The general rule in all states, including California, is that the money or property of a Limited Liability Company (LLC) cannot be attached by creditors to pay off the personal debts or liabilities of the LLC’s members. Similar to corporations, the assets held in an LLC belong to the LLC, not the members individually, and typically may not be applied by creditors to pay a member’s individual debts. This protection from personal creditors has been one of the key reasons LLCs are formed.
In addition to providing LLC members with personal liability protection from the LLC’s business debts, LLCs also protects the business and its owners from exposure to any debts or personal liability the other LLC members may incur that are unrelated to the LLC’s business.
Charging Orders:
Under California law, creditors of LLC members are allowed to obtain a charging order, in order to collect on a judgment obtained against a member. A charging order directs the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the LLC member/debtor. Creditors with a charging order in California only obtain the owner-debtor’s financial rights and cannot participate in the LLC’s management.
Since a creditor with a charging order cannot participate in the LLC’s management, it cannot order the LLC to make a distribution or have the LLC be sold to pay off debts or obligations of the member. Frequently, creditors who obtain charging orders against LLCs end up with nothing because they cannot order any distributions and the LLC can choose not to make any.
Example: John, Meghan, and Louis form a California LLC to operate their website design business. John, a big spender, owes $38,000 on his personal credit cards. When John does not pay, the accounts are turned over to a collection agency which obtains a $38,000 court judgment against him. While the collection agency can attempt to collect on the debt from John’s personal assets, it cannot take money or property owned by the LLC. For example, the judgment holder cannot get any of the money held in the LLC’s bank account.
Although a charging order is often a weak remedy for a creditor, it is not necessarily toothless. The existence of a charging order can make it difficult or impossible for an LLC member/debtor or the other members (if any) to take money out of an LLC, without having to pay the judgment creditor first.
Foreclosure of California LLC Members Interest:
California’s LLC law does not provide that a charging order is the exclusive remedy of LLC members’ personal creditors. Rather, it allows a creditor to foreclose on the debtor-creditor’s LLC interest. Under this procedure, a court orders that the debtor-member’s financial rights in the LLC be sold.
The buyer at the foreclosure sale—often the creditor or other members of the LLC–becomes the permanent owner of all the debtor-member’s financial rights, including the right to receive money from the LLC or obtain a share of the LLC’s assets if it is dissolved. However, the buyer may not participate in the management of the LLC or order that any distributions of money or property be made.
As a practical matter, getting a member-debtor’s LLC interest foreclosed upon can be an expensive and difficult undertaking; but, the ability to do so gives a creditor more leverage in dealing with the debtor. Often, the debtor/member or other LLC members will settle the claim to prevent the foreclosure.
Example: The collection agency obtains a $38,000 judgment against John, co-owner of the web design LLC, for his unpaid credit card debts. The agency obtains a charging order from a California court ordering the LLC to pay over to it any profits it distributes to John up to $50,000. However, the LLC need not, and does not, make any distributions, so the agency gets nothing. The agency then obtains a court order for the foreclosure on John’s interest in the LLC. To avoid this, the LLC settles John’s personal debt with the agency for $38,000.
Dissolution of the LLC is not allowed:
Like most states, California does not permit personal creditors of an LLC member to have a court order that the LLC be dissolved and its assets sold to pay off the creditor.
What About One-Member California LLCs:
The reason personal creditors of individual LLC owners are limited to a charging order or foreclosure is to protect the other members of the LLC. It doesn’t seem fair that they should suffer because a member incurred personal debts that had nothing to do with their LLC. Thus, such personal creditors are not permitted to take over the debtor-member’s LLC interest and join in the management of the LLC, or have the LLC dissolved and its assets sold without the other members’ consent.
This rationale disappears when the LLC has only one member (owner). As a result, court decisions and LLC laws in some states make a distinction between multi-member and single-member LLCs (SMLLCs). California is not one of these states. Nevertheless, whether, and to what extent, California SMLLCs are protected from outside creditors is not entirely clear. Moreover, in some cases the laws of other states that provide less protection to SMLLCs may be applied–for example, where a California SMLLC does business or owns property in another state. In addition, the protections that state LLC laws provide to SMLLCs might be ignored by the federal bankruptcy courts if the SMLLC owner files for bankruptcy.
If you are really concerned about protecting the assets in your California SMLLC against personal creditors, you should consider adding another member to your LLC, or simply change from an LLC to other available structures. If you decide to do this, the second member must be treated as a legitimate co-owner of the LLC. If the second owner is added merely on paper as a sham, the courts will likely treat the LLC as an SMLLC. To avoid this, the co-owner must pay fair market value for the interest acquired and otherwise be treated as a “real” LLC member—that is, receive financial statements, participate in decision making, and receive a share of the LLC profits equal to the membership percentage owned.
Conclusion:
Considering the recent cases in California Courts as well as the watered down statue lessening the protections granted for LLCs, and the somewhat exorbitant gross receipt taxes due to Franchise Tax Board, it is time to rethink LLCs as the vehicle of choice, be it single member or multi member. There are alternatives vehicles and structures available, which are superior in protection, as well as significantly less costly from a state of California tax perspective.
