What is the LLC Charging Order for the Limited Liability Company?

Most business owners create a limited liability company for their business in order to protect their personal selves and their personal assets from the liabilities and obligations of the business.

However, another liability concern relates to what is known as “reverse” liability. If a business owner is sued in his personal capacity for something totally unrelated to his LLC business, is the LLC business protected from being taken over by the person who obtains a judgment against the business owner personally?

The LLC laws of most states contain a “charging order” provision in them which is a great benefit of owning a business through a limited liability company.

The charging order provisions generally state that a creditor of a member of an LLC can only seize the economic rights of the LLC ownership interest held by that member. In other words, the creditor can never get the full ownership and never have voting or management control over the LLC business. What does this mean?

It means that you, as an LLC owner, will continue to be able to run the LLC business as before, and you, as a manager (along with other managers) can decide not to pay out any profits distributions related to ownership interests. This would result in the creditor not receiving any money for foreclosing on the LLC ownership interest AND actually being liable for the tax related to profits of the LLC business that were retained in the company.

Given this, most creditors will not look to take any LLC ownership interests because the potential result could be that the creditor will have to pay taxes on profits he never gets.

LIMITATIONS OF CHARGING ORDER PROTECTION

While charging order protection provisions are found in most state LLC statutes, an important bankruptcy case held that charging order protection would not apply to single member LLCs. This is because the reason for the charging order is to protect other members of your LLC business and the LLC business itself from business interruption related to the personal liabilities of one of its members. With a multi-member LLC, the interests of a personal creditor of one member should not take precedence over the LLC and the other innocent members.

However, if the LLC is owned only by one member and it is that member who is personally liable to a creditor, then in bankruptcy, the law will ignore the charging order protection and could allow the creditor to foreclose on the entire LLC ownership interest and business. To be safe, practitioners are advising that charging order protection should not be relied upon in any single member LLC situations either within or outside of bankruptcy.

This article discusses charging orders generally, but each state has its own scope and details for charging order protection so if this is an important issue to you, please check with your local attorney to receive specific advice for your jurisdiction and circumstances.

Money Contributed to a Limited Liability Company- How is is Categorized?

A new business will always need some capital or access to capital to start a business. Even an ongoing business may need funds from time to time as it deals with cash flow deficiencies or expansion.

While a limited liability company has the right to borrow money, the most common method of getting initial capital is by having the initial members contribute capital to the LLC in exchange for their membership interests.

However, a member can also loan money to an LLC even if he or she is a member.

When a member contributes money to an LLC, it is very important that the transaction categorized as either a capital contribution or a loan and that the transaction be documented in sufficient written documents.

When money sent is a capital contribution, the amount is credited to the member’s capital account but it is not a loan that the LLC is required to pay back. No debtor-creditor relationship exists. If that member is later distributed profits back, it will be credited against the capital contribution amounts of the member.

When money sent is a loan, a debtor- creditor relationship is formed. The LLC owes the member the money back. The terms of the loan (amount, interest rate, repayment terms, default provisions) should be documented in a written loan agreement or promissory note between the member and the LLC.

If there are other members, the loan transaction should be approved by the LLC membership because it is called a “interested transaction” (one between the LLC and one of its own members). It is really important that the loan transaction be fair and equitable to the LLC to avoid any unfair transactions benefitting the lender member.

So, in summary, the LLC and the member can agree on how money sent from the member to the LLC is to be categorized. The categorization of a member capital contribution or a member loan results in a different transaction and different treatment of the transaction by both the LLC and the member. In order to avoid later disagreements, this categorization should be agreed upon and sufficiently set forth in writing signed by the LLC and the member . . . and if applicable, the proper governance vote should take place with all members to approve the transaction.

Why should an LLC include "capital contributions" in its operating agreement?

LLCs: Why should an LLC include "capital contributions" in its operating agreement?