"Limited liability" is an important consideration when choosing an organizational form for your business Limited liability doesn't refer to the amount at risk. It refers to a separate between business and personal assets–so that business creditors can not reach your personal assests and vice versa. Only corporations and LLCs provide of the owners with full "limited liability" in every state.
When choosing an organizational form for your business, one of the important considerations involves the concept of limited liability. Only businesses run as corporations or LLCs provide full limited liability to all of the owners.
But what, exactly, is limited liability?
Limited liability means that there is a wall between your personal assets and your business assets. One type of creditor (e.g., business) can not reach other types of assets (personal.) It is sometimes mistakenly said that a corporation or LLC has limited liability. In fact, the corporation and LLC have unlimited, personal liability for their debts. The LLC or corporation can lose everything it owns--but it can not lose the personal assets of its members or shareholders.
- Without Limited Liability
- Business creditors can reach: Both business assets and personal assets
- Personal creditors can reach: Both personal assets and business assets
- With Limited Liability
- Business creditors can reach: Only business assets
- Personal creditors can reach: Only personal assets
It is the owners who enjoy limited liability from business creditors. The owner's liability for the business's debts is limited to what he or she has invested in the business (i.e., the business's assets.)
Bear in mind, however, that your business can lose everything it owns, and this includes your investment in the business. It is wise, therefore, to invest and maintain as little capital as possible within the business form. This tenet of asset protection may be carried out in a number of different ways, through effective asset exemption planning, proper entity choice, strategic funding and structuring, and careful planning of day-to-day operations. Because of limited liability, of course, the owner's personal assets, outside of the business form, are shielded from liability for business debts.
Michael, operates his business as a sole proprietorship. In 2008, his business was caught up in the national economic downturn. His business suffers severe financial difficulties, resulting in a debt of $1.5 million, due to a loss of market share and default on loans. Michael's personal net worth (unrelated to his business) is $1 million and he has $50,000 invested in his business.
What does Michael stand to lose? In other words, what is the limit of his liability?
Because he was running his business as a sole proprietorship, every asset he has is at risk. This means Michael could lost his entire personal net worth of $1 million and well as the $50,000 he has invested in his business.
If Michael has operated his business as a corporation or as an LLC, he would have limited his liability for business losses to only his business assets. Although he could lose the $50,000 he has in his business, his personal assets of $1 million would be beyond the reach of business creditors provided he had not personally guaranteed any of the loans.
Sole proprietorships, partnerships and limited liability partnerships lack full limited liability
The simplest business forms--sole proprietorships and partnerships--are also the riskiest from the standpoint of asset protection. The sole proprietorship is not a separate entity from it's owner. As a result, every asset of the owner can be seized by business creditors. And, every business asset can be seized by the owner's personal creditors. A general partnership carries the same risks and the additional risk that each owner is fully liable for any misstep by any other partner.
Only level of protection up from the sole proprietorship and the partnership is the business form known as the limited liability partnership (LLP). Many states only offer what is termed a "limited shield" of liability. This means that limited liability is reduced. This is substantially less protection than what is offered by the limited liability company.
A limited shield means that the owners the LLP will have limited liability only with respect to actions of their co-owners. Owners will still have unlimited, personal liability in all other cases, meaning all of their personal assets outside the business will be exposed to liability. Put simply, a limited shield converts the liability exposure of a partner into that of a sole proprietorship, which is really no protection at all.
For example, if a business operating as an LLP sells a defective product that injures a customer, the owners could be sued personally. Similarly, if an employee of the LLP injures someone while carrying out the LLP's business, all of the owners of the LLP would have unlimited, personal liability.
Further, even when a "full shield" is offered, the business interests of the owners of an LLP are still not offered the same protection from the claims of their personal creditors that the owners achieve in the LLC. For this reason, the LLP is usually not a good choice for the small business owner.
