what happens in a multi-member llc (CO) when one member files bankruptcy?

Question

are the other members or the assets of the LLC in a position of liability?

Answer 1

One of the primary reasons to form an Arizona limited liability company is to shield the members from the debts and obligations of the company. If formed and operated properly (i.e. the company complies with applicable laws), the Arizona LLC should protect the members from the company's financial problems. This member protection applies to protect the members from a type of creditor I call the bottom up creditor.

The Bottom Up Creditor



A bottom up creditor is a creditor that has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager or employee. The general rule that the members of the LLC are not liable for the company's debts and obligations works well with claims by bottom up creditors. See my diagram that illustrates the bottom up creditor problem.



The Arizona limited liability company gives good asset protection for its members, whether the LLC has one or many members. A single member, LLC, however, does not give its member any asset protection from a "top down creditor."

The Top Down Creditor

Answer 2

In some cases, a business owner forming a new limited liability company as a single member LLC (SMLLC) may raise a question as to whether there is a advantage or disadvantage to adding another person (perhaps a spouse of the member) simply to cause the LLC to become a multiple member LLC.



In the 1990's as many states were enacting LLC statutes for the first time, many states did not permit SMLLCs at all. If you were in a state that did not allow the formation of LLCs with only one owner, the issue was clear: you needed to add another person in order to take advantage of this newly-available entity. Even if your state allowed the formation of SMLLCs, however, there was a question whether states that did not permit SMLLCs to be formed in their state would recognize SMLLCs formed in other states where they were permitted. Fortunately, all 50 states and the District of Columbia now permit SMLLCs, so that issue is no longer a threat.



There is some lingering concern among legal writers as to whether a member of SMLLC will be given the same protection from liability as a member of a limited liability company with multiple members. In most states, the statute seems clear, but it will take many years for case law to develop that will give some lawyers the comfort that comes from decades of case law on single shareholder corporations. In the end, it seems likely that a member of a SMLLC will have no less protection than a sole shareholder of a corporation.



In a Colorado bankruptcy case, a debtor who filed a Chapter 13 petition that was later converted to the Chapter 7 liquidation was the sole member and manager of a Colorado LLC at the time of the bankruptcy filing. The LLC was not a debtor in bankruptcy. The Chapter 7 trustee argued that because the debtor was the sole member and manager at the time the debtor filed his bankruptcy petition, the trustee now controlled the LLC and could therefore sell the real property owned by the LLC and distribute the net sales proceeds to the bankruptcy estate. The debtor argued that trustee was only entitled to a charging order. The court ruled that because there were no other members of the LLC, the entire membership interest passed to the bankruptcy estate and the trustee became a "substituted member". The court concluded that because there were no other members of the LLC, no written unanimous approval to transfer was necessary, as would otherwise be required under Colorado law if there were other members.

Answer 3

Single Member LLC or Multiple Member LLC?



In some cases, a business owner forming a new limited liability company as a single member LLC (SMLLC) may raise a question as to whether there is a advantage or disadvantage to adding another person (perhaps a spouse of the member) simply to cause the LLC to become a multiple member LLC.



In the 1990's as many states were enacting LLC statutes for the first time, many states did not permit SMLLCs at all. If you were in a state that did not allow the formation of LLCs with only one owner, the issue was clear: you needed to add another person in order to take advantage of this newly-available entity. Even if your state allowed the formation of SMLLCs, however, there was a question whether states that did not permit SMLLCs to be formed in their state would recognize SMLLCs formed in other states where they were permitted. Fortunately, all 50 states and the District of Columbia now permit SMLLCs, so that issue is no longer a threat.



There is some lingering concern among legal writers as to whether a member of SMLLC will be given the same protection from liability as a member of a limited liability company with multiple members. In most states, the statute seems clear, but it will take many years for case law to develop that will give some lawyers the comfort that comes from decades of case law on single shareholder corporations. In the end, it seems likely that a member of a SMLLC will have no less protection than a sole shareholder of a corporation.



There is one circumstance, however, where a multiple member LLC holds a distinct advantage over a SMLLC — protecting the assets of the LLC from the creditors of the member. Generally, a creditor of a member of an LLC can only seek what is known as as charging order against the member's membership interest in the LLC. The creditor cannot directly attach the assets of the LLC but may only receive payments out of the member's distributional interest. However, there is a question as to whether a single-member limited liability company will be effective for protection against a creditor of the sole member.



