right to a charging order or foreclosure. In these states, a creditor may be able to obtain a court order that dissolves the LLC. This outcome would force the LLC to cease operations and sell its assets to pay the creditor.
Single-Member LLC Charging Order Protection
State laws also differ on how they treat single-member and multimember LLCs regarding charging orders.
The intent behind charging order protections is to give creditors a way to recoup the debt owed by one LLC member while not affecting the rights of other members. However, this rationale is not applicable to single-member LLCs, and only a handful of states have statutes specifying that a charging order is the exclusive remedy when the debtor is the sole member of an LLC.
Strategies for Increasing Charging Order Protection
An LLC can take certain steps to enhance its protection against creditors seeking to recover debts owed by its members. These steps include the following:
- Establish the LLC in a state that has strong charging order protection, such as Alaska, Delaware, Nevada, or Wyoming. If this option is not practical, and it is preferable for the LLC to be established in the same state where it has physical operations, another option is to set up an umbrella company (also known as a parent company or holding company) that owns other LLCs, known as subsidiaries. However, depending on the circumstances, a court may determine that applying the law of the state of formation is inappropriate.
- Add members to a single-member LLC. Bringing in a second member to a single-member LLC makes it a multimember LLC; the result is stronger charging order protection applicable to LLCs with multiple members. However, this strategy should involve an additional member who is truly invested in and involved with the company to avoid the appearance of a sham arrangement.
- Restrict distributions and transfers in the LLC operating agreement. In the LLC’s operating agreement, a provision that does not mandate distributions and authorizes them only upon a vote of the members could neutralize the impact of a charging order before one is ever imposed.
- Use a buyout clause that is triggered by a charging order specifically or a collection action generally. Such a clause would grant nondebtor members the right to buy out the ownership interest of a debtor-member at an agreed-upon price.
Talk to a Business Attorney About LLC Asset Protection
LLCs offer important asset protection, protecting the LLC against its members’ debts and the members against the LLC’s debt. Call us today to schedule an appointment if you are interested in forming an LLC for your business or are concerned about claims creditors may have against you or your LLC.