Impact of liability funding decisions
In order to fully protect your assets, there are two types of liability to consider in deciding how to structure and fund what will be your most likely entity choices--the limited liability company (LLC) or corporation. These are
- liability for business debts (i.e., debts that arise from business transactions) and
- liability for personal debts (i.e., debts incurred from activities outside of the business entity).
Shrewd funding and operating reduces risk to business assets
As noted above, most business owners mistakenly believe that assets within a corporation or limited liability company (LLC) are shielded from liability. This is certainly not the case with respect to business debts. In fact, most business owners face the greatest risk of liability from business transactions, and not personal dealings. Thus, these assets, which can be significant in a successful business, will be exposed to the greatest risk of loss. Yet, a corporation or LLC can be structured, funded and operated so that the business's assets are not exposed to any liability.
Unfortunately, today, most small business owners are not structuring, funding or operating their businesses to avoid liability. Thus, owners are unknowingly exposing their personal and business assets to a high risk of loss, many times under the illusion that their corporation or LLC will afford them protection. Typically, owners find out the truth only when financial troubles strike. At that point, usually it is too late, or extremely difficult, to preserve wealth, and the result is a significant loss of personal and business assets and, in the worst case, financial disaster.
You should invest and maintain as little vulnerable capital as possible within the business form, so that your "limited liability" is, in essence, further limited because you expose little or no assets to liability.
However, you should be aware that this strategy can trigger an exception to limited liability, in which a court "pierces the veil" of limited liability and imposes unlimited, personal liability on the owners, on the grounds that the capitalization was inadequate and was a fraudulent scheme against the business's creditors.
Fortunately, an LLC or a corporation can be adequately capitalized so as to avoid this exception, without exposing business assets to liability. Balancing the initial capital structure is critical in avoiding application of this exception.
"Charging orders" let personal creditors attack business assets
Placing assets within a business entity, such as a limited liability company (LLC), corporation or partnership, is sometimes touted as an asset protection device for personal debts. While this strategy has merit, when used by itself it dangerously and unnecessarily exposes these assets to a high risk of loss to the business's creditors.
In order to understand how protection of your business from personal debts is possible, you need to understand something called a "charging order," and how it affects limited partnerships (LPs), general partnerships, limited liability partnerships (LLPs), sole proprietorships, corporations and limited liability companies.
What is a "charging order?"
The charging order concept stems from a theory involving partnership property. It developed to provide relief when a partner's personal assets were insufficient to satisfy his personal creditors. In this situation, the personal creditor of the partner could obtain a "charging order" against the partner's interest in the partnership which made the creditor the "assignee" of this interest. In effect, the creditor attaches the partner's interest in the partnership.
However, according to the law, a partner does not actually own any specific assets in a partnership. His property interest is, in fact, his partnership interest itself, which is deemed a type of personal property. Because of this theory regarding partnership property, a personal creditor of a partner may attach the partner's interest, but the creditor may not directly attach the underlying partnership assets.
Although its roots are in partnership law, the concept of a charging order applies to business interests other than those held by a partnership.
Sole proprietorship assets are always at risk. The sole proprietorship is not recognized as an entity for any purpose and, accordingly, cannot own any property. Thus, the sole proprietor's business assets can always be foreclosed on and liquidated by his personal creditors, because the assets are really personal assets. In this case, personal debt liability is the same as business debt liability
Charging orders can destroy partnerships
A charging order can result in a general partnerships being forced to liquidate. General partnership law as reflected in the Uniform Partnership Act (UPA) has always embraced the liquidation view. Under this theory, a personal creditor with a charging order may foreclose on the debtor's partnership interest, provided the creditor can prove that it isn't fair and equitable to allow the debtor to carry on the business, with the creditor acting as a mere assignee of the business interest. This usually will not be difficult to prove in a small business setting.
The UPA also specifically allows the courts to make all orders necessary to enforce this right, including an order forcing a liquidation of the business to satisfy the owner's personal debt liability. Specifically, the courts are empowered in these states to make all orders, directions, accounts and inquiries which the debtor owner might have made, or which the circumstances of the case may require. This is a very broad power.
