The Kansas single-member LLC can be a good entity choice for the solo entrepreneur especially if the business is operating in a high-risk industry and the business is not all that asset intensive. However, as an asset protection tool the single-member LLC does have certain flaws.
Charging Order Protection of the LLC:
Traditionally, the Kansas limited liability company offers two layers of protection. The first layer protects the LLC member’s personal assets from the claims of creditors of the LLC. Please see, Limitations of Limited Liability Protection. The second layer, called charging order protection, has the opposite effect. It protects the assets of the business from the claims of the individual business owner’s creditors. Charging order protection has its roots in partnership law and the basic premise behind the protection is to protect co-owners of a business from the individual misfortunes of their partners. To better understand this it is best to think of an LLC membership interest as having two parts. The first part is the member’s “economic rights” in the company. These rights include the member’s entitlement to the profits and distributions of the company and the overall value of the membership interest. The second part involves the member’s “non-economic” rights in the company. These include the member’s right to manage the day-to-day operations of the company and to control the general governance of the company. For example, suppose you have a business partner who negligently injures another person in a car accident and that injured person secures a large judgment solely against your business partner. Charging order protection prevents the judgment creditor from effectively gaining access to your partner’s “non-economic rights” accompanying the LLC membership interest. The judgment creditor can gain access to your business partner’s “economic interest” and may become entitled to any profits that are distributed from the company to your business partner, but that is the extent of its reach. Therefore, the charging order is actually meant to serve the non-debtor member by protecting the innocent member from having to involuntarily share control of the business with the debtor member’s creditor. The dilemma with the single-member LLC is that no other business owners exist to justify charging order protection and for this reason the trending theme among courts has been to deny the protection to single-member entities.
Adverse single-member LLC rulings first emerged in the consumer bankruptcy arena, however, we are now seeing it being challenged elsewhere. The first adverse case, In re: Ashley Albright, surfaced in 2003 out of a Colorado bankruptcy court. In this case the debtor, Ashley Albright, was the sole member and manager of a Colorado LLC at the time she filed for Chapter 7 consumer bankruptcy. The bankruptcy trustee contended that because Ms. Albright was the sole member of the LLC, that upon her filing for bankruptcy he gained complete control over the LLC and was entitled to liquidate the property in the LLC and distribute the proceeds to the bankruptcy estate. The Colorado Bankruptcy Court agreed providing in part:
“[t]he charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having to involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.”
Other bankruptcy courts have since followed suit by favorably quoting Albright. Most notably, In Re A-Z Electronics, 350 B.R. 886(Bankr. Idaho 2006).
So what does this mean to you? In Kansas if you are operating a single-member LLC and you are considering filing personal bankruptcy you are running the risk that the bankruptcy trustee may be given full membership rights in your LLC and will have the ability to liquidate the non-exempt assets of your business in order to satisfy the claims of your personal creditors. Secondly, even if you never file for personal bankruptcy, a judgment creditor may still have the ability to successfully petition an appropriate court to acquire full rights to your LLC membership interest.
As of now it seems the only true entity affording both personal liability protection and charging order protection is a properly administered multi-member LLC. However, exercise caution before adding a new member to your business just for the benefit of gaining charging order protection on the off chance you may some day file bankruptcy or become subject to a personal judgment. There are many considerations that must be taken into account before bringing on a partner. First, by adding a partner you are converting from a single-member LLC to a multi-member LLC which is considered a formation transaction for tax purposes even though no actual new business is formed. Depending on how the transfer of membership is structured it could create income tax consequences for the existing LLC member. Secondly, you must be careful when adding a partner with a nominal interest such as 1% ownership. While the courts have not articulated that a minimum ownership amount is required, it is best to avoid any activity that can be viewed as a sham transaction by the court. In addition, you must pay close attention to the value of the property the acquiring member is either contributing or using for purchase in relationship to the membership interest he or she will be acquiring. If the new member does not pay or contribute fair market value for the membership interest it can create numerous difficulties for you under the Kansas Uniform Fraudulent Transfers Act. Finally, adding an additional member to your LLC raises a whole host of business planning issues. You will need to make sure you have a detailed operating agreement in place and a comprehensive buy-sell agreement should be considered.
When utilized properly a single-member LLC still affords the same personal liability protection as a corporation and offers much greater protection than a sole proprietorship. So if you operate an asset-light business a single-member LLC may be perfectly fine for you, but proper business and asset protection planning will always be dictated by your individual facts and circumstances. Please remember though with a single-member LLC it is absolutely vital that you strictly follow all corporate formalities when operating the business to ensure that it is viewed in the eyes of the court as a separate and distinct entity from yourself. If you currently operate your business through a single-member LLC , I suggest you consult with your attorney regarding the above considerations to ensure that you have taken the proper precautions to minimize your liability risk.
John Thompson is a shareholder with Kennedy Berkley Yarnevich & Williamson, Chartered assisting entrepreneurs, families and farmers in the areas of estate and business planning.