Although for many business owners the primary concern is protecting the owner’s personal assets from business liability using the shield of limited liability, there are also circumstances where it would be wise to have a double-sided shield, i.e., protecting the entity from the owner’s personal debt/liabilities.

This consideration may prove vital for business owners who want to prevent the assets of their entity from being subject to one of the entity owners’ personal debts or liabilities. For example: X, Y, and Z form an entity for their hair salon. X and Y each contribute $24,000 and Z contributes $52,000 for a total of $100,000. Unbeknownst to X and Y, Z has been racking up personal credit card debt over the years. When Z ends up defaulting on his debt, the creditors turn the account over to a collection agency which obtains a court judgment against Z.

In this example, if the creditor uses the judgment to force a liquidation of Z’s share in the entity, the other owners of the business will likely be forced into a vulnerable position because they may not have enough capital to continue; this could be devastating to a start-up business.

The threshold issue being; can the collection agency satisfy its judgment against Z by taking the money or property of the XYZ entity? Well, to quote the cliché attorney response–it depends.

In order to fully protect your assets, there are two types of liability to consider in deciding how to structure and fund your most likely entity choices–the limited liability company (LLC) or corporation (Corp). These are

• liability for business debts (i.e., debts that arise from business transactions) and
• liability for personal debts (i.e., debts incurred from activities outside of the business entity).

With respect to liability for business debts, both the Corp and LLC limit the business liability to the business assets. With respect to the liability for personal debts, the Corp and LLC have different rules.

Even though the general rule is that creditors can’t collect directly from a Corp or LLC for an owner’s personal debts, the creditor can obtain a charging order against the owner’s interest in the Corp or LLC.

Charging Orders Affect Corporations and LLCs Differently

Charging orders can result in a forced liquidation of a corporation. When satisfying an owner’s personal debt liability, the law allows a creditor who has acquired the shares through attachment to participate in management of the corporation. In light of this participation, the creditor can vote the shares in favor of liquidation, or in other ways unfavorable to the other owners’ interest. In a small, closely held corporation, this is a real possibility.

In our example above, if the entity were a corporation, Z’s creditor can step into the shoes of Z and participate in management of 52 percent of the corporation. Because Z’s creditor is likely interested in satisfying the judgment as soon as possible, and further because Z has majority vote, the creditor will likely force a liquidation of the XYZ Corp to the detriment of X and Y.

With respect to an LLC, the results may prove more favorable for members depending on the state law the LLC is formed under.

Many states follow the Revised Uniform Limited Partnership Act (RULPA) providing for business friendly rules preventing both foreclosure of an owner’s interest and forced liquidation of the business to satisfy a personal liability of an owner. Accordingly, the unfavorable outcome that occurs with the Corporate form, as discussed above, i.e. forced liquidation, cannot occur in the LLC because a creditor with a charging order does not become a member of the LLC. In states that follow the RULPA, a charging order is the only legal procedure that personal creditors of the LLC can use to get at a member’s(debtor’s) LLC ownership interest. Under the RULPA, a charging order forces the LLC to pay the creditor any distributions of income or profit that would have been distributed to the member. In other words, the creditor acquires no voting or management rights as seen with the Corporate form, instead the creditor is limited to the member’s financial rights. Accordingly, creditors who obtain charging orders against LLCs formed under the RULPA practically end up with a useless order because the LLC can choose to avoid paying out distributions to the member and the creditor can not demand otherwise.

In our example above, if the entity were an LLC formed under the RULPA, Z’s creditor would have a charging order that would mandate the LLC to pay to the creditor any distributions the LLC would otherwise make to Z. However, if there are no distributions, there will be no payments.

The following are states that follow the RULPA view of Prohibiting Foreclosure on an LLC interest: Arizona, Arkansas, Connecticut, Delaware, Idaho, Illinois, Louisiana, Maryland, Minnesota, Nevada, Oklahoma, Rhode Island, Virginia.

Of course, not all states follow the RULPA view. Some are likely to follow the general partnership rules and take the “liquidation view,” under which the creditor can, in fact, foreclose on the partnership interest if they have a charging order. By foreclosing upon the members share, the creditor can effectively force a liquidation of assets so the debt can be satisfied. Note that the Uniform Limited Liability Company Act (ULLCA), which has been adopted in California in addition to some other states, reflects this view. However, recently California’s LLC laws were updated so that in order to get a court to order such a foreclosure, the creditor must establish that the member will not be able to pay the debt within a reasonable time. This modified rule now buys the LLC some time to get its finances in order since the creditor must wait before the foreclosure can be ordered. This is a benefit over the Corporate form because there, the creditor can immediately vote the shares and force a liquidation.

Because the personal liabilities of a partner in a partnership are not always known, it may be wise to avoid the devastating consequences of a sudden forced liquidation and form the partnership as an LLC; better yet, it would be clever to form the LLC in a state that follows the RULPA. Keep in mind that these favorable rules for an LLC apply even if you form as an LLC with S-corp tax election.

In our example above, if the entity were an LLC formed in California under the ULLCA, Z’s creditor would obtain a charging order ordering the LLC to pay it any distributions. If the LLC did not pay out any distributions, the creditor would attempt to request a court order for the immediate foreclosure of Z’s interest in the LLC. In light of this response, it would serve the LLC best to pay out small distribution that would satisfy the creditors judgment over the course of a few years; in effect, preempting the court from granting an immediate foreclosure. This could buy the LLC some time, allowing the LLC to satisfy the judgment without sudden liquidation which would otherwise cripple its financial solvency.

It would also be worth noting that an expulsion clause can protect a California LLC from a member’s bankruptcy. For this reason, a properly drafted LLC operating agreement should contain a clause that expels, or gives the LLC the power to expel, a member who files for bankruptcy. If the clause were exercised to expel the member, the remaining members would still be allowed to regroup and continue the LLC without bankruptcy interference. In fact, you can even specify a buy-out price for the members share in the event of a bankruptcy. Lastly, it should come as no surprise to hear that Delaware, the pro-business state, provides this expulsion directive as a default rule under the Delaware LLC statute; another reason why entrepreneurs consider forming under Delaware law.