Most states have enacted the UPA to govern general partnerships, although a few states have enacted the Revised Uniform Partnership Act (RUPA). However, both versions of general partnership law reflects the liquidation view.
Note that in the general partnership, the law deems the relationship among the partners to be a personal one. Thus, the personal creditor with a charging order cannot become a partner (without the unanimous consent of the other partners) and, accordingly, cannot vote or participate in management. However, general partnership law does not take the extra step afforded by limited partnership law with respect to charging orders. Thus, despite the personal relationship, the personal creditors who attach a general partnership interest can foreclose on the partner's interest and force a liquidation of the business.
In a small business, this is more of a possibility, because the courts will look at the size of the creditor's debt in relation to the size of the business, as well as the effect a forced liquidation would have on the other owners, before deciding whether or not a liquidation is equitable. In the case of larger businesses, or ones with multiple owners, forced liquidation is less likely to be deemed equitable. However, the power is broad enough to allow the court to take all actions that the owner could have taken, including voting, or selling, his interest to a third party.
Limited liability partnerships can be forced to liquidate
Registering a general partnership as a limited liability partnership (LLP) will not be much help in avoiding a forced liquidation through a charging order because of an owner's personal debt liability.
The LLP is simply a general partnership that registers to achieve limited liability for all of the owners, which serves to protect the partners personal assets from business liability. In all other respects, the LLP is subject to general partnership law (i.e., the Uniform Partnership Act or Revised Uniform Partnership Act) regarding charging orders. Thus the owner's personal creditors can attach and then foreclose on an LLP interest, and seek a forced liquidation of the business.
Limited partnership interests immune from foreclosure
In the case of a limited partnership (LP), the law takes the concept of a creditor attacking an owner's partnership interest (and not the partnership's assets) a step further. The creditor with a charging order cannot foreclose on that interest and force a liquidation of the partnership to reach the specific partnership assets, in order to satisfy the owner's personal debt liability. Instead, the creditor is an "assignee" of the partner's partnership interest. As an assignee, the creditor takes over the rights of the partner to receive any income or assets that otherwise, in the normal course of business, would have been distributed to the partner.
However, the relationship among partners is a personal one and new partners can not be admitted unless all partners consent. Therefore, the creditor does not become a partner. Accordingly, the creditor cannot participate in management of the business (by voting or otherwise). This means that the creditor cannot legally force a distribution of income or assets that otherwise would not have taken place.
The business owners can simply stop making ordinary distributions of income. If income or assets are being distributed, the creditor will be holding an interest that will provide no benefit whatsoever. Worse yet for the creditor is the fact that a holder of a partnership interest in an LP must pay federal income taxes on his or her allocated share of earnings, even if they are not distributed. Thus, a creditor with a charging order will be taxed on the owner's share of earnings, even though the creditor receives no income.
Many creditors, knowing that this is a likely outcome, may decide not to pursue the matter, give up collection efforts, or accept a reduced settlement, especially after the debt goes uncollected for a long period of time. But, on the other hand, many potential creditors, knowing this, will be hesitant to extend financing or favorable terms to the business.
All states (except Louisiana) have enacted either the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA), and will follow these rules with respect to charging orders and limited partnerships. Because the limited partnership laws of Louisiana are based on the older law, they are likely to follow the "liquidation view" that applies to general partnerships and charging orders.
Charging orders affect corporations and LLCs differently
Charging orders can force the liquidation of a corporation. In theory, the relationship among corporate shareholders is an impersonal one, as opposed to that in a partnership or limited liability company. Therefore, when satisfying an owner's personal debt liability, the law allows a creditor who has acquired the shares through attachment to participate in management of the corporation. Thus, the creditor may vote the shares in favor of liquidation, or in other ways unfavorable to the debtor's interests. In a small, closely held corporation, this is a real possibility.
When you hold a majority interest in the corporation, and this interest is attached by a creditor with a charging order, your creditor may vote to liquidate the business to satisfy the debt.
