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07/10/14 It's the Law: LLC a Better Bet for Creditor Protection

It's The Law

LLC a Better Bet for Creditor Protection

(07/10/14)

Question:

We are starting a new company. I think we should be a corporation. One of the other investors says we should be a limited liability company because that will provide each of us more protection from our own creditors. Is he right?

Answer:

A limited liability company or a corporation both provide comparable protection of the owners from creditors of the entity. That means, if the company becomes insolvent, the owners' liability is limited to their investment in the company. Absent fraud or other wrong doing, the creditors of the company must look to the company for payment.

Both entities can obtain pass through tax treatment. That means the income of the entity is taxed to the owners even if it is not distributed. Otherwise, it would be double taxed. First, it would be taxed as income to the company. Later, when what was left after taxes is distributed to owners, the owners would pay income tax on that distribution.

A corporation has a rigid structure of directors, officers and shareholders. A limited liability company is more flexible, and has more in common with a partnership. One of the most important differences between the two entities is ability of an owner's creditors to take the owner's ownership interest to satisfy a debt of the owner.

Ownership in a corporation is evidenced by shares of stock and the owners are known as shareholders or stockholders. If the creditor obtains a judgment against a shareholder, the creditor can get the debtor's shares by levy on the stock through a writ of execution. The sheriff seizes the stock and later sells it for benefit of the judgment creditor. Proceeds from sale are applied to reduce the judgment debt and the buyer at sale becomes the new shareholder.

Owners of a limited liability company are generally known as members. Their ownership is usually evidenced by a membership certificate. Florida statutes limit the right of a member's creditor to attach the member's interest in a limited liability company.

Florida statutes provide that unless the articles of organization or the operating agreement of a limited liability company provide otherwise, an assignee of a limited liability company interest may become a member only if all members other than the assigning member consents. It would be expected that the members would not always consent to a member's assignee becoming a member. For that reason, another statutory provision provides that the sole remedy of a judgment creditor of a limited liability company member is to obtain a charging order against a member's interest in the company.

A charging order is a lien against the debtor's membership interest. Under a charging order, the creditor only has the right of an assignee to receive any distribution or distributions to which the owner would otherwise have been entitled from the company, not to exceed the amount of the judgment plus interest. The member debtor retains management rights and in consort with other members even potential ability to avoid distributions, be paid a salary from the limited liability company (which might be also protected by Florida's statutory exemption from garnishment for head of household). The member retains other ownership benefits and rights other than the right to distributions.

It might even be worse for a judgment creditor of a limited liability company member as opposed to a stockholder. The IRS has ruled that a judgment creditor obtaining a charging order against a partnership member must report the phantom income attributable to the debtor's partnership interest, even if it is not distributed. That means a creditor with a charging order against a limited liability company membership interest would be required to report and pay taxes on the income of the company proportionally attributable to the membership interest, even if it is not distributed.

Not all limited liability companies gets the special treatment. The statute carves out an exception for single member limited liability companies. When a limited liability company only has one member, if a court determines that distributions under a charging order will not satisfy the judgment in a reasonable time, the court may order sale of the interest in the company pursuant to a foreclosure sale. The purchaser at the foreclosure sale becomes the member of the company and the former owner ceases to be a member.

Because a limited liability company offers protection from an individual's creditors, it should be seriously considered as an alternative to creating a corporation. Some starting new businesses already have creditor problems. Others may fall into a creditor trap unexpectedly, as in an automobile accident. You should finalize considering options by consultation with an experienced attorney.

By: William G. Morris, Esquire

William G. Morris is an attorney with offices at 247 North Collier Boulevard on Marco Island, Florida. His practice covers a broad range of subjects, including civil litigation, real estate, business and corporate law, estate planning and probate, domestic relations and contracts. He writes this column periodically with respect to legal matters that frequently affect non-lawyers. The information contained in this column is not intended as legal advice and, of necessity, is generalized. For questions about specific circumstances, the reader should consult a qualified attorney.

Questions for this column can be sent to: William G. Morris, e-mail: wgmorrislaw@embarqmail.com or by fax, (239) 642-0722 or

The Marco Island Eagle

Other articles of interest can be viewed at our website, www.wgmorrislaw.com.

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