In a Colorado bankruptcy case, a debtor who filed a Chapter 13 petition that was later converted to the Chapter 7 liquidation was the sole member and manager of a Colorado LLC at the time of the bankruptcy filing. The LLC was not a debtor in bankruptcy. The Chapter 7 trustee argued that because the debtor was the sole member and manager at the time the debtor filed his bankruptcy petition, the trustee now controlled the LLC and could therefore sell the real property owned by the LLC and distribute the net sales proceeds to the bankruptcy estate. The debtor argued that trustee was only entitled to a charging order. The court ruled that because there were no other members of the LLC, the entire membership interest passed to the bankruptcy estate and the trustee became a "substituted member". The court concluded that because there were no other members of the LLC, no written unanimous approval to transfer was necessary, as would otherwise be required under Colorado law if there were other members.



Disadvantages of a Multiple Member LLC over a SMLLC



The principal disadvantage of a multiple member LLC is that it must file a partnership tax return and comply with the sometimes complex rules of partnership taxation. A SMLLC, on the other hand, is disregarded for Federal (and most state) tax purposes. The member of an SMLLC simply reports the income and expenses of the LLC on his or her own Form 1040 on Schedule C.



In addition to the complexity of partnership taxes and the need to file an extra return, in several states (Illinois is one), there are income taxes imposed on partnerships that are not imposed on individuals.

Answer 4

These are tough economic times. Entering into a business relationship with another individual is much like a marriage, for better or for worse. However, in the business relationship, one is allowed to take precautions against "the worse". What happens when one member of a multi-member LLC goes bankrupt? Absent some provision in the operating agreement to the contrary, the member's LLC ownership interest becomes the property of the debtor's bankruptcy estate. Does the debtor still have the authority to act on behalf of the LLC as a member? Unless the operating agreement addresses this issue, the answer depends on which state your LLC is organized in. Some states such as Florida have a specific statute in their LLC code stating that a person ceases to be a member upon filing for bankruptcy. See Florida Stat. § 608.4237 and Uniform Limited Liability Company Act § 601(7).



How does this effect drafting of LLC operating agreements? As not all state LLC acts, to my knowledge, automatically terminate a member's right to vote and participate in the management of an LLC when filing a petition in bankruptcy, it is prudent to write such a provision into the operating agreement. But see below caveat. If the member becomes disassociate, the next issue is what does that member receive in return for his or her membership interest upon disassociation? One turns first to the operating agreement to see if this is spelled out and, if not, then the default provision of the state LLC act control. Using Florida as an example again, I believe Florida Stat. § 608.427 speaks to this situation even though it uses the words "withdraw" of a member rather than ceasing to be a member by operation of law. Section 608.427 states that the withdrawing member receives "the fair value of the withdrawing member's interest". Trust me, that's nearly impossible to calculate in closely held, small business LLCs. There is no market for small business LLC interests so basically one is left with hiring accountants to pull numbers out of their ***, which often leads to litigation. Thus, the smart move is to set forth in the operating agreement exactly what the disassociated member receive upon filing for bankruptcy. Examples include the member's capital account, some multiple of past earnings of the LLC then multiplied by the member's ownership percentage, book value of the LLC multiplied by the member's ownership interest, or naming a specific outside expert to value the departing member's interest if agreement cannot be reached. These examples require the LLC to come up with capital to pay off the departing member in a reasonably short time frame. That may place a burden on the LLC. Another option is for the disassociate member to be stripped of management and voting power within the LLC but to retain all rights to distributions otherwise payable to his or her ownership interest.



As with everything in the law, exception apply. What about a professional service LLC or one whether a significant chunk of the LLC is tied to specific members? It may not be in the best interest of the LLC as a whole to automatically expel a member generating significant revenue for the LLC upon the filing a petition for bankruptcy. In such case, perhaps the prudent course is to suspend the member's voting rights during bankruptcy and, further, limit the bankrupt member's ownership rights to those of an assign (i.e., retains right receive distributions otherwise payable to the LLC ownership interest).

Answer 5

the two are bypass with the aid of entities. extra effective than one member might report a tax return for the entity. A unmarried member LLC is omitted (as an entity) for tax purposes. that distinctive might comprise the interest on their very own return.