Even setting up your corporation as a statutory close corporation does not eliminate the risk that personal creditors of the owner will be able to attach and then vote the shares in favor of a liquidation of the business.
Most states protect LLCs from charging orders
The limited liability company (LLC) is a hybrid--a combination of the best elements from the corporation, the partnership and the limited partnership. The LLC derives a non-liquidation benefit from its limited partnership heritage.
Many states LLC laws follow the Revised Uniform Limited Partnership Act (RULPA) and limited partnership (LP) heritage and have rules preventing foreclosure of an owner's interest and forced liquidation of the business to satisfy a personal liability of an owner. The unfavorable outcome that can occur in a corporation--forced dissolution--cannot occur in the LLC because a creditor with a charging order does not become a member of the LLC and, accordingly, has no voting or management rights.
However, Not all states follow the RULPA view with respect to LLC interests. Some are likely to follow the general partnership rules and take the "liquidation view," under which the creditor can, in fact, foreclose on the partnership interest. In short, the creditor can force a liquidation of the partnership, so that the partner's personal debt can be paid from his or her share of the liquidated assets. Note that the Uniform Limited Liability Company Act, which has been adopted in some states, reflects the general partnership view.
The following states have LLC statutes that follow the RULPA view prohibiting foreclosure and liquidation:
States prohibiting foreclosure on an LLC interest
- Rhode Island
You should consider forming an LLC in one of the states listed above, even if that is not the state where the business will be conducting its operations (see our discussion of a choice-of-state analysis). In these states, the protection afforded to your business interest, against the claims of any personal creditors, is significant.
Note that, under the RULPA view incorporated into the LLC statutes in the states listed above, courts are not given the power to make any orders, except the mere granting of a charging order. In fact, the courts that have interpreted the RULPA charging order provision have concluded that the charging order is the only remedy available to the personal creditor. This should also extend to LLCs in the states listed above.
Bankruptcy courts vary in applying charging orders
The limitations on a creditor under the RULPA may also apply in a federal bankruptcy proceeding. However, the federal bankruptcy courts have other powers that come into play. Further complicating the exercise of these powers is the fact that the bankruptcy code does not yet have specific provisions that apply to LLCs. This often leads to uneven results across the states in bankruptcy cases.
The LLC operating agreement is likely to be deemed an "executory contract" in bankruptcy parlance. The trustee appointed by the bankruptcy court can, under the federal bankruptcy code, exercise powers over the debtor's interests in an executory contract. This power can be used to sell or assign the owner's rights under the agreement. This right should only apply to the extent a creditor with a charging order could exercise these rights. Thus, an LLC statute with a RULPA charging order provision should work to prevent the bankruptcy trustee from usurping, or assigning, any management rights in the LLC, or naming an assignee of the interest as a full-fledged owner.
In other words, the trustee should have no greater rights than could be exercised by a creditor with a charging order under state law. However, because of a lack of express provisions in the bankruptcy code related to LLCs, this result is not assured. It is possible that bankruptcy courts in some states could reach a different conclusion.
Expulsion clauses can protect LLC from a member's bankruptcy. For this reason, a properly drafted LLC operating agreement may contain a clause that expels, or gives the LLC the power to expel, an owner who files a bankruptcy action. This clause, if it is exercised to trigger expulsion, severs the filing member from the contract and allows the remaining owners to regroup and continue the LLC without bankruptcy court interference. (Note that this is the default rule under the Delaware LLC statute--one more reason to consider forming your LLC in Delaware.)
The right to expel might include the requirement that it can only be exercised if the bankruptcy court concluded the trustee had the power to exercise or transfer the management rights of the owner. In the event of an expulsion, management and voting rights could, under the agreement, be vested in the existing voting/managing owners, or if none exist, in the owners who originally held nonmanager/nonvoting interests.
