Most businesses are formed to protect the owners from personal liability. The first corporations were chartered in the 17th century to protect the shareholders from liabilities of the corporation. As the law has evolved to accommodate more flexible and modern business structures—including LLCs—liability protection has remained at the forefront of business planning.
Business owners have two primary types of risk: Inside liability and outside liability. This article discusses these risks and how to protect against them using LLCs.
Protecting Against Inside Liability
Inside liability is risk associated with the debts and obligations of the business. Without inside liability protection, an owner of business assets can be personally liable for debts and obligations associated with those assets.
Historically, most businesses were formed to protect against inside liability. People formed corporations to take advantage of the corporate shield that would protect the shareholders from the debts and obligations of the business. This same type of protection was later extended to LLCs, which can provide better protection with more flexibility.
If a corporation or LLC is properly formed and operated, the business owner has no liability for the business obligations unless the owner signs in a personal capacity (for example, by signing a personal guarantee for a loan). The debts and obligations of the business are confined to the business. The owner’s other (non-business) assets are not at risk for debts of the business.
As discussed below, while corporations and LLCs both protect against inside liability, LLCs can provide more protection than corporations when it comes to outside liability.
Protecting Against Outside Liability
Whereas inside liability deals with debts and obligations of the business, the second type of risk—often called outside liability—deals with the debts and obligations of the owners. Specifically, it deals with how a personal liability of an owner could affect the ongoing operation of the business or the other business owners.
When a creditor of an owner seizes an owner’s interest in a company, the creditor’s objective is to collect on the debt. This objective is likely to differ from the goals of remaining business owners, who are often interested in continuing to operate the business. Without outside liability protection, a creditor of an owner could seize his or her interest in the business and act in ways that are detrimental to the going concern of the business. Depending on the circumstances, the creditor could force liquidation of the business or otherwise override the decisions of other business owners.
LLCs are the go-to business entity for outside liability protection. This is due to a remedy called a charging order, which LLCs borrow from partnership law. A charging order is a statutory remedy that limits the creditor to distributions that an owner would receive. Although the creditor will receive any distributions that would otherwise go to the owner, the creditor receives no management or voting rights and cannot force a liquidation. If the LLC is properly structured, the creditor is blocked from getting to the underlying assets of the company.
As discussed below, it is important to understand the reason for charging-order protection. Charging orders protect the business—and specifically the other owners of the business—from the repercussions of one owner’s legal problems. Without charging-order protection, innocent owners of the business would be unfairly penalized by the seizure of the business assets by one of the owner’s creditors. The charging order prevents this by limiting the creditor’s right to manage or otherwise interfere with the business. This limitation protects the other business owners from being forced into a partnership with the creditor.
Corporations do not provide the same protection against outside liability. The shareholder’s creditors can seize the shares held by the shareholder. When the creditor owns the shares, the creditor has all of the management and voting rights associated with those shares. In most small businesses, the ownership rights associated with the shares creates a risk that the creditor could take control of the business or even liquidate the corporation to satisfy the judgment.
The charging-order protection offered by LLCs can be further bolstered by proper planning. For example, the LLC can be structured to be manager-managed and the operating agreement can be drafted to give the managers the control over when distributions will be made. Separating the economic ownership of the company from the managerial functions provides an added layer of protection. A creditor of a member would have no managerial rights. If the members are also the managers, there is no downside to using this structure.
The charging-order protection can also be enhanced by including provisions in the operating agreement that assign phantom income to the creditor. Phantom income is income that is taxable to the creditor, even if the creditor does not receive any economic distributions from the company. The possibility of taxable phantom income without a mechanism to compel distributions could make an LLC interest an unattractive asset for a creditor and better protect the business.
Outside Liability and Single-Member LLCs
LLC law is based largely on partnership law. When state legislatures first authorized LLCs, they borrowed the charging-order remedy from partnership law. But there are important differences between LLCs and partnerships. By definition, a partnership requires at least two owners. An LLC, on the other hand, can be owned by a single owner (creating a single-member LLC or SMLLC).
Single-member LLCs do not provide the same level of charging-order protection as multi-member LLCs. As mentioned above, the purpose of a charging order is to protect innocent owners from bad economic consequences resulting from one owner’s legal problems. This rationale breaks down with a single-member LLC, because there are no other owners to protect. Beginning with In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) and In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005), Federal bankruptcy courts have refused to extend charging-order protection to single-member LLCs that file for bankruptcy and have allowed creditors to seize the member’s interest.
Because charging-order protection is strongest with multi-member LLCs, single owners considering the LLC structure should add an additional member to help support charging-order protection. The addition of a member can often be accomplished without sacrificing control or causing negative tax consequences. For example, a member could name his or her grantor trust or another LLC as the other member, thereby invoking the full charging-order protection of LLC law with little downside.
Single-member LLCs also remain useful in general planning. They are often used as subsidiaries of parent companies in the holding company model, allowing them to segregate liability from different sources (like separate parcels of real estate or different lines of business). This structure does not rely on charging-order protection, but on the traditional inside liability protection offered by LLCs. This inside liability protection applies regardless of whether the LLC is a single-member LLC or multi-member LLC.