Is a Single-Member LLC a Tool for Asset Protection?
August 2003 - by Jack S. Johal, Esq.
In April, 2003, a Federal Bankruptcy Court in Colorado held that a bankruptcy trustee could seize control of a single member limited liability company ("SMLLC") and liquidate its assets to satisfy the debtor-member's creditors. In re: Ashley Albright, 291 B.R. 538 (Bankr. D.Colo. 2003). The debtor argued that her member status should limit the trustee's recourse to a charging order and could not assume control or management of the LLC. While slightly different from state to state, a charging order generally permits a creditor to satisfy its claim from a partner's interest in a partnership or an LLC. In the Colorado case, the debtor attempted to use it to restrict the trustee from taking control of the LLC and liquidating its assets to satisfy her creditors' claims.
The Court rejected the premise that a charging order could even be granted in the context of a SMLLC. The Court focused on the primary purpose of a charging order, which is to protect other members of a partnership or LLC from sharing ownership with a member they did not select, (e.g. a bankruptcy trustee). Similar to California, Colorado law permits a member to assign their economic interest in an LLC to outside parties. To assign a membership interest, which permits the holder to participate in the management of the LLC, Colorado law requires unanimous written consent by all other members. California requires majority consent of other members. The Court in this case found, however, that unanimous consent is unnecessary in a SMLLC, because there are no other members to protect. Thus, the goal of a charging order, which is to protect other members, is irrelevant. By filing for bankruptcy, the debtor effectvely assigned her entire membership interest in the LLC to the bankruptcy court.
A different situation arises, however, when an LLC includes a passive member and one controlling or dominant member. If the dominant member files for bankruptcy, can a passive member's nonconsent bar the trustee from assuming the debtor's membership interest? The court concluded that the answer is yes, even if the passive member has a minimal interest and management role in the LLC. Rather, the trustee would simply be entitled to a charging order, which would provide the bankruptcy with the normal share of distributions attributed to the debtor-member. Nonetheless, the Court warned that this does not create "an asset shelter for clever debtors." The debtor will be subject to bankruptcy avoidance provisions and fraudulent transfer laws if they intend to hinder or defraud creditors through a "multi-member LLC with 'peppercorn' co-members."
The ramifications of this case are clear. A business planner should not create a SMLLC where creditors of the member are a concern. Under no circumstances should a SMLLC be used solely for asset protection. Asset protection is still a valuable result of an LLC; however, to realize these benefits, the LLC must include other members with more than minimal interests and demonstrable control commensurate with their interest. Furthermore, the SMLLC should protect the member from creditors of the SMLLC, similar to the veil provided by a corporation. These additional members need not be on equal footing with the dominant member, but they must be more than "peppercorn" members. So far this is the first case following this view, but it is reasonable to expect that other bankruptcy courts will adopt a similar rule to reach assets assigned to a SMLLC solely for asset protection.
A word to the wise is that no single structure provides "bullet-proof" asset protection. Asset protection is best done in layers and there shoud be other economic or business reasons to justify the planning.