The expulsion clause may further provide for a diminished payout (e.g., equal to book value, rather than fair market value) to an owner who is so expelled. The clause also can provide that the bankruptcy action amounts to a material breach of the agreement by the debtor/owner, entitling the LLC to recover damages from the owner. Further, the clause can provide that this diminished amount be reduced further on account of the damages caused to the LLC by the breach. These provisions reduce any amount that would be paid into the debtor/owner's bankruptcy estate and could persuade the trustee to abandon the executory contract.
Because of the fairly severe consequences an expulsion clause itself can cause, it is wise to seek professional guidance in this matter. For example, an expulsion clause may be more appropriate in a family owned LLC, where expulsion and a diminished payout would not, in reality, diminish the family's overall wealth.
As you may have guessed, trustees sometimes challenge these clauses. A court may uphold the clause, however, if applicable state law incorporates the RULPA charging order concept, and thus prevents a judgment creditor from assuming all the rights of an owner, and allows the remaining owners the power to reject admitting the creditor as full-fledged owner. Thus, it is essential that the LLC be formed in a state that incorporates the RULPA charging order concept, and that the operating agreement contain a clause along the lines described above.
Weigh options to avoid charging order calamities
When choosing an organizational form for your business, most small business owners will usually want to form the business as an limited liability company (LLC) or a corporation. The LLC will usually be a better choice when it comes to protecting the owner's business assets from the claims of personal creditors.
Care must be taken to form the LLC in a state that follows the Revised Uniform Limited Partnership Act (RULPA) view in its LLC statutes. Remember, you do not have to form your business in the state in which you reside or plan to do business and asset protection is an excellent reason to consider out-of-state formation.
However, if the business is to be formed in a state that allows foreclosure and liquidation in an LLC, the owner may want to consider a limited partnership (LP)as an alternative to the LLC, at least where the owner is especially concerned about protecting assets from the claims of personal creditors and the business will be family-owned, so that all of the owners will not necessarily be interested in managing the business.
If this is done, care must be taken to insulate the general partner from personal liability (by making the general partner a corporation or LLC owned by you). Of course, this will undermine the very purpose of the strategy--preventing foreclosure and liquidation by a personal creditor, because the strategy will have been undertaken in a state that allows foreclosure and liquidation in both the corporation and the LLC. Nevertheless, the limited partnership interests will still be protected from foreclosure and liquidation.
As more states begin to recognize the limited liability limited partnership (LLP), this strategy will be an even more effective alternative to the LLC.
Even when state law reflects the RULPA view prohibiting foreclosure and liquidation, is the result really satisfactory to a business owner? Assume the personal creditor does not give up or accept a reduced settlement. Under the modern view, the personal creditor of the owner attaches the owner's interest in the business and, thus, becomes entitled to all of the distributions of assets and income to which the owner would have been entitled.
The owner works in the business, but derives no benefits whatsoever. Any distributed income goes to the creditor, and when the business is finally voluntarily liquidated, all of the assets go to the creditor. How many small business owners would find this outcome satisfactory?
Nevertheless, the personal creditor, in many or even most cases, will give up or accept a reduced settlement. In particular, the fact the creditor will be taxed on the LLC's earnings, even though he or she receives nothing, usually will persuade the creditor to drop collection efforts, to cut his or her losses. Be sure to take care when drafting the entity's documents to avoid making any distributions to the owner mandatory (see our discussion of withdrawal strategies).
Since you can obtain protection from your personal creditors for assets owned by your LLC, some business owners think that they should convert as many assets as possible into business assets. Placing assets within a single LLC (in contrast to a single corporation), can offer significant protection from the claims of the owner's personal creditors, because, in many states, these creditors will not be able to foreclose on the interest and force a liquidation of the business.
However, the benefits of this strategy, within a single LLC, are very small, because most business owners are more likely to face a business liability or judgment than a personal one. The business's assets, as opposed to the owner's personal assets outside of the business, are usually at the greatest risk of loss, which means this strategy actually increases the risk of loss. A better approach would be to use two entities, an operating entity and a holding entity. In this way, you can protect your assets against the claims of both your business and your personal creditors.