Single Member LLC: Still a Viable Choice for Liability Protection
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 in order to satisfy creditors of the debtor-member. This case has created concern among many business owners and advisors as to whether the SMLLC remains a viable choice of entity to provide an owner with limited liability in the event of a claim against the SMLLC. This article will briefly discuss the Colorado Bankruptcy Court’s decision, outline the manner in which a SMLLC retains its liability shield, and provide guidance regarding how to structure certain business activities to maximize liability protection.
BANKRUPTCY COURT DECISION
In re: Ashley Albright provides that a bankruptcy trustee may seize control of a SMLLC and cause its liquidation to satisfy creditors of the debtor-member. In Albright, the debtor argued that her member status in the SMLLC is analogous to that of a shareholder of a corporation or member of a multiple-member LLC, limiting the trustee’s recourse to a charging order against the owner’s interest in the entity rather than assuming control of the entity. The Colorado Bankruptcy Court determined that a charging order (i.e., a right to receive the owner’s share of income from the entity) is not appropriate in the context of a SMLLC, as the primary purpose of a charging order is protection of other owners of an entity from sharing ownership and management with an owner they did not choose.
The intricacies of this case are beyond the scope of this article, but in essence, the Court determined that by filing for bankruptcy, the single-member essentially assigned her entire ownership interest in the SMLLC to the bankruptcy estate. A future article will explore the impact of this Colorado Bankruptcy case and subsequent Oregon cases on borrowers and lenders.
ASSET PROTECTION VS. LIABILITY PROTECTION
An important distinction to note from the above referenced case is the difference between asset protection and liability protection. Both forms of protection are very important, but the significance of each will often depend on the different priorities of each business owner.
Asset protection is the concept of shielding assets from claims against the owner resulting from circumstances such as bankruptcy, personal liability, personal guaranty, or divorce. In Albright, the individual bankruptcy filing by Ms. Albright gave rise to the claims against Ms. Albright’s assets, including the ownership interest in the SMLLC. Claims against an individual for which the individual has personal liability are typically satisfied by personal assets. Because a SMLLC only has one owner, the court determined that the Trustee had the right to cause the business assets of the SMLLC to be liquidated, the proceeds thereof becoming personal assets. Regardless of whether you agree with the court’s decision, the Albright case shows us that the using a SMLLC to protect assets from liability claims against the owner may not achieve the desired results.
Liability protection is the concept of protecting business owners, and their non-business assets, from liability claims against the business. Liabilities of the business should be satisfied by the business assets and not the owner’s other assets, unless the owner provided a personal guaranty. Where a business is operated as a sole proprietorship or general partnership, with no limited liability entity in place, there is little distinction between business assets and personal assets. If liability protection is a priority for the business owner, a SMLLC provides limited liability, so long as the statutory formalities with respect to such entity are followed (e.g., separate bank account, separate books and records, not an alter-ego of the owner).
If a SMLLC is properly formed and maintained by the owner, claims made against the SMLLC will be limited to the assets owned by the SMLLC. For this reason, many clients choose to form a LLC for each separate project, property or venture. Similarly, many lenders require borrowers to form a single-purpose SMLLC for particular projects requiring separate financing.
MAXIMIZE YOUR LIABILITY PROTECTION
For income tax purposes, a SMLLC is a disregarded entity. Thus, the SMLLC does not file an income tax return, and items of income or deduction resulting from the SMLLC operation are included on the income tax return of the owner. A SMLLC does not have the income tax reporting obligations of an entity taxed as a corporation or partnership, including a multiple-member LLC. In the context of an IRC 1031 like-kind exchange, the IRS has acknowledged that acquisition of all of the ownership interest in a SMLLC owning “like-kind” replacement property may be treated the same as acquisition of the replacement property. This is the logical result for an entity that is generally ignored for tax purposes, but recognized for liability protection purposes.
For all of these reasons and more, individuals and entities should still consider use of a SMLLC to limit liability for a particular project, venture or investment to the assets of such project, venture or investment. Our lawyers have extensive experience advising clients on choice of entity issues and structuring business endeavors to accomplish our clients’ goals. Please contact us if we can be of assistance.